I was snooping around the U.S. Treasury website looking up stuff on potentially laddering I-Bonds, when I came across Treasury Bills again. Treasury Bills are short-term investments (from 4-26 weeks usually) that common folk like us can also buy at TreasuryDirect.gov. The minimum investment is $1,000, and you buy them at a discount to their face value. In their example, you might pay $970 for a $1,000 T-Bill. I’ve never really bothered to learn much about them though, since their yields recently have beem much lower than online savings accounts like EmigrantDirect. For example, a recent rate for a 29-day T-Bill is 3.696%.
But, one key thing is that interest earned from T-Bills are exempt from state and local income tax. For example, if you were in the 28% federal tax bracket, and in a 10% marginal state income tax bracket, that’s 3.696% turns into 4.29%!!
Some things that cloud the picture are the fact that the price is set by auction, and it seems like you can’t participate directly in those auctions at TreasuryDirect – you just pay the rate that is decided at auction. But I would think the rates are somewhat predictible. Also, you could use laddering T-Bills to flatten out any rate swings. This definitely something I’m going to look into further. I might even buy one just to see how it works, since the maturities are so short. But anyone in a high tax state should take a second look.
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How do you figure that 3.696 % yield is 4.29 % if no state tax is charged on the interest.
Best I can get is that since we dont have to pay 10% state tax on the interest, the yield in 10% higher effectively (i.e. 3.696 + 10 % of 3.696 ) = 4.0656 % but this too may be optimistic if one itemizes on federal return as in tax case effective marginal state tax rate is ( 10% -28% of 10%) 7.2 %
Can you please explain how do you get 4.29 % effective tax yield
Yes you are right I am assuming that you are not itemizing your state tax paid, which some people do and some do not.
I was right with you on your logic before, but it’s not quite right. I’ll explain it better in my next post, I promise 🙂 Gotta finish homework.
3.696% pre-tax return – 28% for taxes = 2.66% return after-taxes.
But if you pay 10% state tax, then your effective tax rate is 38% (assuming you don’t itemize).
2.66% / (100%-38%) = 4.29% pre-tax equivalent.
If you do itemize your state taxes, then your effective composite rate is only 35.2%. This makes your pre-tax equivalent yield:
2.66% / (100%-35.2%) = 4.10% pre-tax equivalent
Could you explain what itemizing means and why it would make a difference? Furthermore, if your tax rate (fed and state included) is 38%, wouldn’t your pretax equivalent of 3.696% merely be 3.696/(100%-38%) = 5.961%? Why subtract 28% first then adjust for the lack of taxes?
Itemizing: When one is itemizing, once can deduct state taxes from their federal income. It makes sense to itemize only if sum of all things available for itemized deduction (state tax, property tax, mortgage interest, charity) is more than the statndard deduction (about $10,000)
When one itemizes, effectively federal government is giving you a discount ( by letting you reduce you taxable income by that amount)
So if you pay 20k in state taxes and are in 28% federal tax bracket, you dont pay federal tax on that 20000, saving you (20000*.28) 5600. Thus your effective state tax is reduced to 14400
I see that the bond help if you have state tax, Can you explain if it helps in a non taxed state?
No, it is not so attractive for states/counties/cities without local income taxes. In most cases it seems that there are bank alternatives that will pay more.