The return required by a taxable bond to match the yield of an equivalent tax-exempt municipal bond is known as the tax-equivalent yield. Investors can use the formula to compare the returns of a tax-free investment with a taxable option.
- The return that a taxable bond would need to provide in order to match the return on a comparable tax-exempt bond, such as a municipal bond, is known as the tax-equivalent yield.
- Investors can use the formula to compare the returns of a tax-free investment with a taxable option.
- In general, tax consequences are a challenging, significant, and frequently ignored component of any financial strategy.
Tax-Equivalent Yield: An Overview
In general, tax consequences are a challenging, significant, and frequently ignored component of any financial strategy. Investors might benefit from the tax-equivalent yield computation, especially those in higher tax rates. The yield on a taxable bond that an investor would need to earn in order to equal the return on a comparable tax-free municipal bond is known as the tax-equivalent yield.
Although municipal bonds often have modest projected returns, the true impact of investing in them to save on taxes is frequently difficult to fully quantify. The computation aids the investor in choosing between taxable and tax-free investments, such tax-free municipal bonds. This knowledge is essential since it might be challenging to match municipal bonds’ tax-free benefit with other investments.
Yet, the narrative is not over yet. While doing such a comparison, extra tax factors may be taken into account. Federal taxes are not applied to municipal bonds, although certain states do. Municipal bonds may not have unlimited liquidity.
Calculation for Tax-Equivalent Yield
A municipal bond may not be the greatest investment for a portfolio, depending on the investor’s tax status. The filing status and taxable income of an investment will determine their tax bracket. For 2020 and 2021, the federal income tax rates 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, making sure to account for both your federal tax rate and any applicable state taxes.
When ReturnTEY = ReturnTX (1 – t)
- Return on fully taxable equivalent yield is known as ReturnTEY.
- ReturnTX: Return on investment made tax-free.
- t: The marginal tax rate for investors
The tax-free equivalent yield on a municipal bond that would equal the return on a taxable bond may be calculated using the opposite of this method.
Example of Calculations Using the Tax-Equivalent Yield Formula
The resultant tax-equivalent returns depend significantly on the investor’s tax rate. Consider a tax-free bond with a 7% return, for instance. The investor’s marginal tax bracket has a significant impact on whether they choose to invest in this specific bond or any of the several taxable options available. There are seven separate marginal tax bands in the US as of 2020: 10%, 12%, 22%, 24%, 32%, and 35%. The following are the tax-equivalent yield calculations for certain brackets:
- 10% R(te) = 7% / (1 – 10%) = 7.78% Bracket
- 12% R(te) = 7% / (1 – 12%) = 7.95% Bracket
- 22% R(te) = 7% / (1 – 22%) = 8.97% Bracket
- 24% R(te) = 7% / (1 – 24%) = 9.21% Bracket
- 32% R(te) = 7% / (1 – 32%) = 10.29% Bracket
- 35% R(te) = 7% / (1 – 35%) = 10.77% Bracket
- 37% R(te) = 7% / (1 – 37%) = 11.11% Bracket
Using this knowledge, suppose there is a taxable bond with a yield of 9.75%. Investors in the top four tax brackets would benefit more from choosing the taxable bond in this scenario because, even after paying their tax obligations, they would still earn more than a 7% non-taxable bond. The tax-free bond would be a superior choice for investors in the top three tax bands. But, keep in mind that none of this is investment advice, and you should speak with a tax or financial professional.
A Tax-Equivalent Yield Example
A tax-exempt municipal bond with an 8% coupon rate is owned by a shareholder who is subject to a federal income tax rate of 22% and no state income tax. Use the calculation above to get the fully taxable equivalent yield that a taxable bond would need to achieve to equal the yield of the municipal bond.
ReturnTEY = 0.08 (1 – 0.22), which is 10.26%
In other words, to match the 8% return of the tax-free municipal bond, a taxable bond would need to provide an equivalent yield of 10.26%.
The needed fully taxable equivalent yield will be more than 10.26% if the marginal tax rate is higher. The fully taxable equivalent yield, assuming everything else is equal and the investor is in the 37% tax band, would thus need to be:
ReturnTEY=0.08 (1 – 0.37), which is 12.70%
Why are municipal bonds exempt from taxes?
Since the enactment of the federal income tax in 1913, interest on state and municipal bonds has been free from taxation. At first, individuals believed the Constitution forbade the federal government from taxing this revenue, which led to this situation. Since then, the argument for tax exclusion has been backed up by the notion that because local infrastructure initiatives benefit society as a whole, federal tax policy ought to promote them.
Tax-free municipal bonds aren’t always available. If a project is not considered to be beneficial to the general public by the Internal Revenue Service (IRS), federal taxes may be due on a local bond. While they are uncommon, taxable municipal bonds can be issued for many purposes, including a sports stadium or a pension shortfall. If a bond is bought at a large discount from par value, the IRS may also classify municipal interest income as taxable.
Capital gains tax still applies to a mutual fund made up of bonds that are exempt from tax.