What Is Tax-Equivalent Yield?

The tax-equivalent yield is the return a 澳洲幸运5官方开奖结果体彩网:taxable bond needs to equal the yield on a comparable tax-exempt 澳洲幸运5官方开奖结果体彩网:municipal bond. Investors use this calculation to compare the returns between a tax-free investment and a taxab𝐆le alternative.

Tax-Equivalent Yield Formula

The tax-equivalent yield is the yield on a taxable bond that an investor would have to earn to match the 澳洲幸运5官方开奖结果🉐体彩网:return on a comparab🍃le tax-free investment. Depending on an investor's tax bracket, a tax-free vehicle like a municipal bond may not be the best investment decision for their 澳洲幸运5官方开奖结果体彩网:portfolio.

An investor's tax bracket depends on their filing status and income. The federal income tax brackets for 2024 and 2025 are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. To ﷽calculate the taxa𒀰ble equivalent yield of a tax-free municipal bond:

Return (TEY) = Return (TX) / (1 - t)

Where:

• Return (TEY) = Return on fully taxable equivalent yield
• Return (TX) = Return on tax-exempt investment
• t = Investor's marginal tax rate

This formula can be reversed to determine the tax-free equivalent yield of a municipal bond that would match the return on a taxable bond.

Tax Rate Implications

An investor's tax bracket and rate affect the resulting tax-equivalent yields. For example, assume there is a tax-free bond yielding 7%. Investing in this bond or any of the many taxable choices available greatly depends on the investor's marginal tax bracket. In 2024,🦋 the tax-equivalent yield calculations for these brackets are:

• 10% Bracket: R(te) = 7% / (1 - 10%) = 7.78%
• 12% Bracket: R(te) = 7% / (1 - 12%) = 7.95%
• 22% Bracket: R(te) = 7% / (1 - 22%) = 8.97%
• 24% Bracket: R(te) = 7% / (1 - 24%) = 9.21%
• 32% Bracket: R(te) = 7% / (1 - 32%) = 10.29%
• 35% Bracket: R(te) = 7% / (1 - 35%) = 10.77%
• 37% Bracket: R(te) = 7% / (1 - 37%) = 11.11%

Given this information, assume a taxable bond yields 9.75%. Investors in the first four marginal tax brackets would be better off investing in the taxable bond because they would still earn more than a 7% non-taxable bond af✱ter tax liability. Investors in the highest three brackets may choose the tax-free bond.

Examples

An investor in the 22% federal income tax bracket with no state taxes owns a tax-exempt municipal bond with an 8% coupon rate. To calculate the fully taxable equivalent yield that a taxable bond would have to earn to match the municipal bond's yield:

Return (TEY) = 0.08 / (1 - 0.22) = 10.26%

A taxable bond would have to earn an equivalent yield o💖f 10.26%. After taxes are deducted this bond would match the 8% return of the tax-꧃free municipal bond.

If the marginal tax rate is higher, the required fully taxable equivalent yield will also be higher than 10.26%. If the investor is in the 37% tax bracket, the fully ꧟taxable equivalent🅷 yield would have to be:

Return (TEY) = 0.08 / (1 - 0.37) = 12.70%

The Bottom Line

The tax-equivalent yield is the return a taxable bond needs to equal the yield on a comparable tax-exempt bond, such as a municipal bond. A bond's interest income, called coupon payments, is 澳洲幸运5官方开奖结果体彩网:taxed acco𓄧rding to the type of bond and where it's issued. Coupon payments from a U.S. Treasury bond are free from state and local taxes. Coupon payments from municipal bonds are also exempt from regular federal income t𝓀ax.