There are many investments that offer tax advantages to investors. Tax free bonds, for example, are just one popular option for high income earners and retirees. The idea of not paying taxes sounds great, but are you getting the best return on your money? Knowing the tax equivalent yield will help you decide if a tax-free bond will give you a better return than a taxable bond.
If you had to choose between a taxable and tax-free bond or bond fund with the same amount of risk, credit quality and maturity, the choice might be the one with the higher yield. But that is an apples to oranges comparison. We need to look at both yields under the same light or same tax situation, to make the best choice. The easiest way to fix that is with the tax equivalent yield formula or through the chart below.
Tax Equivalent Yield Formula
The tax equivalent yield formula is used to compare the yields between a tax-free investment and a taxable investment. The formula looks like this:
Tax Equivalent Yield = Tax Free Yield ÷ (1 – marginal tax rate)
For a quick example, lets assume a marginal tax rate of 25% and we want to know the taxable equivalent yield of a municipal bond paying 3%:
Tax Equivalent Yield = 0.03 ÷ (1 – 0.25) or 0.03 ÷ 0.75 = 0.04 or 4%
Based on this example, you’d have to find a taxable bond with a yield of 4% to get the same return as a municipal bond. Another way to look at it, to get a better return than a municipal bond paying 3%, you’d have to find a corporate bond, CD, money market account, or dividend stock paying more than 4%.
For our second example, let’s cheat and use the chart below. Say you were offered a municipal bond paying 3% or a corporate bond paying 4.5% with the same credit quality and maturity. If you were in the 25% marginal tax bracket, based on the example above and the chart below, the better return is with the corporate bond paying 4.5%.
In fact, the corporate bond is the better choice for each bracket until you reach the 35% marginal tax bracket. At that point the 3% municipal bond has a taxable equivalent yield of 4.62%, slightly higher than the corporate bond.
Tax Equivalent Yield Chart
Here’s a cheat sheet of the taxable equivalent yield based on each marginal tax bracket. It is based on the federal income tax only. It does not include state taxes.
|Tax Free Yield||Tax Equivalent Yield per Marginal Tax Rate|
|15% Tax Bracket||25% Tax Bracket||28% Tax Bracket||33% Tax Bracket||35% Tax Bracket|
Are Tax Free Investments For You
You’ll notice at the lower marginal tax brackets, the difference between a tax-free and taxable yield is small. As your marginal tax bracket rises, you’ll benefit more from tax-free investments.
That’s not to say, you shouldn’t take advantage of tax-free investments if you are in the lower tax brackets. The amount of tax savings is small enough that it shouldn’t be a high priority when choosing investments.
On the other hand, those sitting in the top marginal tax brackets will see a bigger tax benefit to using tax-free investments. That said, tax advantages alone don’t guarantee an investment advantage.
There are other factors that need to be considered, for example time horizon or interest rate risk, that should be looked at before making any investment. Knowing the tax equivalent yield will give you a head start in making the right decisions.