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  • Writer's pictureTad Jakes

How to Maximize After-Tax Yield and Pitfalls to Avoid

Due to the Federal Reserve's rate hiking cycle, interest rates for many fixed-income securities are the highest we’ve seen since 2007.  For years, investors looking for income were discouraged by the paltry .01% interest earned in their savings accounts or the 1% to 2% they could earn on a 10-year Treasury note.  But investors are once again excited about fixed income as rates have moved substantially higher.  However, the allure of the stated yield can quickly diminish once taxes come into play, and to truly understand the benefit of a fixed-income investment, one must assess the after-tax yield.

This blog post will clarify the concept of after-tax yield, dissect the tax implications of various fixed-income securities, and provide tangible examples of how to compare the after-tax yield of your investments. 

What is After-Tax Yield?

After-tax yield is the actual rate of return earned on an investment after federal and state taxes are considered. It is a key metric for fixed-income investors, or any investor, as it reflects the true income generated from their investment.  However, bonds and cash investments, unlike stocks, generate returns primarily through interest payments, which can be subject to ordinary income tax and, depending on your tax bracket, could remove a substantial portion of your return.

The Tax Treatment of Fixed-Income Investments

There are many different fixed-income investments, but we will focus on the most common investments and products that investors encounter.

Savings Accounts and Certificates of Deposit (CDs)

Savings accounts and CDs are accounts or investments available through banks or credit unions, and pay an interest rate in return for leaving a lump sum on deposit.  In the case of CDs, the money typically can’t be accessed without penalty until the term has expired.  Interest income from these products is taxed as ordinary income at both the federal and state levels. This means the yield must be adjusted to reflect these taxes to understand the actual benefit to the investor.

Corporate Bonds

Corporate bonds are debt securities issued by corporations to fund their operations and growth. The interest income from these bonds is taxable as ordinary income at both the federal and state level.

Treasury Securities

Treasury securities, such as Treasury bonds, notes, and bills, are issued by the U.S. government. The interest earned on these securities is exempt from state and local taxes, but it is taxable at the federal level. This tax exemption can make Treasuries more attractive to investors in high-tax states and high tax brackets.  However, if you live in a state with no state income tax, the tax benefit of a Treasury is null, but these investments should not be overlooked as part of a diversified fixed-income portfolio.

Municipal Bonds

Municipal bonds are issued by states, cities, and other local government entities. One of the most significant advantages of municipal bonds, or "munis," is that the interest income is often exempt from federal income taxes and, if the investor lives in the state where the bond was issued, is exempt from state and local taxes as well.  This tax exemption can lead to a higher after-tax yield, particularly for investors in higher tax brackets.

Key Point: Municipal bond interest is not subject to the Net Investment Income Tax (NIIT), which is a 3.8% surcharge on investment income, including interest income, for higher earners who make over $200,000 for individual filers or $250,000 for married couples.  To keep this discussion simple, the examples below do not factor in the NIIT, but certainly keep it in mind if you are subject to this tax.

Computing After-Tax Yield

To compute the after-tax yield of a fixed-income investment, you must know your federal and state marginal tax rate.  This is the amount of tax you pay on your last dollar earned. If you don’t know your marginal tax rate, you can access the IRS tax table here.  As for your state’s tax tables, you’ll have to look that up on your own. 

Ready for a formula?  The formula for after-tax yield is:

After-Tax Yield = Stated Yield x (1 – (Federal Marginal Tax Rate + State Marginal Tax Rate))

That wasn’t too bad, right?  Here’s an example:

A CD pays 4.5% interest and you are in the 24% federal and 5% state tax brackets.  Your after-tax yield would be 4.5 x (1 - (.24 + .05)) or 3.2%.   If an investment is exempt from either state or federal taxes, you simply leave it out of the equation. 

Now, let’s say you live in California and you’re in the highest federal and state tax brackets, which is 37% and 13.3%, respectively.  Your after-tax yield would look like this:  4.5 x (1 - (.37 + .133)) or 2.2%.  Big difference and this doesn’t even account for the NIIT.

Real World Comparisons

Now that we understand the math, let's look at a real example based on current rates as of March 1st, 2024. 

Despite the lower nominal yield, the municipal bond offers the highest after-tax yield for this investor due to its tax advantages.  Investing $100,000 in the muni bond could net an additional $760 over the corporate bond.  If you’re investing $1,000,000, it’s $7,600.  Those tax advantages are magnified even more for those in higher income tax brackets or for those subject to NIIT.

Comparing Apples to Apples

As investors, we look to maximize our after-tax return. However, it’s important not to lose sight of some very important considerations.

  • Diversification: Loading up on one type of investment or one sector of the fixed-income market due solely to after-tax yield may not be prudent.  Just like equity investments, investors should look to diversify their fixed-income portfolio.  A lower after-tax yield from a less risky investment might be a beneficial addition to your portfolio. 

  • Credit Quality – Low quality fixed-income investments tend to pay higher yields than high quality investments.  In search of yield, make sure you’re comparing the credit quality of your investment options and aren’t overweighting your portfolio toward lower-quality investments and subjecting yourself to undue risk. 

  • Term: As a general rule, but not always, longer-term bonds or CDs pay higher interest rates than their short-term counterparts.  It’s possible a lower-quality short-term bond could pay a higher yield than a higher-quality long-term bond, so make sure you understand the dynamics of credit quality, term, and rates.

Strategic Considerations

Investors should consider the following strategies when selecting fixed-income investments:

  1. Match Investments to Your Tax Bracket: Higher tax brackets amplify the benefit of tax-exempt investments.  High-income investors may favor municipal bonds and Treasuries, while those in lower brackets might opt for securities with fewer tax advantages.  However, don’t lose sight of diversification and risk factors.

  2. Geographic Diversification: Investing in out-of-state municipal bonds can offer diversification, but be mindful of potential state tax liabilities.

  3. Tax-Advantaged Accounts: Holding taxable fixed-income assets in retirement accounts like IRAs can nullify the tax benefits of tax-advantaged investments.  Develop an “asset location” strategy where your most tax-efficient investments are in your taxable accounts and your tax-inefficient investments are in tax-advantaged accounts such as IRAs.

  4. State of Residence: Living in a high-tax state or a state with no income tax can affect the attractiveness of Treasuries and municipal bonds.

  5. Municipal Bond Tax Traps: Some municipal bonds may be subject to the Alternative Minimum Tax (AMT), which could reduce the tax benefits for certain investors.  Municipal bonds, if purchased at a steep discount, can be subject to de minimus tax, which can be taxed as capital gains or ordinary income depending on the level of the discount.  Additionally, some municipal bonds are taxable at the Federal level but often pay a higher interest rate to make up for it.  Lastly, although most municipal bond interest is not included in your income, municipal bond interest is factored into your Modified Adjusted Gross Income when determining the taxability of your Social Security benefits and the amount you pay for Medicare premiums.  Make sure you understand if any of the above apply.



After-tax yield is a chief consideration when investing in fixed-income securities as it provides a truer representation of the income one can expect to keep after taxes. By carefully considering the tax implications of various fixed-income investments, investors can make choices that align with their financial goals and tax situation. However, after-tax yield should not overshadow important factors such as investment objectives, investment time horizon, risk tolerance, and proper diversification.  As always, it’s recommended that you speak to a tax or investment professional who can help you better understand the nuances of tax laws and their impact on your investment portfolio.

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