Tax-Equivalent Yield Explained: Definition, Calculation, Examples

(Many of the links in this article redirect to a specific reviewed product. Your purchase of these products through affiliate links helps to generate commission for LiveWell, at no extra cost. Learn more)

What is Tax-Equivalent Yield?

Are you confused about the concept of tax-equivalent yield? Wondering what it is and how it affects your investments? Well, you’ve come to the right place! In this article, we will explore tax-equivalent yield, its definition, calculation, and provide you with some examples to help you better understand this important concept in finance.

Understanding Tax-Equivalent Yield

When it comes to investing, understanding the impact of taxes on your returns is crucial. Tax-equivalent yield is a tool that allows investors to compare the after-tax yield of a tax-free investment with that of a taxable investment. It takes into account an investor’s marginal tax rate to calculate the pretax yield required for the taxable investment to be equivalent in terms of after-tax returns.

In simpler terms, tax-equivalent yield helps you determine how much return a taxable investment would need to generate to provide the same after-tax income as a tax-free investment. It allows investors to make more informed decisions by considering the tax implications of different investment options.

Calculating Tax-Equivalent Yield

To calculate the tax-equivalent yield, you need to follow these steps:

1. Determine your marginal tax rate: Your marginal tax rate is the percentage of tax you pay on the last dollar of your taxable income.
2. Subtract your marginal tax rate from 1: This will give you the after-tax rate of return.
3. Divide the tax-free yield by the after-tax rate of return: This will give you the tax-equivalent yield.

Here’s an example to help illustrate the calculation:

Let’s say you are considering two investments: a tax-free municipal bond with a yield of 4% and a taxable corporate bond with a yield of 6%. Your marginal tax rate is 30%. To calculate the tax-equivalent yield for the municipal bond:

1. Your after-tax rate of return is calculated as 1 – 0.30 = 0.70 (or 70%).
2. Divide the tax-free yield (4%) by the after-tax rate of return (0.70) = 4% / 0.70 = 5.71%.

Therefore, the tax-equivalent yield for the tax-free municipal bond is 5.71%.

Examples of Tax-Equivalent Yield

To fully understand the concept of tax-equivalent yield, let’s look at a couple of examples:

• Example 1: An individual with a marginal tax rate of 25% is considering investing in a municipal bond that offers a tax-free yield of 3%. To calculate the tax-equivalent yield:
1. After-tax rate of return = 1 – 0.25 = 0.75 (or 75%).
2. Tax-equivalent yield = 3% / 0.75 = 4%.

Therefore, the tax-equivalent yield for this individual is 4%.

• Example 2: Another individual with a marginal tax rate of 40% is considering investing in the same municipal bond with a tax-free yield of 3%. To calculate the tax-equivalent yield:
1. After-tax rate of return = 1 – 0.40 = 0.60 (or 60%).
2. Tax-equivalent yield = 3% / 0.60 = 5%.

Therefore, the tax-equivalent yield for this individual is 5%.

As you can see from these examples, a higher marginal tax rate results in a higher tax-equivalent yield, indicating that a taxable investment needs to offer a higher pre-tax yield to match the after-tax yield of a tax-free investment.

Understanding tax-equivalent yield allows you to make more informed investment decisions, taking into consideration the tax implications of various investment options. It is a valuable tool for comparing the after-tax returns of tax-free and taxable investments.

So, next time you are evaluating investment opportunities, don’t forget to take the tax-equivalent yield into account!