Does The Tax Advantage Of Treasuries Outweigh The Lack Of Compounding?

kcfield | Oct 4, 2022 | 188 posts since 2012

If one has the opportunity to invest in a 5 year treasury note or a 5 year CD--each at the same rate of interest (let's say 4% for illustration) which is the better option?

On one hand, treasuries have the advantage of being exempt from state and local taxes. However, because the interest is paid out every six months, there is no opportunity for the interest to compound. On the other hand, the five year CD, while having a tax disadvantage (since it is subject to state and local taxes), has the advantage of the interest compounding over the five years (assuming one does not take the interest payments for income). So, the question is: Does the tax advantage of the treasury note/bond make it the better investment; or does the compounding advantage of the CD make it the better choice? I understand that one's particular tax bracket may make a difference here, but I am inviting a general discussion, since this important topic is simply not addressed financial sites.

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sams1985 | Oct 4, 2022 | 781 posts since 2022

Fidelity has a calculator for this-

https://digital.fidelity.com/prgw/digital/taxyieldcalc/
They have a separate calculator for figuring out yields

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CuriousDave | Oct 4, 2022 | 233 posts since 2018

You can effectively compound your interest by reinvesting it elsewhere, but currently you will not be able to replicate the 5 year Treasury rate. Currently some FIs are offering 3% or more on savings accounts. The problem though is that the FIs can lower their rates any time they wish. If the dollar amount of interest is sizable you can place the money in a CD, such as the recent limited time offering by MACU featured by Ken today - an 18 month CD paying 4.00% with a free one time “bump” option. Or, consider reinvesting your interest in a mutual fund that holds a basket of medium term Treasury securities (these are not term certain investments like individual bond holdings, so it’s possible the investment may lose money for you if you later need to cash out during an environment of increasing rates).

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w00d00w | Oct 5, 2022 | 360 posts since 2012

using your example and a $10000 initial investment in each, after 5 years, a CD that compounds monthly comes out ahead by $210 (rounded)...$12210 vs $12000. this assumes the treasury interest paid out is not subsequently invested at all.

would need to pay state/local taxes on the $2210 interest earned on the CD. the breakeven point on those taxes would be 9.5% (rounded) or $210/$2210. a state/local taxation rate higher than 9.5%, would favor treasury over CD. again, though, that breakeven rate realistically is lower, based on getting some interest income on the $200 paid out semiannually from the 5 year treasury.

let's say you could get 2% annually, without compounding, on those treasury coupon payments every 6 months. that would amount to $90 of additional interest income, and reduce the CD's advantage to $120 ($210-$90). the breakeven state/local tax rate in that scenario would be 5.4%

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kcfield | Oct 5, 2022 | 188 posts since 2012

w00d00w: Thank you very much for taking the time to do such thorough and helpful analysis!

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