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.
Comparing Taxes on Treasury Bonds and CDs
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. Essentially, expect to find interest on government bonds taxable by your state or local government if the bonds are issued by a state or local agency and taxable by the federal government if they're issued by the federal Treasury. An exception is that municipal bond interest is generally tax-exempt in the state in which it is issued; thus, California muni bonds, for example, are usually exempt from California state tax.
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.
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 9 percent. These states include Hawaii, California, Oregon, Iowa, Minnesota, New York and New Jersey. Check your own state tax bracket to determine the benefit of Treasury bond interest.
To compare the interest rate from a CD with the rate from a Treasury bond and see if US Treasury bond prices and yields are a good deal, 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, say 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.
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.
Tax Exempt Government Bonds and Tax Credit Bonds
There are certain government bonds issued by state and local governments known as tax credit bonds. Rather than be exempt from federal tax, they effectively come with a tax credit that can be subtracted from federal taxes. In some cases, the tax credit can be transferred separately from the interest-bearing part of the bond.
Depending on your tax bracket and how the credits work, these can save you more in taxes than simply not paying taxes on interest on an ordinary municipal bond.
Taxes on Treasury Bonds and Municipal Bonds Under 2018 Tax Law
Whenever the federal or state governments change their tax policies, it can change which investments are most profitable after taxes.
Since federal tax rates are generally going down for the 2018 tax year, that can make the federal tax savings on municipal bonds less advantageous over other investments like CDs and Treasury bonds.
State and local governments are also generally not allowed to issue new tax credit bonds under the new tax law, though they can still issue ordinary municipal bonds exempt from federal tax.
Bonds, CDs and 2017 Tax Laws
Federal tax rates are generally higher in 2017 than in 2018. That can make the federal tax savings on municipal bonds more advantageous when those securities are compared to other investments such as Treasury bonds and CDs.
Video of the Day
- Bankrate: Tax Equivalent Yield Formula
- Tax Foundation: Top State Marginal Income Tax Rates, as of January 1st, 2012
- TreasuryDirect: Treasury Bonds -- Tax Considerations
- Investopedia: How Are Treasury Bills Taxed?
- Kiplinger: 8 States with the Highest Income Tax Rates
- BondBuyer: Tax Credit Bonds Are Gone. Now What?
- Investopedia: How Are Municipal Bonds Taxed?