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How to Use Tax Equivalent Yield to Compare Taxable and Tax-Free Bonds

Danielle Letenyei - Author

Feb. 10 2023, Published 1:53 p.m. ET

When investing in bonds, you can choose whether to buy corporate bonds, which are issued by companies, or municipal bonds, which are issued by municipalities like cities and states. The difference between the two is in how they are taxed.

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You earn money with bonds through regular interest payments, and depending on the type of bond you have, the interest income you receive may be taxed. Corporate bonds are taxable and municipal bonds are usually tax-exempt.

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Which type of bond is going to bring you a better return? To figure that out, you need to figure out the tax-equivalent yield income.

What is a tax-equivalent yield?

The tax-equivalent yield is the pre-tax amount (or yield) that a taxable bond must pay in order to equal the yield of a tax-exempt bond. Basically, it's used to level the playing field between taxable and tax-exempt bonds so you can compare the possible returns on both to decide which is best for you.

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As a general rule, the pretax yield on a corporate taxable bond should be higher than a tax-free municipal bond to get a favorable return.

What is the tax yield formula?

There's a formula for calculating the tax-equivalent yield, which uses your marginal tax rate. Your marginal tax rate is the amount of additional tax paid for every additional dollar earned as income.

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The formula used to calculate the tax-equivalent yield is:

Tax-equivalent yield = Tax-free bond yield / (1 – marginal tax rate)

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Here’s a tax-equivalent yield example.

Say you have a tax-free bond with a 5 percent yield. Your estimated taxable income is $80,000, which gives you a federal marginal tax rate of 12 percent, and you have no state income tax. That means your tax-equivalent yield would be 5.68 percent. So, if you're investing in a corporate bond, it should yield at least 5.68 percent.

If math isn’t your strong point, many tax equivalent yield calculators are available online to do the math for you. Make sure that the online calculator you use uses the federal income tax brackets for 2023.

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Compare bonds with similar credit ratings.

When you’re using the tax-equivalent yield formula to compare taxable and tax-free bonds, make sure that the bonds you are comparing have similar credit ratings. A bond credit rating shows the bond's creditworthiness or how likely it's to uphold its financial obligations. Bonds with lower credit ratings may offer higher yields, but they're also riskier.

When can you buy bonds?

Companies issue corporate bonds to raise money for capital improvements. Municipalities use the bonds to fund public projects and services. You can buy bonds through a brokerage firm or investment and commercial banks.

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