Calculating After Tax yield on CD

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Expro
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Calculating After Tax yield on CD

Post by Expro » Mon Jun 18, 2018 8:27 pm

I'm trying to decide whether to break a CD and either reinvest into a new CD or invest in a muni fund or bonds.

Yes, two different decisions.

First off. The original 5 year CD was chosen for a specific reason and that reason no longer exists. Basically it was to be cash for re entry to the US after an ex pat gig. Taxes weren't even much of a consideration then and 2.25% for the 5 years was fine. Today, there are no plans to re enter the US and my taxes are now much higher.

This CD matures in 32 months and has a rate of 2.25%

Current tax rate is 36.63% and will probably go to 41.63 next year. I'm using the 36.63 for now.

A CDs after tax yield is calculated on paid interest per year but the CD compounds without the taxes. So calculating the ATY is not so straight forward. I calculate ATY on this CD to be 1.51%

Have I made an error?

Shouldn't I use this after tax yield when comparing to munis when deciding to switch?

Choosing a muni fund or bond would mean looking at duration or maturity. I expect to need this cash in 5 years. So I should be looking at a muni bond maturing in June 2023 or an intermediate TE fund. Correct?

Any comments beyond fixing my bad math or odd assumptions?

Thanks
Last edited by Expro on Tue Jun 19, 2018 1:01 am, edited 1 time in total.

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Kevin M
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Re: Calculating After Tax yield on CD

Post by Kevin M » Mon Jun 18, 2018 9:34 pm

Expro wrote:
Mon Jun 18, 2018 8:27 pm
A CDs after tax yield is calculated on paid interest per year but the CD compounds without the taxes. So calculating the ATY is not so straight forward. I calculate ATY on this CD to be 1.51%
First, can you please explain this part a bit more? If in the US, you would pay taxes when the interest is credited to the CD, which normally would be annually at most. Are you saying you don't receive a 1099-INT showing any interest for the CD, or that you receive it, but for the way you pay taxes, you ignore it?

Calculating the after-tax yield for the CD normally is straightforward, but if we don't understand how you pay taxes, I don't know how we can check your math. Normally it would be 2.25% * (1 - 36.63%) = 1.43%. Your figure of 1.51% is slightly higher, which I assume is due to your assumption of not paying taxes until the CD matures, so less tax drag.

Also, is this a direct CD (purchased directly from bank or credit union) with an early withdrawal penalty (EWP)? If so, what is the EWP (typically expressed in years, months or days of interest lost when you do an early withdrawal). This is an important part of the calculation of whether or not it makes sense to break the CD and reinvest in something else.

For example, ignoring the tax aspects, you can get something like a 32-month brokered CD at about 3% now. If your EWP is six months of interest, you lose about 1.13% to break the CD, but since you can earn 0.75% per year more, you earn that back in about 1.5 years, and then get the benefit of the higher rate for the remaining term.

Or is this a brokered CD, in which case you would sell on the secondary market, probably taking a haircut due to higher interest rates, as well as probably a fairly high bid/ask spread.

Kevin
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Expro
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Re: Calculating After Tax yield on CD

Post by Expro » Mon Jun 18, 2018 9:54 pm

Kevin M wrote:
Mon Jun 18, 2018 9:34 pm
Expro wrote:
Mon Jun 18, 2018 8:27 pm
A CDs after tax yield is calculated on paid interest per year but the CD compounds without the taxes. So calculating the ATY is not so straight forward. I calculate ATY on this CD to be 1.51%
First, can you please explain this part a bit more? If in the US, you would pay taxes when the interest is credited to the CD, which normally would be annually at most. Are you saying you don't receive a 1099-INT showing any interest for the CD, or that you receive it, but for the way you pay taxes, you ignore it?
No. Nothing to do with taxes. I get the usual 1099 INT and pay the taxes annually for the interest the CD generates. My point was that the CD doesn't see these tax payments so the taxes remain within the CD for compounding. Maybe I am making this too complicated.
Kevin M wrote:
Mon Jun 18, 2018 9:34 pm
Calculating the after-tax yield for the CD normally is straightforward, but if we don't understand how you pay taxes, I don't know how we can check your math. Normally it would be 2.25% * (1 - 36.63%) = 1.43%. Your figure of 1.51% is slightly higher, which I assume is due to your assumption of not paying taxes until the CD matures, so less tax drag.
I used 2.25%-(2.25%*36.63%) = 1.426% but then created a spreadsheet with the actual numbers. I pulled the yearly interest out,calculated and subtracted the taxes. These yearly numbers were summed and the 1.51% was derived from there.
Kevin M wrote:
Mon Jun 18, 2018 9:34 pm
Also, is this a direct CD (purchased directly from bank or credit union) with an early withdrawal penalty (EWP)? If so, what is the EWP (typically expressed in years, months or days of interest lost when you do an early withdrawal). This is an important part of the calculation of whether or not it makes sense to break the CD and reinvest in something else.
Bank/Direct CD with 12 month EWP.
Kevin M wrote:
Mon Jun 18, 2018 9:34 pm
For example, ignoring the tax aspects, you can get something like a 32-month brokered CD at about 3% now. If your EWP is six months of interest, you lose about 1.13% to break the CD, but since you can earn 0.75% per year more, you earn that back in about 1.5 years, and then get the benefit of the higher rate for the remaining term.

Or is this a brokered CD, in which case you would sell on the secondary market, probably taking a haircut due to higher interest rates, as well as probably a fairly high bid/ask spread.

Kevin
I would break this CD, take the EWP and either reinvest into a new CD or more likely into a muni bond or fund.
Thanks

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grabiner
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Re: Calculating After Tax yield on CD

Post by grabiner » Mon Jun 18, 2018 10:06 pm

Expro wrote:
Mon Jun 18, 2018 9:54 pm
Kevin M wrote:
Mon Jun 18, 2018 9:34 pm
Expro wrote:
Mon Jun 18, 2018 8:27 pm
A CDs after tax yield is calculated on paid interest per year but the CD compounds without the taxes. So calculating the ATY is not so straight forward. I calculate ATY on this CD to be 1.51%
First, can you please explain this part a bit more? If in the US, you would pay taxes when the interest is credited to the CD, which normally would be annually at most. Are you saying you don't receive a 1099-INT showing any interest for the CD, or that you receive it, but for the way you pay taxes, you ignore it?
No. Nothing to do with taxes. I get the usual 1099 INT and pay the taxes annually for the interest the CD generates. My point was that the CD doesn't see these tax payments so the taxes remain within the CD for compounding. Maybe I am making this too complicated.
However, the money you pay in taxes is money you can't invest, so it has the same effect as if you had taken it out of the CD. Losing $1000 to taxes four years before your CD matures costs you the amount in four years that you could earn by investing that $1000 in a new four-year CD.

If rates change, this isn't quite a match, but the difference is trivial. Suppose that you invest $100K in a five-year CD yielding 3%, and you are in a 33% tax bracket. One year later, four-year CDs yield 2%. Because you didn't pay the taxes from the CD, you have $990 in a four-year CD yielding 3% (which grows to $1073 after tax), rather than in a four-year CD yielding 2% (which grows to $1044 after tax). This is a difference of $29 in net value of the $3000 income, so your effective tax rate was 32% and not 33%.
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Re: Calculating After Tax yield on CD

Post by Expro » Wed Jun 20, 2018 4:12 am

Thanks for the responses.

So I am going to use these figures for after tax yield when comparing this CD and the candidate muni bonds or funds I find.

Am I wrong to think that, at my tax rate and with no short term need for the money - need is out past 4 or 5 years, I am thinking - that a CD would be a poor choice?

Choices for funds would be MUB and MEAR if the cash landed in Fidelity or VWIUX and VWSUX if in Vanguard.

Comments?

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Kevin M
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Re: Calculating After Tax yield on CD

Post by Kevin M » Wed Jun 20, 2018 12:59 pm

You need to factor in the EWP of 12 months of interest on your existing CD. Using this calculator, https://www.depositaccounts.com/tools/b ... lator.aspx, you will find that you must earn a taxable-equivalent yield (TEY) of about 3.15% on a 32-month security to make breaking the CD barely worth it.

At a 36.3% federal marginal tax rate, that equates to 2.00% tax free = 3.15% * (1 - 36.63%).

On Fidelity's yield summary page, I see 2-year AAA muni at 1.89%, and 3-year at 2.08%. That's before commission of 0.1%, so knock the 2-year down to about 1.84% (amortize 0.1% over two years) and the 3-year down to about 2.05%.

If you wanted to take a bit more credit risk, I see 2-year AA at 1.96% and 3-year at 2.30% before commission, so 3-year after commission about 2.27%.

So it looks like breaking the CD and investing in a 32-month AA muni might barely be worth it. Not sure I'd bother considering the complexity of evaluating munis.

Personally, I would not extend maturity beyond three years, as the muni yield curve flattens out too much after that.

I know nothing about ex-pat taxation, but I assume that you pay no US state income tax. Otherwise, for high state income tax, Treasuries could be a better deal.

The term risk of a fund does not decrease as the target liability date approaches, as it does with an individual fixed-income security (CD or muni), so there is uncertainty in the return over a 5-year period (or any period really). With this in mind, SEC yield of VWSUX (short-term muni) is only 1.65%, so doesn't meet the required 2% threshold. SEC yield of VWIUX (intermediate-term muni) is 2.45%, so it meets the threshold, but with significantly more term risk than the CD (fund has a duration of 5.1 years).

Kevin
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Re: Calculating After Tax yield on CD

Post by Expro » Wed Jun 20, 2018 10:31 pm

Kevin M wrote:
Wed Jun 20, 2018 12:59 pm
You need to factor in the EWP of 12 months of interest on your existing CD. Using this calculator, https://www.depositaccounts.com/tools/b ... lator.aspx, you will find that you must earn a taxable-equivalent yield (TEY) of about 3.15% on a 32-month security to make breaking the CD barely worth it.

At a 36.3% federal marginal tax rate, that equates to 2.00% tax free = 3.15% * (1 - 36.63%).

On Fidelity's yield summary page, I see 2-year AAA muni at 1.89%, and 3-year at 2.08%. That's before commission of 0.1%, so knock the 2-year down to about 1.84% (amortize 0.1% over two years) and the 3-year down to about 2.05%.

If you wanted to take a bit more credit risk, I see 2-year AA at 1.96% and 3-year at 2.30% before commission, so 3-year after commission about 2.27%.

So it looks like breaking the CD and investing in a 32-month AA muni might barely be worth it. Not sure I'd bother considering the complexity of evaluating munis.

Personally, I would not extend maturity beyond three years, as the muni yield curve flattens out too much after that.

I know nothing about ex-pat taxation, but I assume that you pay no US state income tax. Otherwise, for high state income tax, Treasuries could be a better deal.

The term risk of a fund does not decrease as the target liability date approaches, as it does with an individual fixed-income security (CD or muni), so there is uncertainty in the return over a 5-year period (or any period really). With this in mind, SEC yield of VWSUX (short-term muni) is only 1.65%, so doesn't meet the required 2% threshold. SEC yield of VWIUX (intermediate-term muni) is 2.45%, so it meets the threshold, but with significantly more term risk than the CD (fund has a duration of 5.1 years).

Kevin
Thanks very much for the reply, Kevin. I think I am on the same page as you now - after doing more spreadsheets etc. lol.
At this point it's about a wash when breaking this CD so I'll just leave it as is for now. Regarding your last paragraph, thanks for making clear what I have been suspecting. There's still a chance that I will accept more term risk and opt to go with VWIUX but some details of the work gig need to be confirmed before I commit.

As for the ex-pat taxes, in my case it is all hypo tax. I pay my home state income tax. I should have moved my domicile to Texas before all this...

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Kevin M
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Re: Calculating After Tax yield on CD

Post by Kevin M » Thu Jun 21, 2018 2:46 pm

Expro wrote:
Wed Jun 20, 2018 10:31 pm
As for the ex-pat taxes, in my case it is all hypo tax. I pay my home state income tax. I should have moved my domicile to Texas before all this...
With hypo tax do you get the state tax exemption on US Treasury interest? If so, you should factor your state income tax into your taxable-equivalent yields, or after-tax yields if you prefer. I still looks unlikely that you will benefit much if at all by breaking the CD and paying the EWP.

Kevin
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