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Understanding Tax-Equivalent Yield
Let me explain tax-equivalent yield directly to you: it's the return a taxable bond must provide to match the yield of a comparable tax-exempt municipal bond after taxes. As an investor, you use this to compare tax-free options with taxable ones, and remember, its value hinges on your personal tax bracket.
Key Points on Tax-Equivalent Yield
To put it plainly, tax-equivalent yield shows what a taxable bond needs to yield to equal a tax-exempt bond's return. You compare these to decide between tax-free investments like municipal bonds and taxable alternatives. Your tax bracket directly impacts how beneficial this is for you.
The Tax-Equivalent Yield Formula
Here's the formula you need: Return (TEY) = Return (TX) / (1 - t), where TEY is the taxable equivalent yield, TX is the tax-exempt return, and t is your marginal tax rate. This helps you see if a tax-free municipal bond fits your portfolio, especially if your tax bracket makes taxable options less appealing. You can reverse it to find the tax-free yield matching a taxable bond. Don't forget to factor in state taxes alongside federal rates for accuracy.
How Tax Rates Affect Your Calculations
Your tax bracket and rate shape the tax-equivalent yield outcomes. Take a tax-free bond yielding 7%—your choice between this and taxable bonds depends on your marginal bracket. For 2024, calculations show: in the 10% bracket, it's 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 prefer it in the lower four brackets since it nets more after taxes than the 7% tax-free option, but in the top three, the tax-free bond wins. Keep in mind, taxable municipal bonds exist for things like stadiums or pensions, though they're uncommon.
Real-World Examples
Suppose you're in the 22% federal bracket with no state taxes and hold a municipal bond at 8% coupon. The taxable equivalent is 0.08 / (1 - 0.22) = 10.26%—that's what a taxable bond must yield to match it after taxes. If your rate is 37%, it jumps to 0.08 / (1 - 0.37) = 12.70%. Higher taxes mean you need a higher taxable yield to compete.
Why Municipal Bonds Get Federal Tax Exemption
Since the federal income tax began in 1913, state and local bond interest has been exempt, rooted in constitutional views and the idea that these projects benefit the public, so federal policy supports them.
Do State Taxes Apply to Municipal Bonds?
Municipal bonds escape federal taxes, but some states tax the earnings, so factor that into your comparisons—it's a key detail that could reduce the tax-free advantage.
Capital Gains on Tax-Free Investments
The IRS might tax municipal interest if you buy the bond at a big discount to par. Also, mutual funds of tax-free bonds face capital gains taxes, so watch for that in your strategy.
Wrapping It Up
In summary, tax-equivalent yield is what a taxable bond must return to match a tax-exempt one like a municipal bond. Bond coupons are taxed based on type and issuer—U.S. Treasuries skip state and local taxes, while municipals avoid regular federal income tax. Use this to make informed choices in your portfolio.
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