Calculating Tax Equivalent Yield: Are Municipal Bonds Right for You?
Knowing how to calculate the tax-equivalent yield on municipal bonds is a key element of determining whether munis make sense for your investment portfolio.
Most municipal issues are tax-exempt on the federal and state levels, which sounds like a great deal at first. You wouldn't want to pay taxes on your investment income when you have the option not to.
Unfortunately, the decision isn’t quite that simple. For investors in lower tax brackets, it may, in fact, pay to invest in taxable securities, since the taxable bond issues often bring higher pre-tax yields than the returns from tax-free municipal bonds.
Knowing the municipal bonds' tax-equivalent yield (TEY) calculation is the first step in making a comparison and determining whether munis fit your needs.
Calculating Tax Equivalent Yield
The good news: the calculation's not difficult. The following shows how to calculate the tax-equivalent yield in a few steps:
- Find the reciprocal of your tax rate, or in other words, use (1 – your tax rate). If you pay 25 percent tax, for example, your reciprocal would be (1 - .25) = .75, or 75 percent.
- Divide this into the yield on the tax-free bond to find out the tax-equivalent yield. For example, if the bond in question yields 3 percent, use the equation (3.0 / .75) = 4 percent.
If you plug different tax rates into the equation above, you will see that the higher your tax rate, the higher the tax-equivalent yield, illustrating how tax-free bonds are best suited to those investors in the higher tax brackets.
Municipal bonds issued within your state of residence may be tax-free on both the federal and state levels, referred to as “double tax-free.” In this case, be sure to factor in your state's income tax rate when calculating your reciprocal in Step 1 of the tax-equivalent calculation.
For example, if your federal tax rate is 25 percent and your state tax rate is 3 percent, the appropriate math in Step 1 would be (1 - .28) = .72. You can view current federal income tax brackets here for your calculation.
Comparing Bond Issues
With this understanding, you can now make an apples-to-apples comparison between taxable and tax-free bond issues. If a taxable bond of equivalent credit quality and time until maturity yields more than 4 percent, then you would be better off investing in a taxable bond.
Two Additional Wrinkles
First, U.S. Treasuries are tax-free on the state level. If you’re comparing a municipal bond to a Treasury issue, you need to take the yield to maturity of the Treasury at the time of purchase and multiply by (1 – your state tax rate).
Second, if you sell an individual bond before it matures, or if you buy a bond fund and sell it again, you will be on the hook for a capital gains tax. Even though the income itself is tax-free, the capital gains are not. Learn more about how mutual funds are taxed.
The Bottom Line
Always do this simple math before you buy a municipal bond or muni bond fund. Tax-free income sounds like a great idea on paper, but you may be passing up the chance to earn higher after-tax income with your muni bond investments.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.