Compare tax-free investments (like municipal bonds) with taxable investments. Calculate the taxable yield you need to match your tax-free return.
The yield on your tax-free investment (e.g., municipal bond)
Your marginal tax rate (federal, state, or combined)
The taxable yield needed to match your tax-free return
Tax Equivalent Yield (TEY) is a calculation that helps investors compare the returns of tax-free investments (like municipal bonds) with taxable investments (like corporate bonds, CDs, or savings accounts). It shows you what yield a taxable investment must earn to match the after-tax return of a tax-free investment.
This metric is especially important for investors in higher tax brackets, as tax-free investments can provide better after-tax returns even when their stated yields are lower than taxable alternatives.
Tax equivalent yield helps you make apples-to-apples comparisons between tax-free and taxable investments, ensuring you're maximizing your after-tax returns.
The tax equivalent yield formula is straightforward:
TEY = Tax-Free Yield ÷ (1 - Tax Rate)
TEY = Tax Equivalent Yield (as a percentage)
Tax-Free Yield = The yield on your tax-free investment (as a decimal)
Tax Rate = Your marginal tax rate (as a decimal)
Let's say you're considering a municipal bond with a 3% tax-free yield, and your marginal tax rate is 25%.
Step 1: Convert percentages to decimals: 3% = 0.03, 25% = 0.25
Step 2: Apply the formula: TEY = 0.03 ÷ (1 - 0.25) = 0.03 ÷ 0.75 = 0.04
Step 3: Convert back to percentage: 0.04 = 4%
Result: You would need a taxable investment yielding 4% to match the after-tax return of your 3% tax-free municipal bond.
Municipal bonds are typically tax-free at the federal level (and sometimes at the state level). Use TEY to compare them with taxable corporate bonds to see which offers a better after-tax return.
Some financial institutions offer tax-free CDs. Calculate the TEY to determine if they're more attractive than traditional taxable CDs based on your tax situation.
Investors in higher tax brackets (32%, 35%, or 37% federal) often benefit more from tax-free investments. TEY helps quantify this advantage.
When planning for retirement, consider how your tax situation might change. Tax-free investments can be particularly valuable if you expect to remain in a high tax bracket during retirement.
Tax-Free Yield: 3.5%
Tax Rate: 22% (federal)
Calculation: 3.5% ÷ (1 - 0.22) = 4.49%
Tax Equivalent Yield: 4.49%
A taxable investment would need to yield 4.49% to match this tax-free return.
Tax-Free Yield: 3.0%
Tax Rate: 37% (federal) + 5% (state) = 42%
Calculation: 3.0% ÷ (1 - 0.42) = 5.17%
Tax Equivalent Yield: 5.17%
For high earners, tax-free investments can be significantly more attractive.
The tax equivalent yield calculation uses your marginal tax rate (the rate on your last dollar of income), not your effective tax rate. Your marginal rate is typically higher and provides a more accurate comparison.
If you're comparing state-specific municipal bonds (which are often tax-free at both federal and state levels), include your combined federal, state, and local tax rates in the calculation.
While TEY is important, also consider credit risk, liquidity, duration, and other factors when choosing between tax-free and taxable investments.
Tax equivalent yield shows what a taxable investment must earn to match a tax-free investment. After-tax yield shows what you actually keep after taxes on a taxable investment. They're related but serve different purposes in investment comparison.
Not necessarily. Tax equivalent yield is just one factor. Also consider credit quality, liquidity needs, interest rate risk, and your overall investment strategy. A slightly lower TEY might be worth it for better credit quality or liquidity.
It depends. If you're comparing a state-specific municipal bond (which is tax-free at both federal and state levels), include your combined tax rate. For federal-only tax-free investments, use just your federal rate.
The higher your tax bracket, the higher your tax equivalent yield will be. This makes tax-free investments relatively more attractive for high-income investors. For example, a 3% tax-free yield equals a 4.62% taxable yield at 35% tax rate, but only 3.75% at 20% tax rate.
Most municipal bonds are tax-free at the federal level, but rules can vary. Some municipal bonds may be subject to alternative minimum tax (AMT). Always verify the tax status of specific bonds and consult a tax professional for your situation.
Use our tax equivalent yield calculator to compare tax-free and taxable investments. Understanding TEY helps you maximize your after-tax returns and build wealth more efficiently.
