Tax Equivalent Yield
What is a Tax Equivalent Yield of a
To compare the municipal bond yields and
corporate bond yields, you need to work out the tax equivalent
yield of the municipal bond. The tax equivalent yield
calculation of a municipal bond is useful when an investor
wants to compare a municipal bond to a corporate bond to see
which bond has higher yield and is therefore a better
When calculating the tax equivalent
municipal bond yields, you need to also take into account the
investor's tax bracket. For example, if an investor who is in
the 30% tax bracket invests in a municipal bond with a yield of
7%. Calculating the tax equivalent yield of that municipal bond
will tell you what the yield of a corporate bond has to be for
the corporate bond to be a better investment than the municipal
bond. Below is the tax equivalent yield formula. Replace
Municipal Bond Current Yield by 7% and Investor's Tax Bracket
by 30% and you will have your Tax Equivalent Yield of that
particular municipal bond.
Tax Equivalent Yield formula for municipal
Which to invest, municipal bonds or
Below is an example of how the Tax
Equivalent Yield formula can help you decide which is a better
investment between a municipal bond and a corporate bond.
Assume you are in the 35% federal tax bracket and are
considering tax free investing in California municipal
bonds in a $10,000 investment yielding 4% or a taxable
investment yielding 6%. At first glance, the taxable investment
appears to be the more advantageous choice, earning $600 versus
the tax free investment $400 earnings.
However, after taxes are considered, tax
free investing would actually provide the better yield. That’s
because the taxable investment would provide only $390 in
income after federal income taxes are deducted. (We will have a
handy calculator for finding your amounts here in the future.
In order to earn $400 after taxes, you would
need a taxable investment yielding 6.2%. This is commonly
referred to as the "taxable equivalent yield".
Generally, taxable equivalent yields rise
with income tax brackets. In other words the higher your tax
bracket, the more you need to earn on a taxable investment to
match the tax free investments earnings on municipal bonds
fund. Therefore, in general, investing tax free with municipal
bonds is more appropriate for investors in high tax brackets,
and is not suitable for investors in low tax brackets.