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The Taxable Equivalent Yield of a Structured Settlement – Don’t Forget Local and State Taxes
When comparing a structured settlement to other personal investment options, remember to take into consideration not only Federal Taxes you will pay on interest earned, but State and Local taxes as well.
By: John McCulloch, JD, CSSC, FLMI
Many people are aware that the vast majority of the states, 43 in total, impose a tax on income. The only states without individual income taxes are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming. However, many people are unaware that in 17 states there is some form of local or county taxes, with an overall average rate of 1.55%. The first local income taxes emerged in Philadelphia in 1939 as the city sought to avoid bankruptcy. They spread gradually to select cities in Ohio (1946), Kentucky (1947), Missouri (1948), and Michigan (1962). New York City and Baltimore adopted municipal income taxes in 1966.
Local income taxes appear under a variety of designations: wage taxes, income taxes, payroll taxes, local services taxes, and occupational privilege taxes. Some are imposed as a percentage of salaries or wages, while others are stated as a percentage of federal or state tax, and still others are flat amounts charged to all. For example, residents of Yonkers, New York pay 15% of their state tax as a “piggyback” local tax. In Maryland and New York City, residents pay their local income tax when they file their state income tax.
There are a total of 4,943 local jurisdictions that impose taxes. The states that have local taxes are as follows: Alabama (4); California (1); Colorado (3); Delaware (1); Indiana (91); Iowa (297); Kansas (535); Kentucky (218); Maryland (24); Michigan (22); Missouri (2); New Jersey (1); New York (4); Ohio (774); Oregon (2); Pennsylvania (2961); and West Virginia (3).
Why is this important? While most local income tax rates are low (1% to 3%), they generally have been ignored when computing the taxable equivalent yield of a structured settlement and as such the structured settlement may be undervalued. Taxable equivalent yields are the return that is required on a taxable investment to make it equal to the return on a tax-exempt investment, such as a municipal bond. As such, it is commonly used when evaluating the tax-exempt return of a structured settlement. It is expressed as a formula, R(te) = R(tf)/(1-t), where R(te) represents the taxable yield to an investor, R(tf) is the tax-exempt return on the structured settlement, and t is the taxpayer’s marginal tax rate.
By way of example, let’s say a structured settlement proposal has a return of 4%, which may not sound exciting to a claimant. But if the claimant is in a 28% Federal tax bracket, this brings the taxable equivalent yield of the structured settlement to 5.56%. However, if the taxpayer is in a taxable local jurisdiction in New York, the calculation results in a higher tax equivalent yield. Factoring in state income tax of 8.97% and local tax of 1.005%, the same structured settlement with a rate of return of 4% now has a tax equivalent yield of 6.45%, a guaranteed rate that is unmatched by any conventional investment.
Author’s Note: In a time of historically low yields, structured settlements remain one of the safest, and best yielding vehicles around. In fact, as tax rates rise, on both a Federal and state level, the value of a tax-exempt structured settlement will increase over time.