What Is Tax Equivalence and How Do You Calculate It?

Investors often face a choice between different types of investments, each with unique tax implications. Comparing a tax-free investment with a taxable one can be misleading without a method to level the playing field. Tax equivalence is a calculation that allows for a direct, after-tax comparison of returns. It converts the yield from a tax-free investment into its equivalent taxable yield, answering the question of which option provides a better net return once taxes are factored into the equation.

Key Components for Comparison

To accurately compare taxable and tax-free investments, it is necessary to understand three core components. The first is the investment’s “yield,” which represents the income return on an investment. This figure, typically expressed as a percentage, is the starting point for any comparison, indicating how much an investment pays out relative to its cost or market value.

The next component involves the two main categories of investments being compared. On one side are tax-free investments, with municipal bonds serving as a common example. The interest income from these bonds is generally exempt from federal income tax and, in some cases, state and local taxes as well. On the other side are taxable investments, such as corporate bonds, where the interest income is subject to taxation at all levels.

The final component is the investor’s “marginal tax rate.” This is not the average tax rate paid on all income, but rather the rate applied to the next dollar of earned income. It is a combination of the investor’s federal income tax bracket and their applicable state and local income tax rates.

The Tax-Equivalent Yield Formula

The formula is: Tax-Equivalent Yield = Tax-Free Yield / (1 – Marginal Tax Rate). This equation effectively scales up the tax-free yield to show what a taxable investment would need to return to provide the same after-tax income. It directly accounts for the portion of income that would be lost to taxes with a taxable investment.

To illustrate, consider an investor with a combined marginal tax rate of 30%, which includes a 24% federal bracket and a 6% state rate. This investor is evaluating a tax-free municipal bond that offers a 3% yield. In this case, 1 – 0.30 equals 0.70.

The tax-free yield of 3% (or 0.03) is divided by the 0.70 figure, resulting in a tax-equivalent yield of 4.29%. This means a taxable investment must yield at least 4.29% to be comparable to the 3% tax-free yield for this specific investor.

Applying the Result to Investment Choices

The calculated tax-equivalent yield serves as a direct benchmark for making an investment decision. It is the minimum yield a taxable investment must offer to match the after-tax return of its tax-free counterpart. This allows for a true apples-to-apples evaluation.

Using the previous example, the investor determined the tax-equivalent yield of a 3% tax-free municipal bond is 4.29%. Now, they can look at a comparable taxable corporate bond. If that corporate bond offers a yield of 4.50%, it is the better choice because its return is higher than the 4.29% tax-equivalent yield benchmark. After paying the 30% marginal tax, the net return would still be greater than the 3% from the municipal bond.

Conversely, if the comparable taxable bond only offers a yield of 4.00%, it falls short of the 4.29% threshold. In this scenario, the investor would be better off choosing the tax-free municipal bond. Even though its stated yield of 3% is lower, the absence of tax liability results in a superior after-tax return compared to the 4.00% taxable option.