Treasury Bond vs. CD Interest Tax

Treasury securities and bank certificates of deposit are two maximum-safety investments competing for investor dollars. Although both pay interest that is taxable, Treasury bonds have a slight tax bill edge. Doing some taxable-equivalent math will let you pick the best option based on the yield from the CD and the Treasury bond.

Treasury Tax Benefits

The interest earned from a CD is taxable for both federal and state income taxes. Interest from a Treasury bond is also taxable at the federal level but is exempt from state income taxes. Think of Treasury bonds as the opposite of municipal bonds. Muni bond interest is tax exempt at the federal level and taxable at the state level. Because Treasury interest is not taxed on your state income tax, it leaves you with more after-tax money than you would get with a CD with the same yield.

State Income Tax Rate

The extra benefit from the state-tax-exempt status of Treasury bond interest depends on your state income tax bracket. A handful of states do not have state income taxes, so these states offer no additional benefit for Treasury bonds over CDs. At the other end of the spectrum are states with top tax brackets near or above 10 percent. These states include Hawaii, California, Oregon, Iowa, New York, New Jersey and Maine. Check your own state tax bracket to determine the benefit of Treasury bond interest.

Tax Equivalent Yield

To compare the interest rate from a CD with the rate from a Treasury bond, calculate the state-taxable-equivalent yield of the Treasury bond. The equivalent yield is determined by dividing the Treasury bond yield by one minus your marginal tax rate. As an example, your state income tax rate is 8 percent and the Treasury bond you are looking at yields 3 percent. One minus 8 percent -- 1 minus 0.08 in decimal form -- gives 0.92. Divide the 3 percent by 0.92 to get a taxable equivalent yield of 3.26 percent. A CD must yield more than 3.26 percent to be a better deal than the Treasury bond.

Finding Rates

The function of the bond markets is to set the rates and yields for Treasury bonds. If you are looking at Treasuries, the only choice is what term to maturity to pick based on the yields at different maturities. CD rates, on the other hand, are set by individual banks, and the rates are calculated to both be competitive and attract customer deposits. Once you have calculated the taxable equivalent yield of a Treasury bond, you can shop CD rates from different banks to see if a higher after-tax return is available.

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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