Table of Contents
- What Is Tax-Equivalent Yield?
- Key Takeaways
- Tax-Equivalent Yield Formula
- Tip on Including State Taxes
- Tax Rate Implications
- Important Note on Taxable Municipal Bonds
- Examples
- Why Are Municipal Bonds Exempt From Federal Taxation?
- Are Municipal Bonds Subject to State Tax?
- When Are Capital Gains Taxes Applied to Tax-Free Investments?
- The Bottom Line
What Is Tax-Equivalent Yield?
Let me explain what tax-equivalent yield means to you as an investor. It's the return a taxable bond would need to provide to equal the yield on a comparable tax-exempt municipal bond. You use this calculation to compare returns between a tax-free investment and a taxable one, and remember, its value depends on your individual tax bracket.
Key Takeaways
Here's what you need to know: the tax-equivalent yield is the return a taxable bond requires to match a comparable tax-exempt bond like a municipal one. You compare returns between tax-free and taxable alternatives this way. And again, the value to you hinges on your tax bracket.
Tax-Equivalent Yield Formula
The tax-equivalent yield is what you'd need to earn on a taxable bond to match a tax-free investment's return. Depending on your tax bracket, a tax-free option like a municipal bond might not always be the best for your portfolio. Your tax bracket comes from your filing status and income, with federal rates for 2024 and 2025 at 10%, 12%, 22%, 24%, 32%, 35%, and 37%. To calculate it for a tax-free municipal bond, use this formula: Return (TEY) = Return (TX) / (1 - t), where Return (TEY) is the fully taxable equivalent yield, Return (TX) is the tax-exempt return, and t is your marginal tax rate. You can reverse this to find the tax-free yield matching a taxable bond.
Tip on Including State Taxes
When you calculate the return, include any state taxes along with your federal rate.
Tax Rate Implications
Your tax bracket and rate directly impact the tax-equivalent yield. Take a tax-free bond yielding 7%, for example. Whether you choose this or a taxable option depends on your marginal bracket. For 2024, the calculations are: in the 10% bracket, it's 7% / (1 - 10%) = 7.78%; 12% is 7.95%; 22% is 8.97%; 24% is 9.21%; 32% is 10.29%; 35% is 10.77%; and 37% is 11.11%. If a taxable bond yields 9.75%, you'd be better off with it in the first four brackets, as it beats the 7% after taxes. In the top three, go for the tax-free bond.
Important Note on Taxable Municipal Bonds
Taxable municipal bonds are uncommon but can appear for projects like sports stadiums or pension shortfalls.
Examples
Suppose you're in the 22% federal bracket with no state taxes, holding a tax-exempt municipal bond at 8% coupon. The taxable equivalent is 0.08 / (1 - 0.22) = 10.26%. A taxable bond needs to yield 10.26% to match after taxes. If your rate is 37%, it jumps to 0.08 / (1 - 0.37) = 12.70%.
Why Are Municipal Bonds Exempt From Federal Taxation?
Interest on state and local bonds has been tax-exempt since the federal income tax started in 1913. Many believed the Constitution barred federal taxing of this income. Today, it's justified because local projects serve the public good, so federal policy supports them.
Are Municipal Bonds Subject to State Tax?
Municipal bonds offer a tax-free edge hard to beat, but watch for extras. They're free from federal taxes, but some states tax the earnings.
When Are Capital Gains Taxes Applied to Tax-Free Investments?
The IRS might tax municipal interest if you buy the bond at a big discount to par. A mutual fund of tax-free bonds faces capital gains tax.
The Bottom Line
In summary, tax-equivalent yield is what a taxable bond must return to equal a tax-exempt one like a municipal bond. Bond coupon payments are taxed based on type and issuer. U.S. Treasury bonds skip state and local taxes, and municipal bonds avoid regular federal income tax.
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