Tax-free investments such as municipal bonds have lower yields due to their tax-exempt status. Use this calculator to determine an equivalent yield on a taxable investment. The higher your marginal tax bracket (state and federal), the higher the tax-equivalent yield.
How Do I Calculate Tax Equivalent Yield?
You can use the taxable equivalent yield calculator at Money Help Center to easily calculate the tax equivalent yield of potential investments. If you’d like to calculate these numbers manually, use this formula:
return on tax-free investment/(1-marginal tax rate)= taxable equivalent yield
To see this formula in use, let’s say that you are considering a muni bond with an 11% interest rate, and you are in a tax bracket that sees your federal taxes set at 28%. In this case, the formula would look like this:
0.11/(1 – 0.28) = 0.15277
This means that for this specific bond, the taxable investment of bond being considered would need to have a yield of more than 15.278% to be a better profit option than the municipal bond in question.
Why Should I Calculate the Tax Equivalent Yield?
Bonds are popular form of investment because they can be more stable than stocks. As long as a company continues to operate, it is obligated to repay its debts, including its bonds. Bonds from organizations are taxable, which can reduce the return on investment you can expect, but they do have a higher interest rate when compared with muni bonds. Municipal bonds, however, are seen by many investors as more stable since cities rarely go bankrupt, and these bonds offer tax savings as well.
Comparing lower-interest but tax-free bonds with taxable but higher-interest private sector bonds can be a challenge, though. It can be like comparing apples and oranges. In addition, different investors have different goals, and since they may be in various tax brackets, considering tax equivalent yield is important. Tax equivalent yield can show how one investor can get a better return on one muni bond while another investor in a lower tax bracket may actually do better with a taxable bond.
For instance, in the above example, if a different investor were considering the same muni bond but was in a 20% income bracket, the formula indicates he or she would need to consider bonds with a yield of more than 13.75% yield to choose a better option than the muni bond. The same securities but different investors mean varied results.
As an investor, your tax bracket has an impact on how wise an investment is. If you are in a higher tax bracket, for example, the tax-free advantage of the muni bond can outweigh the lower return. The only way to know for sure which investment makes sense for you between a muni and taxable bond is to check the tax equivalent yield. Comparison allows you to weigh your options and helps you decide which investments are right for you.
If you want more help in determining whether muni bonds are right for you or need help budgeting or finding ways to invest more, Money Help Center has free and unbiased calculators to help you with virtually every area of your finances.