Investing Tax Free
 

Tax Equivalent Yield

What is a Tax Equivalent Yield of a Municipal Bond?

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 investment.

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 bonds

Municipal Bond Yields

Which to invest, municipal bonds or corporate bonds?

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. Stay tuned!)

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.