There are many investments out there that are exempt from certain taxes. For example, U.S. Savings Bonds and Treasury Bonds are exempt from state and local income taxes. In addition, there are money market funds available that are exempt from federal income tax and others that are even exempt from a specific state or city’s income taxes.
Therefore, it is desirable to know what the equivalent fully-taxable rate is for one of these investments. For example, is it more profitable to earn a federal tax-exempt interest rate of 3.8% or a fully taxable 5.0%? How about a Treasury Bill paying 4.8%? Several variables affect this rate, including your marginal tax brackets for each area, as well as if you itemize your state and local taxes on your federal tax return. I could not find a calculator that accurately captured all of this, so I made my own.
(You may need to be on the individual post page for it to work.)
Let’s say you live in California, and your marginal federal tax rate is 25%, your state rate is 9.3%, and you have no local income taxes. You do not itemize your taxes. You are trying to compare the taxable Vanguard Prime Money Market Fund (VMMXX, yielding 5.08%), the federally exempt Vanguard Tax-Exempt Money Market Fund (VMSXX, yielding 3.48%), and the state and federal tax-exempt Vanguard California Tax-Exempt Money Market Fund (VCTXX, yielding 3.38%).
With that profile, the tax equivalent 7-day yields would be 4.804% for VMSXX, and 5.145% for VCTXX, making the California Tax-Exempt Fund the best bet currently for this specific situation.
How It Works (Warning: Math Ahead!)
The calculator computes the tax-equivalent rates by comparing after-tax returns. That is:
Using the California Tax-Exempt Fund example above:
So earning 3.38% free from federal and state taxes is the same as earning 5.145% in a fully taxable account.
Note that itemizing deductions means that you deduct your state income taxes from your federal taxable income. The effect is that your overall tax liability is reduced, which lowers the benefit of any tax-exemptions and thus the equivalent rates. That would change the previous equation to:
The inclusion of this option may give different results from some of the other online calculators out there, but I believe it makes the results more complete. Another fully-worked-out example can be found here for savings bonds.
Finally, it may be handy to use this in conjunction with my Ultimate Interest Rate Chaser Calculator. Be sure to compare APRs to APRs and APYs to APYs.