What Is Equivalent Taxable Yield and How to Calculate It?
Comparing tax-free and taxable investments requires an adjustment for tax status. Learn a method to see the true, comparable yield for both options.
Comparing a tax-free investment, such as a municipal bond, to a taxable one, like a corporate bond, is difficult because their stated yields are not directly comparable. A taxable bond’s return does not account for income taxes, while a tax-free bond’s yield is generally exempt from federal income tax. The equivalent taxable yield calculation translates the yield of a tax-free investment into the yield a taxable investment would need to offer for the same after-tax return. This allows investors to make an accurate, apples-to-apples comparison based on their tax situation.
Information Needed for the Calculation
To calculate the equivalent taxable yield, you must gather two pieces of information. The first is the yield on the tax-free investment you are considering, which is the stated annual return of the bond expressed as a percentage.
The second piece of information is your marginal tax rate. This is the rate you pay on your next dollar of earned income, not your average tax rate. For this calculation, you must determine your combined marginal tax rate, which includes your federal, state, and any local income tax obligations.
To find your combined rate, you simply add your federal marginal tax rate and your state marginal tax rate together. For example, if your federal rate is 24% and your state rate is 6%, your combined marginal tax rate for this calculation would be 30%. Some investors may also be subject to the 3.8% Net Investment Income Tax, which should be factored into the marginal rate if it applies to their income level.
The Equivalent Taxable Yield Formula
The formula is expressed as: Equivalent Taxable Yield = Tax-Free Yield / (1 – Marginal Tax Rate). In this formula, the marginal tax rate is expressed as a decimal, so a 30% rate would be written as 0.30. The denominator, (1 – Marginal Tax Rate), represents the portion of income you keep after taxes. Dividing the tax-free yield by this figure determines the pre-tax yield a taxable investment would need to match the after-tax return of the tax-free one.
Applying the Formula
To see the formula in action, consider an investor in a combined federal and state marginal tax bracket of 32%. This individual is evaluating a tax-free municipal bond that offers a yield of 3.5% and wants to understand what a taxable bond would need to yield to be a better investment.
The first step is to convert the marginal tax rate percentage into a decimal, so 32% becomes 0.32. Next, subtract this from 1, which gives you 0.68. The calculation is then: 3.5% / (1 – 0.32), or 3.5% / 0.68.
Performing this division gives an equivalent taxable yield of approximately 5.15%. This result means a taxable investment must offer a yield of at least 5.15% to provide the same after-tax return as the 3.5% tax-free municipal bond. If this investor were also considering a corporate bond with a yield of 4.9%, the calculation clearly shows that the municipal bond is the better choice for their specific tax situation.
Without this calculation, the 4.9% yield on the corporate bond might appear more attractive than the 3.5% from the municipal bond. The equivalent taxable yield provides the necessary context to make an informed decision, ensuring the impact of taxes is not overlooked.