How to Calculate Tax Equivalent Yield

The tax equivalent yield (TEY) serves as a valuable metric for investors seeking to compare investment returns across different tax treatments. This calculation allows for standardized evaluation, helping individuals assess whether a tax-exempt investment offers a superior return compared to a taxable alternative. By adjusting the yield of a tax-exempt security to its taxable equivalent, investors can make more informed decisions.

Understanding Key Components

To accurately determine the tax equivalent yield, understanding its primary components is necessary. These include the taxable yield, the tax-exempt yield, and an investor’s specific marginal tax rate.

A taxable yield represents the return an investment generates before any taxes are applied. This income is subject to federal, and potentially state and local, income taxes. Common examples of investments that produce taxable yields include corporate bonds, interest from certificates of deposit (CDs), and earnings from taxable savings accounts.

Conversely, a tax-exempt yield refers to the return from investments whose income is generally free from certain taxes. Municipal bonds, often called “muni bonds,” are a prominent example. Interest earned from municipal bonds is typically exempt from federal income tax, and often from state and local income taxes if issued in the investor’s state of residency.

The marginal tax rate is the tax rate applied to the last dollar of income an individual earns. The marginal rate is the most relevant for TEY calculations because it determines the tax savings on additional tax-exempt income or the tax burden on additional taxable income. Investors can determine their federal marginal tax rate by consulting IRS publications or reputable tax software.

Calculating the Tax Equivalent Yield

The fundamental formula for calculating the tax equivalent yield is: Tax-Equivalent Yield = Tax-Exempt Yield / (1 – Marginal Tax Rate).

For instance, a tax-exempt bond offering a 3.0% yield to an investor in the 24% federal marginal tax bracket would be calculated as: 0.03 / (1 – 0.24), which simplifies to 0.03 / 0.76, resulting in a tax equivalent yield of approximately 3.95%. This indicates a taxable investment would need to yield at least 3.95% to provide the same after-tax return.

For an investor in the 32% federal marginal tax bracket evaluating the same 3.0% tax-exempt bond, the calculation is 0.03 / (1 – 0.32), which equals 0.03 / 0.68. The resulting tax equivalent yield is approximately 4.41%. This higher TEY demonstrates that the benefit of tax exemption increases as an investor’s marginal tax rate rises.

To illustrate further, imagine comparing a 3.0% tax-exempt municipal bond with a taxable corporate bond yielding 4.0%. For the investor in the 24% marginal tax bracket, the municipal bond’s TEY of 3.95% is less than the corporate bond’s 4.0% yield. In this specific case, the taxable corporate bond offers a slightly better after-tax return. However, for the investor in the 32% marginal tax bracket, the municipal bond’s TEY of 4.41% surpasses the corporate bond’s 4.0% yield, making the tax-exempt option more attractive on an after-tax basis.

If the calculated tax equivalent yield of a tax-exempt investment is higher than the stated yield of a comparable taxable investment, the tax-exempt option provides a greater after-tax return. Conversely, if the taxable investment’s stated yield is higher than the tax-exempt investment’s TEY, the taxable option may be more financially advantageous after taxes are considered. This comparison helps investors make informed decisions.

Factors Influencing the Calculation

Several factors can influence the accuracy and relevance of the tax equivalent yield calculation. Investors should evaluate these for a comprehensive financial assessment, as ignoring them could lead to an incomplete understanding of an investment’s true after-tax return.

State and local income taxes significantly affect the effective tax rate and the tax equivalent yield. Many municipal bonds offer exemption from federal, state, and local income taxes if the investor resides in the state of issuance. This “triple tax-exempt” status can further enhance the after-tax yield, particularly for investors in high-tax states. To account for this, the marginal tax rate used in the TEY calculation should include applicable state and local rates, considering any federal deductibility.

The Alternative Minimum Tax (AMT) is another consideration for certain municipal bonds. While most municipal bond interest is exempt from regular federal income tax, interest from some “private activity bonds” may be subject to the AMT. This could reduce the tax benefits for investors who are subject to the AMT, effectively lowering the true after-tax yield of these specific bonds. Individuals should consult their tax advisor to understand if their holdings or potential investments might trigger AMT implications.

Beyond tax considerations, investment risk and liquidity are factors that the tax equivalent yield calculation does not incorporate. TEY is a purely tax-focused metric and does not account for credit risk, which is the possibility that the bond issuer may default. It also does not factor in interest rate risk, where bond values can decline if interest rates rise, or liquidity risk, which relates to the ease with which an investment can be bought or sold without affecting its price. These non-tax elements are fundamental to a holistic investment evaluation.

Tax laws and rates are not static; they can change over time due to legislative actions or inflation adjustments. Any alterations to federal, state, or local tax rates, or changes to tax exemptions for specific types of income, will directly impact the tax equivalent yield calculation. Investors should remain aware of potential legislative developments that could alter the tax landscape and necessitate recalculating their TEY.