Some bond coupon payments are exempt from state or federal taxes, others are not. Tax-equivalent yield is a number that tells you how much a taxable bond needs to yield before taxes to provide an equal yield to a taxable bond. Because you’ll be comparing a taxed bond to a tax-exempt bond to determine tax-equivalent yield, you’ll need to factor in your personal income tax bracket. Afterall, that is how to calculate how much tax you’d be responsible for with a taxable bond. You’ll want to know which government taxes a taxable bond is subject to so you can compare it to a tax-exempt bond. Interest on typically is taxed as ordinary income. However, government-issued bonds usually are exempt from some taxes. For example, interest on Treasury bills, notes, and bonds is taxable at the federal level but exempt from state and local taxes.
How To Calculate Tax-Equivalent Yield
The formula for tax-equivalent yield is the tax-free bond yield divided by one minus the investor’s marginal tax rate, or income tax bracket: Tax-equivalent yield = Tax-free bond yield / (1 – marginal tax rate)
Example of Tax-Equivalent Yield
Suppose you’re an investor whose tax bracket is 32%. You’re comparing a tax-free municipal bond that yields 5% to a taxable corporate bond. Using the tax-equivalent yield formula, it would only make sense to invest in the corporate bond if it yields at least 7.35%. 7.35% = 5% / (1 – 0.32) If the corporate bond only yielded 6%, you’d earn lower returns than you would have gotten from the municipal bond after accounting for taxes.
Do I Need Tax-Equivalent Yield?
If you’re an investor who’s comparing a taxable bond to a tax-exempt bond, you need to consider tax-equivalent yield. Using the formula will help maximize your after-tax yield. Comparing the yields of two bonds won’t give you the full picture of which bond would be more profitable, because yield alone doesn’t account for taxes. The formula is especially important for investors with high incomes because they’ll pay higher tax rates on interest earned from corporate bonds.
What Tax-Equivalent Yield Means for Individual Investors
Taxes are an important factor in any investment decision. Individual investors should consider tax-equivalent yield to maximize their after-tax returns. If you invest solely based on which bond pays the highest yield, you may lose a significant portion of your returns to taxes. Tax-equivalent yield helps you compare bonds to determine which is right for your tax situation. Tax-equivalent yield will vary for individual investors based on their federal, state, and local income tax rates.
