Bonds can provide passive income, some of which may be tax-free if you’re investing in municipal bonds. The tax-equivalent yield formula can be a useful tool for comparing taxable and tax-free bond investments. Tax-equivalent yield tells you how much of a return a taxable bond would need to generate in order to equal the yield on a tax-exempt bond.
A financial advisor can help you create a balanced portfolio with a blend of bonds and other investment types.
What Is Tax-Equivalent Yield?
Tax-equivalent yield is a calculation that investors can use to compare taxable and tax-free bonds. To understand how it works, it first helps to know a little about bond yields.
Bond yield measures the return an investor can expect to get from it. The coupon yield of a bond, or coupon rate, is the annual interest rate set when the bond is issued. The current yield of a bond is the coupon yield, divided by the current market price.
Investors can use bond yields to gauge how much of a return they’re likely to get from investing in a particular bond. Yield doesn’t factor in what you might pay in taxes on the interest the bond generates. Municipal bonds can be an attractive option for investors who want to maximize their returns since interest is exempt from federal taxes.
Tax-equivalent yield can help you figure out how much a taxable bond needs to yield, before taxes are factored in, to put it on par with the yield generated by a tax-exempt bond.
What Does Tax-Equivalent Yield Tell Investors?
Putting a taxable bond side-by-side with a tax-exempt bond and focusing solely on yield can create a misleading picture of its profitability. Again, taxable bond yields don’t account for the impact of taxes that you have to pay on the interest you earn.
If you choose bond investments based on yield only, that could belie a larger-than-expected tax liability. By factoring in the tax-equivalent yield, it becomes easier to compare bonds and gain a more accurate picture of the kind of returns you can expect.
That’s helpful if you’re weighing the benefits of municipal bonds against something like corporate bonds or high-yield bonds. While municipal bonds can offer higher yields than other types of bonds, they may not always match the yields of corporate or high-yield bonds. Calculating the tax-equivalent yield can tell you whether the promise of higher yields is worth it, once taxes are factored in.
How Is Bond Interest Taxed?
Bonds can generate interest income for investors. Whether you pay tax on that interest depends on the type of bond.
Here’s how bond interest is taxed:
- Corporate bond interest is always taxable.
- Municipal bond interest is usually tax-exempt at the federal level, though some muni bonds are taxable.
- Municipal bond interest may be tax-exempt at the state level if the bond is issued by the state in which you file your return.
- Treasury bonds are subject to federal tax but exempt from state and local taxes.
Bond interest has to be included on your tax return, even when it’s not taxable.
When you sell bonds for more than what you paid for them the end result can be a taxable gain. That’s a scenario you might run into if you sell a bond before its maturity date. Capital gains are subject to the capital gains tax rate.
The short-term capital gains tax rate applies to investments held for less than one year. The more favorable long-term capital gains tax rate applies to investments held for more than one year.
How to Calculate Tax-Equivalent Yield
To find tax-equivalent yield, all you need is a few pieces of information and a simple formula. Specifically, you’ll need to know the yield of a tax-exempt bond and which federal income tax bracket you fall into. Your tax bracket tells you which marginal tax rate applies.
If you have those details, you can then apply the tax-equivalent yield formula:
Tax-equivalent yield = Tax-exempt bond yield / (1 – Marginal tax rate)
Here’s an example of how tax equivalent yield works. Say you want to compare a taxable bond that offers a 5.0% yield with a tax-exempt bond that’s offering a yield of 4%. You’re in the 28% tax bracket. Your calculation would look like this:
4% / (1 – 0.28) = 5.56%
What does this mean? The tax-equivalent yield of the tax-exempt bond is 0.56% higher than the yield of the taxable bond.
Your income and resulting tax bracket can influence the yield that’s necessary for a taxable bond to generate in order to keep pace with tax-exempt bond returns. The higher your income and the higher the yield on the tax-exempt bond, the more that a taxable bond would need to yield.
Are Municipal Bonds or Taxable Bonds Better?
Municipal bonds can be attractive for investors who want to minimize the amount of tax they’re obligated to pay on interest income. If you’re in a higher tax bracket, then you might appreciate the tax-free income that muni bonds can generate.
However, it’s important to consider the investment as a whole when choosing bonds. For example, you’d also want to look at what’s happening with interest rates.
Bonds and interest rates have an inverse relationship. When interest rates fall, bond prices rise and bond yields decrease. If interest rates rise, then bond prices fall but bond yields rise. How interest rates are moving at a given point in time can determine what type of return you’re able to realize with taxable or tax-exempt bonds.
It’s also a good idea to weigh the credit risk of bond issuers. Municipal bonds are issued by state and local governments, meaning the odds of default is low. High-yield bonds, on the other hand, are typically issued by companies with lower credit ratings. So, while you may be able to get a higher yield compared to municipal bonds, there’s also a greater risk that the issuer could default, leaving you with nothing.
The Bottom Line
Tax-equivalent yield can be a helpful metric for comparing bond investments. Along with stocks, investing in bonds may allow you to build a well-rounded portfolio. Understanding how to compare taxable and tax-exempt bonds from a tax perspective can make it easier to decide which types of bonds make the most sense for your goals.
Tips for Tax Planning
- Calculating and planning around tax-equivalent yield considerations can be complex. A financial advisor can help. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- A financial advisor who specializes in tax planning can help lower your taxes by harvesting tax losses. This means that you will be able to use your investment losses to reduce taxes on capital gains or income.
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