Investment Securities - Tax Implications

Tax Equivalent Yield
Because municipal bonds have at least one tax-free component - they are free of federal tax - you will need to know how to calculate the tax equivalent yield (TEY). This yield describes the interest rate that one would need to earn with a taxable bond issue to equal the tax advantages of a municipal bond. The equation is simple:
 

After-tax Yield =     Muni Bond Yield
                                           (100% - customer's tax bracket rate)

For example, let's say Stanley Lehman, MD, is a high-income client of yours. He tells you that he earns a lot of money and is in the 35% tax bracket. You confirm his annual salary at $300,000 a year. Right now, 20-year munis are paying 4.8%. If Dr. Lehman is in the 35% tax bracket, the tax-equivalent yield (TEY) would be calculated as follows:

.048 = .048 = 7.38%
100-35 .65

 

If you were to compare the muni bond yielding 4.8% with a similar quality corporate bond that corporate bond would have to yield at least 7.38% to be considered as an investment option. If the corporate bond yields more than 7.38% the corporate bond would be a better investment.

Corporate Securities: Common Stock


Related Articles
  1. Bonds & Fixed Income

    Muni Bonds, Taxable Bonds or CDs: Which is Best?

    Here's how to tell if municipal bonds are a better investment than taxable bonds or CDs.
  2. Bonds & Fixed Income

    Calculating the Tax-Equivalent Yield

    Tax-equivalent yield is the pretax yield a taxable bond must possess for its yield to equal that of a tax-free municipal bond.
  3. Professionals

    Determining Muni Suitability For Clients

    FINRA Series 7 Online Study Guide Section 5
  4. Options & Futures

    20 Investments: Municipal Bonds

    What Is It? Municipal bonds, or "munis" for short, are debt securities issued by a state, municipality or county to finance its capital expenditures. Such expenditures might include the construction ...
  5. Professionals

    Municipal Bonds

    FINRA/NASAA Series 65: Section 8 Municipal Bonds. In this section calculation of taxable equivalent yield and general obligation and revenue bonds.
  6. Bonds & Fixed Income

    A Look at the Pros and Cons of Muni Bonds

    Considering muni bonds? Here's a look at their pros and cons.
  7. Financial Advisors

    Top 4 Ways to Avoid Muni Bond Mistakes

    Muni bonds are often perceived as safe investments. But it's important to do some thorough research before investing.
  8. Professionals

    After Tax Yield of a Taxable Security

    CFA Level 1 - After Tax Yield of a Taxable Security. Learn the relationship between taxable yields and tax-exempt issues. Provides samples on after-tax yield calculations.
  9. Taxes

    Taxation Rules For Bond Investors

    Several factors affect the taxable interest that must be reported. Learn more here.
  10. Bonds & Fixed Income

    How to Diversify with Muni Bond ETFs

    Thinking of diversifying with bonds? Consider these muni bond ETFs.
RELATED TERMS
  1. Tax-Equivalent Yield

    The pretax yield that a taxable bond needs to possess for its ...
  2. Fully Taxable Equivalent Yield

    The yield on a municipal bond, when the effect of reduced taxes ...
  3. After-Tax Basis

    A comparison of the net yields produced by taxable and tax-exempt ...
  4. Municipal Bond

    A debt security issued by a state, municipality or county to ...
  5. Bond Yield

    The amount of return an investor will realize on a bond. Several ...
  6. Municipal Bond Fund

    A mutual fund that invests in municipal bonds, or "munis." Municipal ...
RELATED FAQS
  1. How are municipal bonds taxed?

    Discover information about trading municipal bonds, specifically the various tax implications municipal bonds have at state ... Read Answer >>
  2. What is the importance of calculating tax equivalent bond yield?

    Calculate the tax-equivalent yield of tax-free municipal bonds to compare with taxable bonds. Find out if the tax savings ... Read Answer >>
  3. What is the difference between the yield of stock and the yield of a bond?

    Explore and understand the various meanings of the investment term "yield" as it is applied to equity investments and bond ... Read Answer >>
  4. How is a corporate bond taxed?

    Understand the three components of a corporate bond that are subject to taxes. Learn about the ways the federal and state ... Read Answer >>
  5. What do cities do with the funds generated from municipal bonds?

    Learn more about municipal bonds, including the various types of bonds issued and the purposes of municipal bond funds, such ... Read Answer >>
  6. How do the returns on municipal bonds compare to those of other bonds?

    Learn how tax-free municipal bonds may provide better returns than other types of bonds, and understand the risks of municipal ... Read Answer >>
Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center