Equivalent Taxable Yield

Equivalent taxable yield

The yield that must be offered on a taxable bond issue to give the same after-tax yield as a tax-exempt issue.

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Tax-Equivalent Yield

The yield of a taxable investment that equals the yield of a tax-free investment with a lower stated yield. A corporate bond yields less than its stated interest rate because of taxation whereas a tax-exempt municipal bond does not. Thus, a municipal bond that pays a lower interest rate will often net the bondholder more than a corporate bond with a slightly higher interest rate, depending upon one's tax bracket. The tax equivalent yield is the extra yield required on a corporate bond to equal the post-tax yield of a municipal bond. See also: Municipals-over-bonds spread, After-tax basis.

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Taxable Equivalent Yield

The yield of a taxable investment that equals the yield of a tax-free investment with a lower stated yield. A corporate bond yields less than its stated interest rate because of taxation, whereas a tax-exempt municipal bond does not. Thus, a municipal bond paying a lower interest rate will often net the bondholder more than a corporate bond with a slightly higher interest rate, depending upon one's tax bracket. The taxable equivalent yield is the extra yield required on a corporate bond to equal the yield of a municipal bond. See also: Municipals-over-bonds spread, After-tax basis.

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equivalent taxable yield

The taxable return that must be achieved in order to equal, on an aftertax basis, a given tax-exempt return. Equivalent taxable yield is calculated by dividing the available tax-exempt yield by one minus the investor's marginal tax rate. For example, a tax-exempt return of 9% for an investor in a 40% marginal tax bracket would require a taxable return of ^.09/_0.6 , or 15%, to produce the same aftertax equivalent.

Does the purchase of tax-free securities make sense?

Analyze investments for risk related to return (payout and growth) and yield. Tax-free securities have less risk, but their return is usually lower than riskier growth investments, corporate bonds, or preferred stocks. Determine the equivalent taxable yield of a tax-free security (yield divided by the difference of one minus your marginal tax bracket). Compare the investment to alternative securities with similar or higher yields or returns. Invest for a higher return if you are comfortable with the risk. Tax-free securities make sense for high-income taxpayers looking for safer, certain returns.

Jeffrey S. Levine, CPA, MST, Alkon & Levine, PC, Newton, MA

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Equivalent taxable yield. While taxable bonds normally pay higher interest rates than tax-exempt bonds, they sometimes provide a lower overall yield.

Finding the equivalent taxable yield lets you determine the minimum interest rate a taxable bond must pay to equal the yield of a comparable tax-exempt bond. The formula for the equivalent taxable yield is tax-exempt interest rate ÷ (100 - your tax rate).

So, for example, if a municipal bond pays an annual interest rate of 7%, and your tax rate is 35%, the equivalent taxable yield would be 7 ÷ (100 - 35) = 10.8%. That means that in order to be as attractive an investment as the 7% municipal bond, a taxable bond would need to pay an annual interest rate of 10.8% or more.