David H. Kinder, RFC®, ChFC, CLU
What about Tax Equivalent Yield (TEY) investing?
Updated: Jan 18
Back in my designation studies, we certainly studied the tax code, but it was primarily focused on accumulating money, particularly in the most tax-efficient way as possible, not necessarily spending retirement wealth as tax-efficiently as possible. For those who had after-tax brokerage accounts, a popular tax-efficient strategy would be to invest in municipal bonds. Municipal bonds are federally tax-free, and if you bought state municipal bonds for your state of residence, they are state tax-free as well.
(Quick disclosure: this blog article is not giving any securities investment advice and is for educational and informational purposes only.) Note that municipal bonds *may* not make sense in a tax-deferred account such as a 401(k), IRA, or other similar accounts. They can make sense as part of an asset allocation strategy, but it doesn't make sense for an account that already has tax-deferral as it grows. Okay, so if you have an after-tax brokerage account, and you decide that you want to invest in municipal bonds... what is this 'tax equivalent yield'? Take a look at this chart:
What this chart is saying is that the tax-free yield is far more valuable the higher your particular tax bracket is. The actual net yield to your portfolio is 3.7%. If you're in the highest bracket, you'd have to earn 5.9% in order to NET the 3.7% after taxes.
Here's two problems that are not identified with this 'tax-efficient' method of investing:
This only affects at most TWO areas of the tax code while you are accumulating wealth: taxation on the federal level and possibly taxation on the state level (if you bought a state-issued municipal bond in your state of residence).
This method of investing has nothing to do with how efficiently you can SPEND your money in retirement.
Point #2 is probably the most hidden aspect of this, yet it is out there in the tax code for anybody to see it.
Here's the interesting thing: Non-taxable interest (such as interest earned from municipal bonds) is a factor in determining if your Social Security will be subject to being taxed!
Here's the link to the Social Security Administration about the taxation of benefits: https://www.ssa.gov/benefits/retirement/planner/taxes.html
Here's the Provisional Income formula as it applies for Social Security benefits:
Your adjusted gross income (such as from a job or distributions from a 401(k)/IRA)
+ Non-Taxable interest (such as from municipal bonds)
+ 1/2 of your Social Security benefits
= your "combined income"
Now, that may not be so bad while you're accumulating wealth... but tax-free isn't so tax-free when it comes to spending in retirement while you are collecting on your hard-earned benefits.
That's why we look at the Capital Equivalent Value for determining how much money you'd need in one of the MOST TAX-EFFICIENT PLACES... to spend money in the most tax-efficient manner... compared to having money in the LEAST (or less) TAX-EFFICIENT PLACES.
For more information on the Capital Equivalent Value, read this blog article here: https://www.davidkinderfinancial.com/post/2018/07/16/what-investment-rate-of-return-would-you-need-to-equal-the-tax-and-economic-contract-bene