To be declared tax-equivalent, a bond's yield must be the same as or higher than the yield on a comparable tax-exempt municipal bond. Investors may use the formula to evaluate the tax-free returns of one investment against the taxable returns of another investment or option.

Understanding Tax-Equivalent Yield

In general, tax consequences are a difficult and essential component of any financial plan, even though they are often neglected as a component. The computation of tax-equivalent yield is an important tool for investors, particularly those in higher tax bands. Yield on taxable bond that investor would need to earn to equal return on similar tax-free municipal bond is yield that is referred to as tax-equivalent yield.

Because municipal bonds often have a modest projected return, the true effect of investing in them owing to the potential reduction in tax liability is sometimes not properly measured. This calculation assists an investor in deciding whether to choose a taxable or an investment exempt from taxation, such as a tax-free municipal bond. This information is very important since it might be difficult to find alternative investments that can compete with the tax-free benefit that municipal bonds provide.

Nevertheless, this is not the conclusion of the narrative. When conducting such a comparison, certain extra tax concerns may come into play as potential factors. Earnings on municipal bonds may be subject to taxation in some states, even though the federal government does not tax taxes on these investments. The liquidity of municipal bonds is likely restricted.

Tax-Equivalent Yield Formula

If an investor is in a higher tax rate, purchasing municipal bonds may not be the most advantageous investment choice for their overall portfolio. An investor's income level and filing status will determine which tax bracket they fall into. The following rates will be used for calculating one's federal income tax liability in 2020 and 2021: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Use the following calculation to determine the taxable equivalent yield of a tax-exempt municipal bond. Be careful to include any state taxes that may apply in addition to your personal tax rate at the federal level.

Example

The effective tax rate of an investor has a major impact on the tax-equivalent returns generated. Take, for example, the case of a tax-exempt bond that offers a return of 7%. The investor's marginal tax rate is an important factor to consider when deciding whether to put money into this specific bond or one of the many other available taxable options. As of the year 2020, the United States of America will have seven distinct marginal tax-rate brackets, which are as follows: 10%, 12%, 22%, 24%, 32%, and 35%.

The following information is based on the assumption that there is a taxable bond with a yield of 9.75%. For investors in the lowest four tax brackets, the taxable bond is preferable to the non-taxable bond since their after-tax returns will be higher. The bond's tax-exempt status benefits investors in the top three tax brackets. You should consult a tax or financial expert since this is meant to be something other than investment advice.

Example of Tax-Equivalent Yield

An investor in the 22% federal income tax bracket and no state income taxes holds a tax-exempt municipal bond paying 8%. The yield on a taxable bond would have to be more than the yield on the municipal bond by the amount calculated in the preceding sentence.

ReturnTEY=0.08÷(1–0.22)=10.26%

Put another way, a taxable bond must achieve an equivalent yield of 10.26% to match the 8% return that a tax-free municipal bond would provide after subtracting taxes.

If the marginal tax rate is greater, the necessary fully taxable equivalent yield will likewise be higher. It must be higher than 10.26%. Therefore, assuming that everything else stays the same and the only variable that changes is that the investor is now in the 37% tax band, the fully taxed equivalent yield would need to be:

ReturnTEY=0.08÷(1-0.37)=12.70%

Why Are Municipal Bonds Tax-Exempt?

Since the federal income tax was first implemented in 1913, interest collected on state and municipal bonds has been free from tax. At the time, many individuals believed that the Constitution forbade the federal government from taxing this income. This was the root source of the problem. Since that time, the concept that local infrastructure projects serve the common good has been used to bolster the basis for tax exclusion. As a result, this principle has also backed the idea that federal tax policy should fund such projects.