How to Calculate the Tax-Equivalent Yield on Tax-Exempt Investments
Understanding Your Real Rate of Return on Tax-Exempt Securities
When investors are looking for safer investments that generate income, most think about fixed income securities like bonds. But there are many types of bonds, from corporate bonds to government bonds like Treasury bonds, and even municipal bonds. These types of investments are different from most stocks as they can be used to generate regular, fixed income as opposed to some increase in value due to capital gains. While there are several differences between the different bond types and of course differences between individual bonds with different issuers and interest rates, perhaps on of the most valuable differences in bond types for some investors is their tax treatment.
There is one class of bonds are especially unique in that they are generally exempt from federal and often even state taxes. Those bonds are municipal bonds.
The Tax Benefits of Municipal Bonds
Unlike other bond types, interest on municipal bonds, and some municipal bond funds, is exempt from federal income tax. Additionally, if you reside in the state or municipality from which the bond was issued, it may be exempt from state income tax as well.
Because of these tax breaks, those in higher income brackets may seek these types of bonds in order to avoid paying taxes on the interest that is generated. Even though those in higher tax brackets will see greater benefit, anyone looking for a fixed income investment may benefit. The key is to understand how to compare interest rates between tax-exempt investments like municipal bonds and the more common taxable investments.
How to Calculate Tax-Equivalent Yield
Generally speaking, comparing two bonds is easy. All else being equal, the bond with the higher interest rate will yield more money over time. But you can’t simply compare interest rates when looking at tax-exempt bonds as opposed to the more common taxable bonds. That's because you have to account for taxes or, as is the case of municipal bonds, the lack thereof. If you have a taxable bond that pays 3% interest, your real rate of return would be less than that 3% since you have to pay taxes on the interest.
So in order to compare a taxable investment's rate of return to a nontaxable investment, you have to use the following equation:
Tax-equivalent yield = interest rate ÷ (1 – your tax rate)
In this example, let’s assume you’re in the 25% tax bracket and are looking at a municipal bond that has a coupon, or interest rate, of 2.5%. If you want to know the real rate of return on a nontaxable municipal bond, that is the rate that would be equivalent on a taxable bond, you would perform the following calculation:
Tax-equivalent yield = 0.025 ÷ (1 - 0.25), or 0.025 ÷ 0.75 = 3.33%
This means you’d need to find a taxable savings account, CD, or bond paying at least 3.33% in order to achieve the same effective rate of return as the 2.5% municipal bond. In this example, we only account for the savings in federal taxes. If the municipal bond were also free from state taxes, the real rate of return would be that much higher.
Compare Interest Rates Correctly
When looking at income producing investments, it is important to make sure you’re comparing apples to apples. While many tax-exempt bonds may appear to have a lower interest rate at first glance, you really won’t be able to determine your real rate of return until you calculate the tax-equivalent yield.