How to calculate Equivalent Taxable Yield
About this lesson
In this video, you will learn how to calculate equivalent taxable yield with a numeric example.
Why it matters
Interest from most municipal bonds is free of federal income tax, so they pay lower yields than taxable bonds. To compare them fairly, convert the tax-free yield into the taxable yield that would leave you with the same income after tax.
The formula
Equivalent taxable yield = Tax-free yield ÷ (1 − t)
where t is your marginal tax rate.
Example
A municipal bond yields 4% and your tax rate is 32%:
4% ÷ (1 − 0.32) = 4% ÷ 0.68 = 5.88%
A taxable bond must yield more than 5.88% to beat the municipal bond after tax.
The break-even tax rate
You can also ask: at what tax rate are the two bonds equal?
t = 1 − (tax-free yield ÷ taxable yield)
If a municipal bond yields 4% and a similar taxable bond yields 5%: t = 1 − 4/5 = 20%. Above a 20% tax rate, the municipal bond is the better deal; below it, the taxable bond is.
Keep in mind
- The higher your tax bracket, the more attractive tax-free bonds become.
- Some municipal bonds are also free of state tax for residents of that state, which raises their equivalent taxable yield further.
- Compare bonds with similar maturity and credit quality.