There are many investments that offer tax advantages to investors. Tax free bonds, like municipal bonds, are one popular choice for high income earners and retirees. That idea of not having to pay taxes on investment earnings will always get attention, but are you getting the best return on your money? To find out, you need the tax equivalent yield on a tax-free bond to know whether it offers a better return than a taxable bond.
Given the choice between a taxable and tax-free bond or bond fund with the same amount of risk, credit quality, and maturity, it’s easy to pick the one with the higher yield. In this case, there’s one problem. It is an apples to oranges comparison.
To make the best choice, you need to look at both yields under the same light or, in this case, the same tax situation. 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. All you need is the yield on the bond and your marginal tax rate, since interest earned on bonds is taxed as regular income. You can use the current income tax brackets to find your marginal tax rate.
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%
For this example, you’d need a taxable bond with a yield of 4% to get the same return as a municipal bond. Put another way – 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, using the formula above or 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’s based on the federal income tax only. It does not include state income tax.
|Tax Free Yield||Tax Equivalent Yield per Marginal Tax Rate|
|10% Tax Bracket||15% Tax Bracket||25% Tax Bracket||28% Tax Bracket||33% Tax Bracket||35% Tax Bracket||39.6% 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 fall into the lower 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, such as your time horizon and interest rate risk, before making any investment. Knowing the tax equivalent yield will give you a head start in making the right decision.