Taxable Equivalent yield is the yield that a taxable bond would have to pay in order to match the yield of a tax free bond. Municipal bonds are often free from state and federal taxes. Because of this they normally pay a lower yield than a taxable corporate bond with a similar credit rating. When comparing taxable vs. tax free bonds, you need to calculate the taxable equivalent yield in order to know which bond actually offers the higher yield for your specific situation.
Whether or not tax-exempt bonds make sense for you in particular will depend on your level of taxation. A good rule of thumb is that the higher your tax bracket, the more advantageous a tax exempt bond will be. Once you understand the tax status of a particular bond, deciding whether a taxable or tax exempt bond makes better financial sense for you is relatively simple.
If you want a short-cut, you can find our taxable equivalent yield calculator here. If you want the long version here are the steps:
The first step when calculating your taxable equivalent yield is to make sure that you are comparing bonds with similar credit quality (of at least “investment grade”) and maturity. Let’s take an example of two bonds both with the same high credit rating (AAA for example) and the same maturity of 15 years, with one being a taxable bond and the other one a municipal bond that is tax-exempt. In our example, the taxable bond gives a 5% yield. Because of the tax exemption the municipal bond in this example pays a lesser rate of 3.7%.
If you invest $100,000 in this example, your income after one year (assuming you do not reinvest the coupon payment) from the taxable bond will be $5,000. On the municipal bond you will earn $3,700. To find out which one will really be the most profitable for you, you now need to calculate income after tax.
The municipal bond is tax-free. Your net income from this bond will be $3,700 in all cases. The net income from the taxable bond will be affected by your federal income tax bracket. If you are in the 35% tax bracket, you’ll be taxed 35% of $5,000, meaning $1,750; that in turn means that you’ll only keep $3,250. In this case, the tax-free municipal bond with $3,700 of net income is a better deal for you.
What would happen if you were in the 28% federal income tax bracket? In that case, you’d be taxed 28% of $5,000 and you’d keep $3,600. Now the advantage of the tax-free municipal bond at $3,700, although it still exists, is much slimmer. You can guess what will happen if you are in the 25% tax bracket or lower –in this example, the taxable bond then becomes the more profitable one for you.
**In the example above, we did not add in state or local taxes. (Or, you could say we did the calculation for people living in Texas, Florida, Nevada, Alaska, and New Hampshire which do not have state income taxes.) If you live in a state such as New York or California, there are large state income taxes. Just add your state and local income taxes to your federal income tax when you do the calculation to get the the taxable equivalent yield. If you don’t know your state’s income tax rate you can find it here.
If you start off with a taxable bond and you’d like to know what the yield needs to be on a tax exempt bond to earn the same amount as the taxable bond, then just divide the net income (income after tax) from the taxable bond by the principal. Using the above example of $100,000 invested in a taxable bond by an investor with a 28% tax bracket, you’d have an income after tax of $3,600. In that case, you’d need to find a tax-free bond with a yield of 3.6% ($3,600/$100,000) to match the income on your taxable bond.
To help make this process easier see our taxable vs. non taxable bond calculator.
This lesson is part of our Free Guide to the Basics of Investing in Municipal Bonds. Continue to the next lesson here.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.