What Is a Fully Taxable Equivalent Yield?

Fully-taxable equivalent yield is the return that a taxable bond would need to equal the yield on a comparable tax-exempt (municipal) bond. The calculation is a tool that investors can use to compare the returns between a tax-free investment and a taxable alternative.

Key Takeaways

  • Fully taxable equivalent yield is the return that a taxable bond would need to equal the yield on a comparable tax-exempt (municipal) bond.
  • Fully taxable equivalent yield calculation allows investors to compare the potential results of a tax-free investment with a taxable alternative.
  • The required fully taxable equivalent yield would increase as the investor's tax bracket increases.

Understanding Fully Taxable Equivalent Yield

The fully taxable equivalent yield calculation is a useful tool for investors, especially those in high tax brackets. The calculation helps an investor to decide whether to select a taxable or tax-free investment. This is crucial as the tax-free advantage that municipal bonds offer will be hard to match.

Fully taxable equivalent yield is the yield on a taxable bond that an investor would have to earn to match the return on a comparable tax-free municipal bond. However, it is not the end of the story, and some additional tax considerations can come into play when making such a comparison. While municipal bonds are free of federal taxes, some states do tax the earnings.

Depending on an investor's tax bracket, a municipal bond may not be the best investment decision for their portfolio. An investor's tax bracket will depend on their filing status and income. According to the Tax Foundation, federal income tax brackets range from 10 to 37% for 2020. The actual brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

To calculate the taxable equivalent yield of a tax-free municipal bond, use the following formula and be sure to include any state taxes along with your federal tax rate.

  • ReturnTEY = ReturnTX ÷ (1 - t)

Where:

  • ReturnTEY: Return on fully taxable equivalent yield
  • ReturnTX: Return on tax exempt investment
  • t: Investor's marginal tax rate

This formula can be reversed to determine the tax-free equivalent yield of a municipal bond that would match the return on a taxable bond.

Example of Fully Taxable Equivalent Yield

An investor in the 22% federal income tax bracket, and no state taxes, owns a tax-exempt municipal bond with an 8% coupon rate. To calculate the fully taxable equivalent yield that a taxable bond would have to earn to match the municipal bond’s yield, use the above formula.

  • ReturnTEY = 0.08 ÷ (1 - 0.22) = 10.26%

In other words, a taxable bond would have to earn an equivalent yield of 10.26%, where, after the taxes are deducted, it would match the 8% return of the tax-free municipal bond.

If the marginal tax rate is higher, the required fully taxable equivalent yield will also be higher than 10.26%. So, if all else remains the same, with the only difference being that the investor was in the 37% tax bracket, the fully taxable equivalent yield would have to be:

  • ReturnTEY = 0.08 ÷ (1 - 0.37) = 12.70%

Why Are Municipal Bonds Tax-Exempt?

Interest earned on state and local bonds has been tax-exempt since the introduction of federal income tax in 1913. Initially, this was because many people felt that the federal government should not infringe on municipalities borrowing powers. Since then, the constitutional justification for tax exclusion has been supported by the idea that since local infrastructure projects serve the common good, federal tax policy should support those projects.

Municipal bonds are not always tax-free. Federal taxes may apply to a municipal bond if the Internal Revenue Service (IRS) does not interpret a project as good for the entire public. Taxable municipal bonds are rare but can be issued for projects such as a sports stadium or a pension shortfall.

The IRS can also treat municipal interest income as taxable if a bond is purchased at a significant discount to par value if that bond is subject to the alternative minimum tax or to calculate social security tax. A mutual fund composed of tax-free bonds is still subject to capital gains tax.