Tax-Equivalent Yield

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Tax-Equivalent Yield

What Is the Tax-Equivalent Yield?

The tax-equivalent yield is the return required for a taxable bond to match the yield on a similar tax-exempt municipal bond. The computation is a technique that investors may use to compare the returns of tax-free versus taxable investments.

Key Takeaways

  • The tax-equivalent yield is the return required for a taxable bond to match the yield on a similar tax-exempt bond, such as a municipal bond.
  • The computation is a technique that investors may use to compare the returns of tax-free versus taxable investments.
  • Tax consequences are a difficult and vital aspect of any financial plan, yet they are frequently disregarded.
Image by Sabrina Jiang © Investopedia2020

Understanding Tax-Equivalent Yield

Tax consequences are a difficult and vital aspect of any financial plan, yet they are frequently disregarded. The computation of tax-equivalent return is a valuable tool for investors, particularly those in higher tax bands. The tax-equivalent yield is the yield on a taxable bond required to equal the return on a similar tax-free municipal bond.

Because municipal bonds have a low anticipated return, the real benefit of investing in them owing to tax savings is often underestimated. The calculation assists an investor in deciding whether to invest in a taxable or tax-free investment, such as a tax-free municipal bond. This information is critical since the tax-free benefit of municipal bonds is difficult to match with other investments.

But that is not the end of the narrative. When conducting such a comparison, several extra tax factors may come into play. While municipal bonds are not subject to federal taxes, the gains are taxed in certain states. Municipal bonds’ liquidity may also be constrained.

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Tax-Equivalent Yield Formula

A municipal bond may not be the ideal investment choice for an investor’s portfolio depending on their tax status. The tax bracket of an investor is determined by their filing status and income. For 2020 and 2021, the federal income tax brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

Use the following calculation to determine the taxable equivalent yield of a tax-free municipal bond, being careful to include any state taxes in addition to your federal tax rate.

ReturnTEY= ReturnTX÷ (1 – t)

Where:

  • ReturnTEY: The rate of return on fully taxable equivalent yield.
  • ReturnTX stands for return on tax-exempt investment.
  • t: The marginal tax rate for investors

This method may be used to calculate the tax-free equivalent yield of a municipal bond that corresponds to the return on a taxable bond.

Example of Tax-Equivalent Yield Formula Calculations

The tax rate of an investor has a substantial impact on the resultant tax-equivalent returns. Assume there is a tax-free bond with a 7% yield. The decision to invest in this bond or any of the numerous taxable options available is heavily influenced by the investor’s marginal tax rate. As of 2020, there are seven separate marginal tax-rate brackets in the United States: 10%, 12%, 22%, 24%, 32%, and 35%. The following are the tax-equivalent yield calculations for certain brackets:

  • R(te) = 7% / (1 – 10%) = 7.78% Bracket
  • R(te) = 7% / (1 – 12%) = 7.95% Bracket
  • R(te) = 7% / (1 – 22%) = 8.97% Bracket: R(te) = 7% / (1 – 22%) = 8.97%
  • R(te) = 7% / (1 – 24%) = 9.21% Bracket: R(te) = 7% / (1 – 24%) = 9.21%
  • 32% R(te) = 7% / (1 – 32%) = 10.29% Bracket
  • R(te) = 7% / (1 – 35%) = 10.77% in the 35% bracket
  • 37% R(te) = 7% / (1 – 37%) = 11.11% Bracket
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Assume there is a taxable bond with a yield of 9.75% based on this information. In this case, investors in the first four marginal tax brackets would be better off investing in the taxable bond since they would earn more than a 7% non-taxable bond even after paying their tax due. Tax-free bonds are preferable for investors in the top three tax brackets. However, none of this is investment advice; instead, you should contact with a tax or financial professional.

Example of Tax-Equivalent Yield

A tax-exempt municipal bond with an 8% coupon rate is owned by an investor with a federal income tax bracket of 22% and no state taxes. Use the following calculation to determine the fully taxable equivalent yield that a taxable bond would have to earn to equal the municipal bond’s yield.

ReturnTEY= 0.08 ÷ (1 – 0.22) = 10.26%

In other words, a taxable bond would have to generate an equal yield of 10.26% in order to match the 8% return of a tax-free municipal bond after taxes.

The needed fully taxable equivalent yield will be more than 10.26% if the marginal tax rate is higher. So, assuming everything else stays constant, with the exception that the investor is in the 37% tax rate, the fully taxed equivalent yield would have to be:

ReturnTEY= 0.08 ÷ (1 – 0.37) = 12.70%

Why Are Municipal Bonds Tax-Exempt?

Since the advent of the federal income tax in 1913, interest received on state and municipal bonds has been tax-free. This was initially because many individuals believed the Constitution prohibited the federal government from taxing this revenue. Since then, the case for tax exclusion has been bolstered by the notion that municipal infrastructure initiatives benefit the public good, and so federal tax policy should promote them.

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Municipal bonds are not usually exempt from taxation. Federal taxes may be levied on municipal bonds if the Internal Revenue Service (IRS) does not consider a project to be beneficial to the general public. Taxable municipal bonds are uncommon, however they might be issued for purposes such as a sports stadium or a pension deficit. Municipal interest income may also be taxable if a bond is acquired at a large discount to par value.

A tax-free bond mutual fund is nonetheless liable to capital gains tax.

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