What’s Best -Tax-Free or Taxable Interest Income?

• Posted on June 9, 2011
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A frequent taxpayer question is whether it is better to invest for tax-free or taxable interest. Generally, taxable interest will provide the greater return, but this may not hold true after taking into account taxes on the income. Therefore, the question is really which provides the greater "after-tax" return.  There are basically four types of interest that can be excluded from income, either on the Federal or state return, and each has its own special considerations.

• Municipal Bond Interest – Interest earned from municipal bonds is generally tax-exempt for Federal purposes.  However, some states may tax municipal bond interest from bonds from other state municipalities.  Hence, there are two categories of municipal bonds, namely the tax-free Federal and state and the tax-free Federal only.  Note: For those drawing social security, even though the income itself is tax-free, it is included in the computation used to determine how much of your social security income is taxable.
  
  
• Private Activity Bond Interest – Some municipal bonds, classified as Private Activity Bonds, are tax-free for purposes of the regular tax, but may be taxable for purposes of the Alternative Minimum Tax (AMT).  If a taxpayer is subject to the AMT, then the interest from these bonds may be taxable to some extent.
  
  
• U.S. Government Bond Interest – By Federal law, direct obligations of the U.S. government cannot be taxed by the states.

So how do you determine which interest is best?  You must determine the after-tax return for each type of income and then compare them to determine which is best.  Because the differing tax brackets, state taxes and other considerations impact the results, each taxpayer must make that determination based on their own specific circumstances.  Use our calculator to determine which is best for you.