What is a tax-equivalent yield on municipal bonds?

Municipal bonds offer investors the benefit of a tax-free yield on their investment, a benefit that can provide a significant advantage over traditional income investments. Because the yields on “muni bonds” are typically lower due to this advantage, investors must figure the tax-equivalent yield on munis to get a true apples-to-apples comparison with standard taxable investments.

Here’s how the tax-equivalent yield of a municipal bond works and how to calculate it.

What is the tax-equivalent yield on municipal bonds?

The tax-equivalent yield of a municipal bond is the effective pre-tax yield that you would need to earn to equal the tax-free yield on the muni. If you’re considering investing in muni bonds, it’s critical to make this calculation so that you’re getting the highest after-tax return on your money.

In many cases, it could make sense to go with a lower-yielding tax-free bond than a high-yielding traditional bond, because the after-tax yield on the muni bond is ultimately higher.

As an investor what you care about is what finally goes into your pocket after tax, not the pre-tax yield. For this reason, you need a true comparison between the pre-tax yields of munis and regular bonds, so that you can make a real comparison between the two.

Muni bonds are a more attractive option for investors in high-tax states and cities, so investors in those areas should be sure to calculate the tax-equivalent yield on potential muni investments.

How to calculate the tax-equivalent yield on a municipal bond

Figuring out the tax-equivalent yield on a muni bond is relatively straightforward, and to calculate it you’ll need to know your tax rate, including your federal, state and city rates, if applicable.

Here’s the formula for the tax-equivalent yield:

For example, imagine you pay federal tax at a 24 percent rate and state tax at a rate of 6 percent, and the municipal bond offers a yield of 3 percent.

The tax-equivalent yield of the muni would be 3 percent divided by the difference of (1 – 0.30). So 3 / 0.7, or 4.28 percent. In other words, the muni pays the taxable equivalent of a bond offering 4.28 percent – the threshold where you would be indifferent to the muni over the regular bond.

Of course, if your income grows in future years and you move into a higher tax bracket, then that same bond may have a higher tax-equivalent yield.

For example, let’s say you pay a 32 percent federal rate and an 8 percent state rate. The same 3 percent muni bond now has a tax-equivalent yield of 5 percent. In general, a taxable bond would need to pay more than 5 percent before you’d earn more after-tax than with the 3 percent muni.

Your individual tax rate is a key factor in a muni bond’s tax-equivalent yield, and the same muni bond may offer different tax-equivalent yields to investors depending on their situations.

Investors in high tax brackets – whether due to high earnings, high tax areas or a combination of factors – will want to think carefully about whether they can earn more with muni bonds than with regular bonds, regardless of the reported yields. What matters is what you put in your pocket.

How to compare yields on taxable and municipal bonds

The key value of calculating the tax-equivalent yield on a muni bond is to allow investors to make a smart decision about which type of bond to invest in. A higher headline yield is not always the highest yield once you factor in taxes, especially if you’re in a high tax situation.

You may also want to make other adjustments based on various tax situations:

• Treasury bonds issued by the U.S. government are tax-free at the state and local levels, though they remain taxable at the federal level. If you have to opt between Treasurys and munis, this factor can make the tax-equivalent yield of muni bonds look less attractive.

• You’ll skip federal and state taxes on muni bonds issued in a state where you pay taxes, but income from a muni issued by another state is likely still taxable in your own state.

• Similarly, muni bond funds can be an attractive way to get a diversified stream of tax-advantaged income, but a fund may own bonds issued in many different states, meaning you won’t get the full tax advantage in your own state.

• Some muni bonds own bonds issued only in a specific state, allowing you to take full advantage of that state’s tax advantage and, of course, the federal tax break.

• Like interest on Treasury bonds, interest on savings bonds such as from Series I bonds is also not subject to state and local taxes, making them relatively more attractive.

• If you move from a high-tax state such as California or New York to a low-tax state such as Texas or Florida, your tax-equivalent yields will change.

• If your income falls significantly, say, due to retirement, then you may move to a lower tax bracket, affecting the tax-equivalent yields on your investments.

• If you’re looking for investment income, you’ll also want to consider the tax-equivalent yields on dividend stocks, which may be subject to lower qualified tax rates.

Factors such as these and others can affect the tax-equivalent yield on muni bonds, making them more or less attractive for your financial situation. Maximizing your after-tax returns can help you put more money in your pocket, where it may be able to compound faster.

Bottom line

Calculating the tax-equivalent yield on a municipal bond is an important step in determining whether it’s an attractive place for you to invest. While muni yields are generally lower than on taxable bonds, what matters at the end of the day is how much goes into your pocket after-tax.