How to Find the Highest After-Tax Yields

The highest-yielding investment might not pay you the highest after-tax income. That is because of the different tax rates created by the 2003 tax law. Investors who seek the highest yield following the old rules might have less cash to spend than they could have.

Interest from bonds, certificates of deposit, money market funds, real estate investment trusts, and some other investments is taxed as ordinary income. That means it incurs a tax rate of up to 35%, plus any state income taxes. Most corporate dividends, however, are taxed at only 15%.

That is quite a differential. It means that an investor has to examine the after-tax yield more carefully when choosing investments for income. In the past, the after-tax yield had to be compared only when choosing between taxable bonds and tax-exempt bonds. Now, all income investments need to be tested.

Suppose Max Profits is in the 35% ordinary income tax bracket. He is looking to invest some money primarily to pay income. He considers investing in corporate bonds paying 6% and thinks they cannot be beat. Then, he realizes that since 35% of the interest will be paid in taxes, after taxes his yield would be only 3.90%. That is computed by taking 1 minus .35 to arrive at .65. Multiply .65 by 6% to get 3.90%.

Max casts about for stocks with high dividend yields subject to the 15% tax rate. He spots a company he likes with a stock yielding 4%. He does the same computation. Max subtracts .15 from 1 and gets .85. Multiplying the yield by .85 reveals an after-tax yield of 3.40%. The corporate bonds still have a higher after-tax yield.

Here’s another way Max can evaluate his yield opportunities.

Suppose Max likes a stock with a 4% dividend yield that is eligible for the 15% tax rate. What yield does a taxable bond or other investment facing the ordinary income tax rate need to provide a higher after-tax return?

Max first computes his after-tax yield on the stock and gets 3.40%. Then he again subtracts the ordinary tax rate of .35 from 1 to arrive at .65. He divides this into his after-tax dividend yield of 3.40%. The result is 5.23%. Any ordinary income investment with a pre-tax yield higher than 5.23% will provide Max a higher after-tax yield than the stock.

These examples show how important it is to consider taxes when seeking an income investment. You must get the tax rate right when comparing after-tax yields. Some high yield stocks, such as real estate investment trusts, face the ordinary income tax rate. Preferred stock is a more difficult issue. There are several types of preferred stocks; some qualify for the 15% rate but most do not. To be sure, check with the company’s web site, shareholder services department, or with your broker.

There are risks other than taxes to consider. Volatility and the risk of a permanent capital loss are important factors. A bond, if held to maturity, will not lose money unless the issuer declares bankruptcy and there aren’t enough assets backing the bond. But many bonds can be called, or redeemed, before maturity. That requires you to reinvest when yields are lower. A stock could suffer a price decline in a bear market or a permanent decline if the company’s business deteriorates. A corporation also might reduce its dividend.