Evaluating investment options involving tax-exempt income.

Facts

James has a management position with the DEF Company. His wife is not employed, but instead chooses to care for their two young children at home. James's taxable income is $40,000 ($60,000 of salary less $20,000 of deductions and exemptions).

A close relative who recently passed away bequeathed James $150,000. He wants to invest this money in a relatively safe long-term investment and has identified two investment vehicles. One alternative involves placing the money into AAA-rated insured bonds producing tax-exempt interest of 7%, while the other alternative is the purchase of GNMA bonds producing taxable interest of 9.5 %.

James's Federal tax rate for the current year is 28 %, and his state tax rate is 4%. He asks his tax adviser for an evaluation of the alternatives.

Issue

Which alternative produces the larger after-tax yield?

Analysis

The interest on the AAA-rated insured bonds, because of its tax-exempt status, provides an after-tax yield of 7%. However, the adviser must determine the after-tax yield of the GNMA bonds in order to compare the two investments. The after-tax yield of the GNMA bonds can be determined using the following formula:

Pretax yield x (1 - Federal tax rate - state tax rate) = After-tax yield

In this case, the after-tax yield of the GNMA bonds would be 6.46% (9.5% x (1 - 0.28 - 0.04)).

Conclusion

Because the after-tax yield of the AAA-rated insured bonds (7%) is greater than the after-tax yield of the GNMA bonds (6.46%), the tax-exempt bonds appear to be the better investment. As an additional point, if other investments that produce fully taxable interest are being considered, the adviser will want to inform his client of the point at which it becomes more attractive to invest in such alternatives. This point is reached when the yield of the alternative investment equals the pretax yield of the tax-exempt bonds. Given the stated facts, the pretax rate can be computed as follows:

After-tax yield /

(1 - Federal tax rate = Pretax yield

- state tax rate)

7% / = 10.29% / (1 - 0.28 - 0.04) = 10.29%

Therefore, if James can find an alternative that has a pretax yield in excess of 10.29%, the investment would have a better after-tax yield than the tax-exempt bonds and, in this context, would be considered the better investment. However, other factors (such as liquidity, market risk and safety of principal) may override yield.

Variation

Assume that the exempt bonds are private activity bonds and James's income is significantly greater. In this case, James expects his current year income (before consideration of the additional investment income) to be $120,000, and his deductions and exemptions to be $30,000.

This puts James in the 31% tax bracket and, at first glance, would appear to yield the same results as the preceding analysis. The after-tax yield of the GNMA bonds is now expressed as follows:

After-tax yield = 9.5% x (1 - 0.31 - 0.04) = 9.5% x 0.65) = 6.175%

As before, the after-tax yield of the tax-exempt bonds (7%) is greater than the after-tax yield of the GNMA bonds (6.175%) and would appear to be the better investment. However, at this point, an additional consideration becomes necessary. Because of the higher income level and the fact that tax-exempt interest on private-activity bonds constitutes a tax preference item, the alternative minimum tax (AMT) becomes a factor. If the tentative minimum tax exceeds the regular tax, James's income will be subject to AMT. Assuming that AMT applies, any additional taxable income and tax preference items (that is, tax-exempt interest) would be taxed at the 26% AMT rate. The evaluation must now include the effects of the AMT rate and would be computed as follows:

Private-activity bonds   7% x
(tax-exempt interest)    ( 1- 0.26) =
                         5.18%
GNMA bonds               9.5% x (1-
(taxable interest)       0.26 - 0.04)=
                         6.65%

In this case, the after-tax yield of the GNMA bonds exceeds the after-tax yield of the tax-exempt bonds and, in terms of yield, is the better investment alternative. Note: The after-tax yield of private-activity bonds will be reduced by anywhere from 1% to 26% of their pretax yield, depending on the exemption phase-out and the relationship between regular tax and AMT.