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Treasury Bonds Versus CDs in a Rising Rate Environment


Since the financial crisis in 2008, CD rates have been consistently higher than equivalent term Treasury notes (notes have a maturity between one and 10 years). As a result, in most cases, an investor could get a better rate if they looked to CDs. As the chart below shows, this calculus has changed a bit over the last six months as the rates on Treasuries have shot up with the accelerating economy.

5-Year Treasury Yield History

So, if you have a chunk of money to invest in a risk-free asset, which will be it be: CDs or Treasury notes?

Return comparison

A current comparison of Treasuries versus the best CD rates from DepositAccounts.com shows the following:

Comparison of Treasury Note Yields to the Best CD Rates

TermTreasury YieldBest CD Rate (APY)
1 year 2.05% 2.25%
2 years 2.27% 2.51%
3 years 2.43% 2.56%
5 years 2.64% 3.00%
The above yields and APYs were sampled on 3/12/18. Please refer to our CD rate tables for the latest APYs.

As the chart above shows, Treasury note rates are close to CD rates now. And this chart includes the best rates from across the country. Treasury rates are above the average CD rate for the most common terms.

Because income from Treasury notes is state and local tax-exempt, their return against CDs is even more favorable in high-income tax states. In a state with a flat 5.1% income tax rate like Massachusetts, the return comparison looks like the following:

TermTax Equivalent Yield at 5.1%
State Income Tax Rate
Best CD Rate (APY)
1 year 2.16% 2.25%
2 years 2.39% 2.51%
3 years 2.56% 2.56%
5 years 2.78% 3.00%
The above yields and APYs were sampled on 3/12/18. Please refer to our CD rate tables for the latest APYs.

For someone living in California at the top tax bracket of 13% (people earning over $1,000,000/year), the analysis looks like:

TermTax Equivalent Yield at 13%
State Income Tax Rate
Best CD Rate (APY)
1 year 2.36% 2.25%
2 years 2.61% 2.51%
3 years 2.79% 2.56%
5 years 3.03% 3.00%
The above yields and APYs were sampled on 3/12/18. Please refer to our CD rate tables for the latest APYs.

From a return standpoint, Treasury notes and CDs are virtually indistinguishable right now. But there are reasons to consider one over the other.

Liquidity

Investors can sell their Treasury notes at any time on a very active secondary market in increments of $100. This gives an investor the flexibility of determining when to sell their notes and how much of their portfolio to liquidate.

Depositors who sell their CD before the end of the term (“breaking the CD”) must pay a penalty, which can often eat up a significant chunk of the return. CD breakage penalties range from three to 12 months of interest, often wiping out a significant portion of the deposit’s return. In many cases, you must sell the entire CD. Partial early withdrawals of principal are often not allowed.

Institutional risk

Both Treasury notes and CDs are extremely safe investments. Treasuries are backed by the full faith and credit of the United States. There has never been a missed payment, although it’s been close in the past few years when the government deadlocked on the authorization to raise the debt limit. Investors can hold as much in Treasuries as they would like, meaning there is no limit to the size of the guarantee the government will provide an investor.

CDs are backed by the FDIC up to $250,000 per institution, per individual, for each account ownership category. To receive over $250,000 in protection within one ownership category, an individual must open a CD at another institution or have a spouse open the CD at the same institution. To deposit large sums of CD money and still be covered by the FDIC, an individual has to open multiple accounts at several different institutions. FDIC-insured depositors have never lost money since the establishment of the FDIC during the Great Depression in 1933.

When a bank is closed or fails, the FDIC moves in quickly to ensure that all FDIC-insured deposits are kept whole. During the financial crisis, failed banks were often shut down on a Friday, and the money was available to deposit by the following Monday.

Although depositors who remain below the FDIC limits are made whole in the case of a bank failure, the FDIC or a bank that assumes the failed deposits is not required to honor the original CD rates of the failed bank.

CDs at federally-insured credit unions are backed by the NCUA with coverage limits that mirror the FDIC’s.

Interest-rate risk

If you plan to hold Treasury notes and a CD to maturity, then both instruments will pay you the listed rates and you will receive your principal back. But, if you need to exit early from an investment, there are differences. Treasury prices fluctuate on a day-to-day basis based on the economy, creating what is called interest-rate risk. In a rising rate environment, the market value of a Treasury will decline as interest rates climb. Investors would rather purchase a new treasury at the higher rate, and to get them to purchase a lower yielding Treasury, the market value must be marked down to equalize the return. An investor who needs to liquidate their position might be forced to sell with a loss of principal. If interest rates jump, depending on the duration of the note, an investor could lose a significant amount of principal.

If interest rates rise after the opening of a direct CD, the value of the CD will not change like with Treasuries. That’s because CDs are not liquid and are not meant to be bought and sold. If an investor decides they want to take their money out before the end of the term and reinvest it in a higher yielding CD, they’ll need to “break the CD.” This often results in a penalty to the interest earned and rarely in the principal invested. These penalties are explained in the CD terms and conditions. DepositAccounts provides a calculator to help investors calculate these breakage fees.

Transaction ease

You cannot walk into a bank branch and purchase a Treasury note. Treasuries can be purchased online from the Treasury website at Treasurydirect.gov or from a brokerage. There are no fees to purchase notes from the website. Brokerage charges are generally $0 for new issues and very low fees ($1 per bond) for secondary market transactions. The fee can be higher to buy and sell via a phone or branch transaction. Using Treasurydirect.gov or an online brokerage will require the user to set up an account and send the funds via an electronic bank transfer.

CDs can be opened and funded by walking into most bank branches or using online banking. There is no fee to open a CD. The best CD rates are generally offered by online banks, and require the depositor to open an account online and use an electronic bank transfer to send the funds, much like a Treasury transaction.

Laddering

Both CDs and Treasury notes can utilize many of same investing strategies to generate cash and minimize interest rate risk. One of the most common of these is laddering. While laddering can be done with both Treasuries and CDs, there are some key differences.

Investors ladder CDs to make their portfolio more liquid and to also minimize interest-rate risk. DepositAccounts has a good article on CD laddering here.

Treasuries are already liquid so there is no need to ladder them for this reason. Instead, investors ladder Treasuries to smooth out interest-rate risk and to provide a predictable flow of income.

Like CD laddering, Treasury laddering involves purchasing notes in a variety of terms. For example, an investor could purchase 1-, 2-, 3- and 5-year treasury notes. As the 1-year note matures, the money can then be reinvested into a new 5-year note. There are some nuances to when a Treasury payment is made and when to reinvest, but between new issues and purchasing notes on the secondary market, an investor can generally maintain their ladder. If interest rates rise during this period, the money can be reinvested at this new higher rate. Laddering ensures that money is always coming due and being reinvested at the prevailing market rate, reducing interest rate risk.

Which way to go?

So, should you put your money into a CD or a similar term Treasury note? Until recently, the answer for those interested in maximizing income was to go with the higher yielding CD. But the recent spike in interest rates provides investors with another alternative to earn some yield on a no-risk investment. Which to choose depends on personal circumstances and preferences. For savers long suffering from low rates, a second alternative is welcoming news.

Comments
UCLA
UCLA   |     |   Comment #1
treasuries pay semiannual interest
cd's most often pay interest monthly or quarterly

there are "funds" that hold exclusively treasuries
I don't know of any "funds" that hold CDs exclusively

treasuries do not have a survivor option
brokered CDs most often have a survivor option (put it back to bank at par)

Either a treasury or a brokered CD can be distributed "IN KIND" to satisfy RMD

treasury rates are the same for minimum or jumbo purchase
CD rates are higher for JUMBO purchase

just some extra thoughts
anonymous
anonymous   |     |   Comment #3
For investors who have brokerage or mutual fund accounts, Treasury bond funds may be perhaps the easiest method to add Treasuries into their mix.

Treasury bond funds do behave differently from the underlying Treasury bonds. Principal is not guaranteed and will fluctuate with market rates. They may be either active (bond fund manager tries to buy and sell bonds to try to increase the return, which sometimes can lead to gains or losses) or passive (following a Treasury bond index).

A low-cost Treasury bond fund should, over time, have roughly a similar return as a Treasury bond (or Treasury note) ladder with the same duration. Duration is a measure of interest rate sensitivity. I think a 1-5 year Treasury note ladder would probably be best replicated with a short-term Treasury bond fund (~2-3 year duration) but I'd be interested in other's opinion on this.
Helpful Phil
Helpful Phil   |     |   Comment #5
The "Tax Equivalent Yield" calculations are incorrect. You cannot ignore the federal tax rate when doing the calculation. The good news is that the accurate tax equivalent yields are even better than the ones listed above. The higher your marginal federal rate, the better the tax equivalent yield.
Anonymous
Anonymous   |     |   Comment #6
I think CD interest and Treasury interest are taxed the same at the federal level as the article states, so comparison seems correct to me. I you think the article is wrong please provide more details as to what exactly is the difference you are referring to.

Perhaps Helpful Phil is suggesting that after federal tax, the difference will be smaller between the two but that goes both ways - when Treasuries are higher yielding than CDs (like in California for highest bracket), then on after-tax basis that difference will be smaller as well.
Helpful Phil
Helpful Phil   |     |   Comment #9
Assumptions:
1) CD Rate = 2%
2) State Tax Rate = 13%

Person A with a federal tax rate of 22% has a tax-equivalent yield of 2.4%. Person B with a federal tax rate of 32% has a tax-equivalent yield of 2.47%.

Your federal tax rate cannot be ignored. The math used in the article is too simplistic. Run the numbers for yourself.
Anonymous
Anonymous   |     |   Comment #11
Helpful Phil, I think you are missing the point. Comparison is not about same CD rate for different tax brackets but it's about CD vs Treasury yields after taxes for same federal tax bracket. Yes, the article just accounts for state/local tax rate because adjusting for Federal tax is likely going to result in same effect on both, so it's omitted.

The only way federal tax might get affected that I can think of is when state/local taxes are itemized on federal tax. However for larger tax brackets, you are more likely to be in AMT, in which case state/local taxes won't get deducted at all.

If you still think there is a difference, please describe it qualitatively - what exactly is causing the difference between CD and Treasury rates as far as federal taxes go?
Bozo
Bozo   |     |   Comment #14
Anonymous (re comment # 11). You are correct, I believe. The Taxable Equivalent Yield (TEY) is relevant only where CDs (and similar) are subject to state/local tax.

Example: Joe lives in Texas. Joe is subject to no state or local income tax. Joe buys a Treasury for 3%. The TEY is 3%. Jane, on the other hand, lives in California. She buys the exact same Treasury. She's a high-earner, and her marginal state-income tax bracket is 13%. Her Treasury interest is state-tax exempt. Her TEY (i.e., the equivalent yield she would need to earn on a CD) would be higher than 3%.

The "delta" in the TEY is caused by the exemption (or lack thereof) in state/local taxes.
Bozo
Bozo   |     |   Comment #16
Further to my comment # 14, as a general rule, Treasuries are a better "deal" for high-earners in states and locales with progressive state/local income tax rates.
Lrdx
Lrdx   |     |   Comment #17
No, Phil is right.

If Jane of CA buys a 3% treasury, then if she has an AGI of $150k and is married filing jointly, then her tax bracket is 22% fed + 9.3% CA. Her 3% treasury will yield 3%*(1-0.22) = 2.34%. That's equivalent to a taxable CD's after-tax yield of 3.406% [ 3.406 * (1-0.22-0.093) = 2.34 ].

If Jane has an AGI of $501k, then her tax bracket is 37% + 9.3%. The 3% treasury yields 1.89%. You need a CD that gives 3.52% to get the same yield [3.52%*(1-0.37-0.093) = 1.89].

Jane had 9.3% state tax in both cases, but the TEY was 3.406% in one case, 3.52% in another; the difference is ~0.11%.
figures
figures   |     |   Comment #18
Lrdx and Phil are wrong.

This article is about the broad choice between CDs and Treasuries.

As Ldrx points out, even in extreme cases, the federal tax rate makes little difference, and is unlikely to alter the choice between a CD or Treasury.

Of course, if a person is making several million dollars per year, and Treasuries are in a narrow sweet spot, a spreadsheet will be helpful.
Lrdx
Lrdx   |     |   Comment #19
The wrong math (the same of the article) would've got Jane a 3.31%. The correct math gives you 0.1%-0.21% higher numbers.

Maybe the difference is small, but the math of the article is still wrong.
Lrdx
Lrdx   |     |   Comment #20
With the new tax law, AMT is hardly a concern, but the $10k limit on the state/local tax deduction is.
Helpful Phil
Helpful Phil   |     |   Comment #21
You either understand math or you don't. Run some basic calculations such as the one I presented above. Ignore itemizing deductions, AMT etc. Keep it basic. If you can't see how the assumed federal rate affects Tax Equivalent Yield, then you don't understand math.

I'm not claiming the differences are large. But I expect an article written on this site to be at a higher level of sophistication.
figures
figures   |     |   Comment #23
How about the article's failure to acknowledge even a basic understanding of bank and credit union insurance?

Of course the federal tax rate impacts the after tax yield.

The question is, is the change large enough to make a Treasury of CD more attractive than the other? Generally no.

Unlike Phil, I don't expect any of the commentary or comments on this site to be particularly insightful. The basic data is the only purpose.
CuriousDave
CuriousDave   |     |   Comment #24
Helpful Phil, it seems you may be talking about U.S. Savings Bonds (USSBs) rather than U.S. treasury bills and bonds. Interest on USSBs is exempt from state income tax, as are U.S. treasuries, but, although federal tax is imposed on both kinds of bonds, federal tax on interest on USSBs is deferred until redemption, by default (although the owner can elect out of the default and be taxed on annual earned interest). However, USSBs are out of most discussion nowadays because of (1) the relatively low personal annual dollar limits on the purchase of Series EE and Series I Savings Bonds and (2) the current ultra-low fixed interest rate component of the composite interest rate used (and, until recently, also the ultra-low inflation rate component).
steved
steved   |     |   Comment #25
Phil is 100% correct. The intuitive understanding is that what matters is how much state taxes consume of the money you have left after paying federal taxes. Since a higher federal rate means you have less left, state tax is more significant.

If you want the math, the formula is:

CD-equivalent rate = T-bill rate * (1-fed tax rate)/(1 - fed tax rate - state tax rate)

The difference is actually pretty significant (more than 0.2%) if you're in a high Federal and state bracket like the second table.

I think it would be worth it for DepositAccounts to update this article.
Reader
Reader   |     |   Comment #28
Wow! We are approaching space science math! The formula in #25 is only correct if you do not deduct the state tax paid on the interest income on your federal return (or you are subject to AMT which disallows the state tax deduction). Admittedly, fewer people will claim this deduction now due to the new $10K cap on SALT deductions.
David
David   |     |   Comment #77
Gosh, what a mess of commentary! I'm in California and have taxable income of $130k. The difference for me works out to 11%, per Fidelity's tax equivalent yield calculator. So for round math, if I earned 2.00% on a Treasury or Agency bond, I would need to earn at least 2.22% on a CD to come out ahead. That is because I pay CA taxes on CD interest, but do not pay CA taxes on Treasuries. It is just that simple. No reason to get lost in the woods with SALT and AMT. :-)
john
john   |     |   Comment #7
this fdic info is not correct that if you want more than 250000 protection you have to go to other banks ex jt acct 7 pods coverage is 3.5 million
anonymous
anonymous   |     |   Comment #8
I know that depositaccounts.com publishes a graphs of the average CD rate trend ... which, of course, is usually much lower than the best available rates at any point in time. Can you publish a similar chart with the rate history based on an average of only the top nationally available CDs? It would be interesting to see how this compares to Treasury yields over time, for example. (FRED also publishes an average CD rate chart, which is also much lower than the best available rates.)
jib2424
jib2424   |     |   Comment #10
I agree with Comment #8. A chart of this sort would be very helpful. Please publish it.
Anonymous
Anonymous   |     |   Comment #12
+1. I also like to see the top rates chart. I realize it would not be as smooth due to one-off hot deals. So perhaps, deals that last less than 30 days should be eliminated from such chart.
anonymous
anonymous   |     |   Comment #29
I think if an average of the best deals is used (for example, average of 10-20 best rates) then it would probably be a pretty smooth chart. Because anyway, it's not realistic to assume that everyone always jumps on the best deal and establishes a new CU or bank relationship.

I often browse through the CD rate list, then look at the time chart to see how rates are developing over time ... only to see that the (average) rate in the time chart is always significantly lower than the deals listed!

So it's usually not clear if the megabanks have finally decided to raise their rate from 0.01% to something more realistic (thereby pushing up the average) or if the best rates are pulling up the average.
slovokia
slovokia   |     |   Comment #13
In California the top marginal rate is 13.3%. State taxes are not likely to be deductible at this level due to the 10K SALT deduction limit in the new tax bill. Therefore an investor would need a CD paying 26.76% more interest than a Treasury security to get an equivalent after tax return.

Here is a link to a google spreadsheet with the math:

https://docs.google.com/spreadsheets/d/1rxrkRNZAzkLee-67KuKnhef5Zesf5XHvO3OZonDm5yI/edit#gid=1314025488
Inflation Hawk
Inflation Hawk   |     |   Comment #15
5 year TIPS are also starting to look like a better deal that their CD equivalents.
The current yield is up to 0.50% over the base CPI-U.
You just need an inflation rate of 2.50% to match a 5 year CD (not quite there yet).
That CD's rate is frozen for five years.
The TIPS rate varies with the CPI-U.
Of course, if deflation returns, TIPS are dogs.
anonymous
anonymous   |     |   Comment #30
Thanks for pointing out the nice rise in TIPS yields, I stopped looking at them because for the longest time, they were negative! I compared the TIPS spread to the same Treasury maturities, and it currently implies a pretty consistent forward inflation rate of 2% from 5-30 years.

But TIPS create a minor tax nightmare with calculating OID etc. ...
Inflation Hawk
Inflation Hawk   |     |   Comment #46
To avoid the tax nightmare scenario, I just keep TIPS in retirement accounts.
For taxable cash, I just dump 20K a year in iBonds for some inflation protection.
Due to deflation over the last few years, both TIPS and iBonds haven't been as good as CD's.
With 8 months in a row of steady inflation, it looks like that situation may have gone away.
Phil
Phil   |     |   Comment #22
There's no Treasury security known as a "1 year Treasury note". There is however a 52-week Treasury bill.
steved
steved   |     |   Comment #26
The Transaction Ease section isn't quite right. Most brokerages (Schwab, Vanguard, Fidelity, ML) don't charge a fee to buy either a new issue or in the secondary market. The $1/bond is for other types of bonds.

However, there is a bid-ask spread in the secondary market and it can be significant for trades less than $100K. Surprisingly, this spread is much less at Schwab than the other brokerages (because Schwab makes its own market).
Lrdx
Lrdx   |     |   Comment #27
Not just Schwab, practically every broker (including the Treasury itself through TreasuryDirect) trading bonds have a separate secondary market. You can buy a stock at exchange A and turn around and sell on exchange B. You can't do that with bonds: you can't buy at Schwab's bond desk and sell at Vanguard's desk unless you move the bond to a Vanguard account.
David
David   |     |   Comment #78
I've noted the same. Schwab is great for Treasury trades under $100k! Fidelity does however allow you to adjust the limit price (bid or ask) and the trade often goes through at a good price if volume is lighter on the side you're trading. Vanguard's platform seems antiquated.
lou
lou   |     |   Comment #31
The federal tax rate doesn't matter if you are comparing a CD to a treasury bond for a taxpayer in a high tax-rate state, as long as the interest from the higher yielding CD or treasury doesn't put the taxpayer in a higher income tax bracket (which is what the author and every investment professional are assuming when using the term "taxable equivalent yield"). True this simple formula doesn't take into account the SALT deduction, but as others have pointed out it's less relevant today under the new tax law.
steved
steved   |     |   Comment #32
This is not true. See the many comments above that explain why the federal tax rate does matter.
lou
lou   |     |   Comment #33
Reread my comment.

I said as long as the additional interest from the CD or treasury (with a higher taxable yield) doesn't put the taxpayer in a higher federal tax bracket. In most cases it wouldn't because the incremental interest is generally not sufficient to change your federal tax bracket.

Remember, you're not comparing two different taxpayers; instead you're comparing the taxable equivalent yield for the same taxpayer for either a CD or a treasury, where the federal tax rate is the SAME for either investment. These assumptions are generally quite reasonable.
Helpful Phil
Helpful Phil   |     |   Comment #34
How would the specific investor in your scenario calculate his tax-equivalent yield? How would he decide whether it's better to buy CD or Treasury security? If your investor's calculation does not incorporate his federal tax rate, then he doesn't understand math or taxes.
lou
lou   |     |   Comment #35
Phil, I don't know how many times I can say this. In my example, the marginal federal tax rate for the taxpayer is the same for both the treasury and the CD. The only real difference is that one investment is exempt from state taxes and the other is not.

So the CD may have a higher nominal interest rate, but the treasury may have a higher tax equivalent yield because it is exempt from state taxes. Let me repeat: In both cases the taxpayer has the SAME MARGINAL FEDERAL TAX RATE.
Phil
Phil   |     |   Comment #36
You may be right Lou.
Chris
Chris   |     |   Comment #57
Lou - Let me ask you this. Do you believe the articles author's calculations are correct? For example. he converted a 2.05% Treasury yield to a tax-equivalent yield of 2.16% for a person with a state tax rate of 5.1%.

He did this using the following formula:
2.05% / (1 - .051) = 2.16%

Do you seriously agree with this calculation? You can find no flaws with this calculation? Really?
alan1
alan1   |     |   Comment #37
Let's look at some simple numbers.
1. Taxpayer 1 (20% Fed'l rate, 10% state rate); $10000 CD; 3%. Taxpayer 1 gets $300 interest, keeps $210.
2. Still Taxpayer 1 -- $10000 Treasury security at 2.625%. Taxpayer 1 gets $262.50 interest, keeps pays no state tax, keeps $210.
3. Taxpayer 2 (25% Fed'l rate, 10% state rate). $10000 CD; 3%. Taxpayer 2 gets $300 interest; keeps $195.
4. still Taxpayer 2 -- $10000 Treasury security at 2.600%. Taxpayer 2 gets $260 interest; pays no state tax; keeps $195.

Federal tax rates need to be considered. For taxpayer 1, there's no difference between a 3% CD and 2.625% Treasury security. For taxpayer 2, there's no difference between a 3% CD and a 2.600% Treasury security.

As others have noted, there are numerous errors in the article. The piece reminds of the children's quiz "How many mistakes can you spot in tihis drawing?"

And how about this howler from the article: "The best CD rates are generally offered by online banks..."

Does anyone here other than the author believe that? Did the author bother to look at the rate tables on this website? Is the author aware that credit unions exist?

What a joke.
Phil
Phil   |     |   Comment #38
Thank you ALAN!

So in your example, federal taxes make a difference if a taxpayer earns $100,000 AND the Treasury pays between 2.600% and 2.625%

This IS VERY significant, because Treasuries are known to yield 2.613%

Thank you
lou
lou   |     |   Comment #39
Alan1, the only problem with your scenario with the two taxpayers is that the author is not making the comparison you keep wanting to focus on. Rather, he is comparing a treasury and a CD for the same taxpayer whose marginal federal tax rate does not vary for either investment. The only real variable other than the nominal interest rates for the treasury and the CD is the fact that the treasury is exempt from state tax and the CD is not.

Why is this so difficult to understand? The federal tax rate is not a factor if its the same in either case: One taxpayer, one marginal federal tax rate.
alan1
alan1   |     |   Comment #40
Lou - re Comment #39 -- According to the article, Massachusetts has a flat state income tax of 5.1% According to the article, a Treasury yield of 2.78% is equivalent to a 3% CD, for all MA taxpayers. According to the article: Treasury 2.78% = CD 3.00% for everyone paying the 5.1% state tax.

Please show me the numbers. I don't think it is possible to come up with the 2.78% figure, without knowing the taxpayer's federal tax rate. Please demonstrate the the 2.78% figure will be correct, regardless of the taxpayer's federal income tax rate.

And please use numerical examples, rather than making ex cathedra statements.
lou
lou   |     |   Comment #61
"regardless of the taxpayer's federal tax rate"

DID I SAY THAT? Please read my post again and then again until you understand it. The reading comprehension skills of some of the posters on this site are seriously deficient.
slovokia
slovokia   |     |   Comment #47
Hi Lou,

As indicated above I have created a spreadsheet that lets you calculate all the numbers. You can download it yourself import it into Excel and test your hypothesis:

https://docs.google.com/spreadsheets/d/1rxrkRNZAzkLee-67KuKnhef5Zesf5XHvO3OZonDm5yI/edit#gid=1314025488
slovokia
slovokia   |     |   Comment #52
If state taxes are fully deductible from federal income the marginal federal income tax rate does not make a difference. If state taxes are not deductible the marginal federal income rate rate does make a difference.
Lrdx
Lrdx   |     |   Comment #53
Wrong. Deduction only changes its effective rate, but the federal tax is still a factor in comparing CD vs Treasury rates. Just check the spreadsheet slovokia linked.
slovokia
slovokia   |     |   Comment #55
When I talk about making a difference what is meant is that if the federal marginal rate changes the relative attractiveness of treasury security interest changes with respect to CD interest. My spreadsheet clearly substantiates that effect. The column on the extreme right hand side is that ratio between the after tax interest of treasuries and CD's under a variety of tax rates and deduction regimes.
Chris
Chris   |     |   Comment #56
Lou - Let me ask you this. Do you believe the articles author's calculations are correct? For example. he converted a 2.05% Treasury yield to a tax-equivalent yield of 2.16% for a person with a state tax rate of 5.1%.

He did this using the following formula:
2.05% / (1 - .051) = 2.16%

Do you seriously agree with this calculation? You can find no flaws with this calculation? Really?
lou
lou   |     |   Comment #58
It all depends on how you define a tax-equivalent yield. As long as you are not confusing it to mean an after-tax yield and the marginal federal tax rate is constant (meaning the additional interest doesn't change your federal tax bracket), the answer is yes.
Chris
Chris   |     |   Comment #59
So I guess according to you (and the article's author), if someone is trying to determine whether a CD or a Treasury is better option, they only need three pieces of information; the CD rate, the Treasury rate and their state tax rate. Just divide the Treasury rate by (1 - state tax rate) and see if it exceeds the CD rate?

Absolutely laughable and easily disproven with a quick calculation (as many other posters have provided). Good luck in your sub-optimal decision making.
lou
lou   |     |   Comment #60
Did I say that? Tax-equivalent yield is only one factor I would use to compare a treasury to a CD. Your problem is that you're so committed to being right, you have become close-minded. Your reading comprehension skills are deficient. Instead of responding to my comment (which means you have to read it carefully), you spin a different scenario that I never responded to.

So yeah, if a treasury had a higher tax equivalent yield than a CD (as calculated in your example and my federal tax rate doesn't change) and I was pretty sure interest rates were not going to increase in the time frame before the treasury matures, I would certainly consider treasuries over CDs. So far, that hasn't been my experience in the last 20 years, but it was before then.

BTW, my state tax rate is 9.3%, which hasn't changed in the last 30 years.

PS. I would have agreed with you in the past since any increase in after-tax yield from the treasury was reduced by savings in my federal taxes due to the SALT deduction if I bought the CD. This is no longer true since my state and local tax are now limited to $10,000.
lou
lou   |     |   Comment #63
Chris, Phil, alan1

Let me ask you a question. If I bought a CD instead of a treasury (same maturity and amount) is it likely my marginal federal tax rate would be different?

Yes or no
Chris
Chris   |     |   Comment #82
No, it is not likely your marginal federal tax rate would be different. But you seem to be under the impression that having the same marginal federal tax rate in both scenarios means you can ignore the marginal federal tax rate in the calculations. Although it seems sensible you can ignore it, the fact is that you cannot ignore it. I urge you to spend a few minutes doing time math and you will quickly realize why the author's method of calculating tax-equivalent yields is incorrect.
Anonymous
Anonymous   |     |   Comment #65
alan1, I think while you are correct that "tax-equivalent" yield clearly is dependent on Federal tax rate in its general definition, and while the math could be off in the article regarding Treasury 2.78% = CD 3.00% for 5.1% yield, the overarching point presented by article and lou seems to be the right one.

They concentrate on the case where federal bracket does not change, which I agree is the right assumption in vast majority of cases.

I would give the benefit of doubt the to the author and the way I read the article is that they meant to say "state-tax-equivalend yield" instead of "tax-equivalent yield".

At the end of the day, for most taxpayers, only state tax effects are likely to determine how CD compares to Treasuries (only possible caveat to this is how SALT deduction would affect federal tax but this is even less of an issue with AMT and new tax law)

Disclosure: I am also the poster for #6 and #11
tightwad
tightwad   |     |   Comment #41
I-Bonds should be included in this discussion.
anonymous
anonymous   |     |   Comment #42
Great suggestion. I would say that I-bonds are like the "CDs" of TIPS. They have guaranteed principal, and an EWP feature. Unfortunately, I-bond purchase limits are much lower than they used to be.

The I-bond fixed rate needs to be compared to the real yield of TIPS (for the time period one wishes to hold the I-bond). Since 5-year TIPS now yield 0.6%, with I-bonds you're about 0.5% worse off. But unlike TIPS, I-bonds have some federal tax advantages, such as being tax-deferred until the bond is sold.

Ironically, I-bonds shine during deflation (compared to TIPS), as has happened a couple of times in the last decade. This is because the floor on I-bond rates is 0%. For TIPS, deflationary rates can actually eat into your principal.
Anon Y. Mousse
Anon Y. Mousse   |     |   Comment #43
I like I-bonds because I do not have to pay Federal tax on the interest until I cash the bonds in. And I never have to pay state tax on the interest. I-bonds are a good core holding.
CuriousDave
CuriousDave   |     |   Comment #66
Also, there's the issue of penalty for early redemption on I Bonds. They cannot be redeemed at all for the first 12 months. After that, if held for at least 5 years, there is no penalty. If held for less, there is a loss of 3 months of interest, but that can be substantially mitigated because, surprisingly, I Bonds pay interest for a complete month regardless how long held during that month, not only in the month of purchase, but even in the month of redemption. An I Bond bond purchased on, say, March 31st will pay a full month's interest for March. A bond redeemed on October 1st will pay a full month's interest for October. So, the effective interest rate will vary from one I Bond to another depending on several variables, including dates of purchase and redemtion. The annual personal purchase limitations on I Bonds make them unappealing to folks looking to invest substantial amounts. Although the fixed component of these bonds remains unchanged throughout their 30 year lives, the inflation component can change every 6 months, making mathematical computations problematical - one would need to do some what-if modeling assuming different inflation scenarios.
Inflation Hawk
Inflation Hawk   |     |   Comment #49
The 10K annual maximum per individual does limit iBonds usefulness (20K per couple).
However, it's a good place to park some extra cash as an inflation hedge.

During deflation, iBonds are better than TIPS (but any bank account will beat the iBonds 0%).
If held to maturity, TIPS are guaranteed the par value of the bond (if bought at par value or less).

Due to deflation over the last few years, CD's have provided more interest than TIPS or iBonds.
For that reason, the money I have in both has been a disappointment over that period of time.

With inflation ticking-up recently, that scenario may be changing.
So, like the discussion of bonds in general, it's worthy of discussion.
.0001
.0001   |     |   Comment #44
The FED finally beat us into submission. Savers (those with excess capital) are fighting over measly scraps of interest whose value on $100K investments will purchase one or perhaps two tanks of gasoline.
Anonymous
Anonymous   |     |   Comment #45
#44 Agreed. Valued contributors on this site are getting into an argument with each other over one tenth of 1% (0.001) difference in equivalent yields! Let's keep the discussion at a higher level, everyone.
deplorable 1
deplorable 1   |     |   Comment #48
I have always been able to find a better CD rate than treasuries unless we go back to the 80's so I'll stick with CD's myself. Some people really over complicate things with taxable equivalent yields.
Inflation Hawk
Inflation Hawk   |     |   Comment #50
I like to complicate it even further with inflation equivalent yields!
Now that we are in a rising inflation and interest rate environment, it's a whole new ball game.

In a declining inflation and interest rate environment, any CD was a winner over its term.
That's not the case anymore. So, I really call into question those CD ladder strategies.

That 3% 7 year CD that I got a few years ago is starting to look like a dog now.
The bell curve on that one is probably going to be a break-even proposition at best.

Will interest rates rise faster than inflation - or, vice versa?
That's the question that I'm grappling with.
DCGuy
DCGuy   |     |   Comment #51
As Nuveen put it so succinctly, it's not what you earn, it's what you keep.
anon
anon   |     |   Comment #54
Try this...
CD: paying 10% interest
State Tax: 8%; Fed Tax: 22%; Total Tax Rate = 30% (8+22)
You LOSE 30% of the 10% interest leaving you with a 7% return.

Calculate equivalent Treasury yield.
If a Treasury ONLY taxes you the Federal rate the equivalent Treasury rate will be:
7% divided by .78 (1-22%) or 8.97%

So, a 10% CD paying state and federal taxes totaling 30% will yield the same interest as a Treasury earning 8.97% interest (taxed at federal 22% rate).

CD $10,000 at 10% = $1,000 * .70 = $700 after tax interest
TR $10,000 at 8.97% = $897 * .78 = $699.66 after tax interest (rounding error)
Different interest rates; identical yields.

In this case, a Treasury rate above 8.97% beats the 10% CD due to differences in taxation.

In today's market...$10,000 investment same tax rates.
3% CD pays $300. Taxes are 30% or 90 bucks. Yield: $210
Treasury rate calculation: 210/78 = 2.69% (78% is what you get after the 22% tax)
2.69% TR pays $269. Taxes are 22% or 59 bucks. Yield: $210

I'm only interested in YIELD. In the last case a TR paying 2.7% or higher beats the CD at 3%.
lou
lou   |     |   Comment #62
#54, excellent analysis.

Only caveat: the additional pre-tax interest from the CD doesn't put you in a higher federal tax bracket than the alternative treasury with lower pre-tax interest (which is HIGHLY unlikely).

For some reason, there are a few posters who are utterly incapable of understanding that we are comparing a treasury and a CD for the same investor as opposed to a meaningless analysis of contrasting tax equivalent yields for two different people.
anon
anon   |     |   Comment #64
#62
The simplest thing to do is to compute the effective tax rate on the CD, accounting for state, local, federal taxes and adjustments due to allowed deductions. In other words, given $100 principal how much will I keep after all is said and done. If it's $80 then the tax rate is 20%. If you keep $68 the tax rate is 32%. Compute this percentage first.

I'm in the 24% marginal tax rate for married couples and this WILL NOT change based on estimated earned interest. Since Treasuries are taxed at the federal rate only, 24% is my tax rate on Treasuries. Period. If your rate will change, use that rate. If rates will overlap, enjoy the math (though it's nothing more than basic subtraction and multiplication). Hint: If I earned $1000 interest and $100 of it crossed over into the 32% bracket, I'd pay 24% on $900 (216) and 32% on $100 (32) for a total of $248. My effective tax rate on the $1000 interest = 24.8%

If a 4% CD will YIELD an effective rate of 2.8% (30% effective tax) then my equivalent Treasury calculation is: 2.8% divided by 76% (based on 24% marginal rate) or 3.68%
(.028/.76) = .03684 = 3.68%
steved
steved   |     |   Comment #67
OK, I'm starting to get concerned that the misinformation being posted by Anonymous and Lou may actually convince some people and cause them to make the wrong decision. YOU ABSOLUTELY MUST USE YOUR FEDERAL INCOME TAX RATE IN DOING THIS ANALYSIS.

Here's proof: Assume you're comparing a 2.05% Treasury and a 2.3% CD. You live in CA and your state tax rate is 9.3%.

The article/Lou/Anonymous state that all you need to look at is the state tax rate. This calculation says the Treasury would have a tax effective yield of 2.05/(1-.093) = 2.26%, so you should choose the 2.3% CD.

But look at your after tax earnings once you take into account Federal taxes (assume a 32% bracket and no SALT deduction):
Treasury: 2.05% * (1 - .32) = 1.394%
CD: 2.30% * (1 - .32 - .093) = 1.350%
The Treasury is actually the better choice.

Note that both calculations are the same taxpayer and the interest does not cause the bracket to change. Using only state tax simply gives the wrong answer and would cause you to make the wrong decision.
Bogie
Bogie   |     |   Comment #68
I don't thing anyone bases their financial decisions solely on what they read here in the comment section or on any internet blog site. Least wise, not before verifying the facts from a more reliable and trusted source.
lou
lou   |     |   Comment #69
Technically, you're right. But you chose the one example out of a very small band of possibilities that proves your point. Only when the tax effective yield of the treasury ranges from 1.99 to 2.08 (a difference of only 9 basis points) are you right. The treasury at any other rate in the universe would give the answer the author of the article suggests. Also, that band narrows even more prior to the change in the law of the SALT deduction.

You must have gone through many iterations to find the one example which proves your point. Your last sentence is still almost always wrong.
steved
steved   |     |   Comment #70
Actually I chose the actual current Treasury rate. But if you're comfortable with a method that is right some of the time and wrong some of the time, feel free. Just don't try to tell other people that it's correct.
Anonymous
Anonymous   |     |   Comment #86
Thank you Steved, you are right. There are some cases indeed where (1-fedRate) * (1-stateRate) multiplier results in different comparison vs (1-fedRate-stateRate) multiplier.

I also agree with lou that in most cases this won't make a difference in the choice and when it does, it's quite small. But you are also right that one might as well just use the formula that is always right instead of an approximation.

I am the Anonymous in posts 6,11 and 65. Thank you for correcting with precise example.
anon
anon   |     |   Comment #73
#69
Technically correct is better than sometimes correct. I understand your point about rough estimates but to criticize mathematical precision seems ill-advised on a financial discusion forum.
aaa
aaa   |     |   Comment #74
lou:

You are arguing against math .... Don't.

Answer given by #67 is mathematical certainty, it's pointless to talk about probability in vain attempt to muddy what ought be extremely clear.
lou
lou   |     |   Comment #76
steved & aaa, do you know what the expression " how many angels can dance on the head of a pin" means? This is what you're engaging in. You have lost all perspective.

The author is generally right, even though he might be a few basis points off in a limited number of possibilities. Even in the example you used, either investment would be a good choice since the difference in yield is a few basis points, hardly a meaningful difference.

You made it sound like a crime the author used the tax equivalent formula almost everyone in the investment community relies upon, when in fact it almost always gives you the right answer and when it doesn't, the difference in yield is infinitesimal. Your inability to see the forest for the trees calls attention to your preoccupation with minutiae.

The author may be guilty of jaywalking, while you guys are condemning him as if he murdered someone.
aaa
aaa   |     |   Comment #80
lou:

Don't try to whitewash about being "generally right".

Why? That's because there is no such thing in math. Either it's "completely right" or it's "completely wrong".

I think there is difference between law and math. And for sure we're talking about math here - not law. Lawyer might go with "generally right", but not mathematicians. ... Sorry.
lou
lou   |     |   Comment #87
What's interesting is that I would choose the CD over the treasury in your example.

Why? Because the difference between 1.35% and 1.394% is insignificant (on a $100,000 that's $44 of additional interest over the course of one year), at least for me. I'm assuming we are talking a 1 yr maturity, so a CD with a low EWP would be more attractive than a treasury, where in a rising interest rate environment it would be less costly to break the CD than sell the treasury before the end of one year.

Furthermore, some CDs confine the penalty to lesser of interest earned/accrued or the penalty, meaning you can't lose principal, unlike treasuries where it's very likely you can lose principal depending on the increase in interest rates during the term of the treasury.
anon
anon   |     |   Comment #71
#67
Correct.
Given your data any Treasury above 1.98% is better.

Once I know your CD return I just divide it by (1 - yourfederaltaxrate)
1.35 / (1-.32) = 1.35/.68 = 1.98%
Reader
Reader   |     |   Comment #72
"steved" is correct in his comment #67 analysis. His formula in comment #25 is also correct (assuming no SALT deduction). If you want to calculate correct TEYs for Treasuries, you absolutely have to take your federal tax rate into account too and you cannot just use the state tax rate.
I also appreciate "steved"'s respectful tone in his comments, unlike some other posters here who get hot under the collar when they disagree with someone.

"anon" #64 is also correct in his analysis for those who want to take the SALT deduction.
anon
anon   |     |   Comment #75
On a positive note it appears most on this forum understand the notion of "effective tax rate". It's quite amazing how many people think their marginal rate is their tax rate (very wealthy excluded).
figures
figures   |     |   Comment #79
Ironic observation, considering everyone here is calculating the "effective tax rate" using the marginal tax rate.
steved
steved   |     |   Comment #81
Well, the discussion is actually about tax EQUIVALENT yields, although some people (including me!) have used the word effective. These are properly calculated using a person's marginal tax rate.
Bozo
Bozo   |     |   Comment #83
steved (re comment # 81), a person's effective tax rate is certainly nice to know when calculating things like withholding or estimated taxes. Taxable equivalent yield is a "comparative" analysis, correct? Should I buy a Treasury or a CD, and if so, at what rate (for the CD). Gets back to Joe (in Texas) and Jane (in California), both of whom are high-earners.
steved
steved   |     |   Comment #84
Yup, I didn't mean to imply that there was no use for effective tax rates. In this analysis, though, it makes more sense to use marginal rates since the decision affects marginal income.

As you say, taxable equivalent yield is used to compare differently taxed securities. It is the yield a fully taxable investment must have to provide the same after-tax return as a tax-advantaged one.
Bozo
Bozo   |     |   Comment #85
steved (re comment # 84): "As you say, taxable equivalent yield is used to compare differently taxed securities. It is the yield a fully taxable investment must have to provide the same after-tax return as a tax-advantaged one."

Bingo.
kaight not kaight
kaight not kaight   |     |   Comment #88
BINGO indeed!

As always, thank you for being an island of reason AND high intelligence.

The arguing here is hurtful.

Can't we all just get along?
anon
anon   |     |   Comment #90
#88
kaight, we have run head on into the problem with mastering basic mathematics. This problem (comparison) has many variables but, essentially, requires nothing more than four basic functions (add, subtract, divide, multiply).
anon
anon   |     |   Comment #89
Folks, of course the marginal rate is used to calculate their effective tax rate. I was not speaking about the TR/CD debate but in general taxation terms. In speaking of TR/CD rates one should really use the term yield rate, not effective rate.
anonymous
anonymous   |     |   Comment #91
While I really appreciate commenter's contributions to tax equivalent yields here, I think it would also be worth while to discuss in more detail here the consequences of breaking a CD vs. selling a Treasury security, because the yield comparison only works if the CD or Treasury are held to maturity. In reality, many of us will be faced with deciding to break our CDs (or sell our Treasuries) in rising rate conditions.

It's interesting to note that the penalty for breaking a CD depends on the CD's nominal interest rate, while the "penalty" for exiting a Treasury security is a function of the change in interest rates. For example, selling a Treasury note when interest rates have not changed, will incur no penalty (except bid-ask spread or brokerage fees). On the other hand, when selling a 5-year note after holding it for one year, if interest rates have risen by 1%, would drop the note's value by about 4%. In that case, you might be better off with a CD with a reasonable EWP. (Come to think of it, I think it would rarely make sense to sell the Treasury note due to rising rates, because the rate increase is always "built into" the market value of the note to match the value of other Treasury securities with same maturity.)
steved
steved   |     |   Comment #93
Haha, if you thought this forum had a hard time with the math on tax equivalent yields, wait until you try comparing early withdrawals and sales!
Bozo
Bozo   |     |   Comment #95
Anonymous (re comment # 91), I will candidly admit I have long been flummoxed with regard to break strategies (as to CDs) and selling individual bonds prior to maturity on the secondary market. I have dodged the issue entirely by never using a break strategy on a CD and by never buying an individual bond. Which is not to say I have avoided fixed income. Au contraire, mon ami. While CD ladders require a bit of maintenance (the same could be said for yours truly, pushing age 71), they provide procrastinators with the perfect excuse to "wait for a few months". Kinda like Cubs fans used to say. Bond funds have been lame of late, but they also allow one to say to the wife "it's all about duration." My wife's eyes glaze over, so I get away with an otherwise lame investment. The trick is to keep enough in liquid accounts so you can fool yourself (and others) into thinking you are a master of fixed-income. Which, in my case, is certainly not true.
Morris
Morris   |     |   Comment #92
I did read most of your comments and my conclusion is that some of you are focused on the TAX issue instead of WHAT you keep is that it counts. Tax brackets are irrelevant because the cost of money varies by your tax bracket and not the interest received.
Many times the value of your money keeps going down the more you receive (save) and vice versa.
Therefore, you should try to avoid taxes by investing in non taxable investments or into long term capitol gains or into qualified dividend (those are free money in certain tax brackets).
Furthermore, do what the rich people do, create charitable trust and put all of your income there and when the money are needed, pay yourself from the trust with most of it again exempt from taxes. There is a way to set it up with very little work on your part and your tax wary will disappear for life.
Sophocles
Sophocles   |     |   Comment #94
Worthy of mention:

At times investments routinely considered taxable . . . . are not. ;-)
Michael
Michael   |     |   Comment #96
many comments on TEY , have tried to find such a calculator on line , currently 13week treasury sells at a 1.9% yield ( before taxes) a similar CD sells for a yield of 1.80 to 1.85% so the 13 week treasury would be a better buy before one factors in it's exempt from a State income tax of 5.2%

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