Investing What Is Tax-Equivalent Yield? By Robin Hartill Updated on December 9, 2022 Reviewed by Marguerita Cheng Fact checked by Kyra Baker In This Article View All In This Article How Does Tax-Equivalent Yield Work? Do I Need Tax-Equivalent Yield? Tax-Equivalent Yield for Individual Investors Frequently Asked Questions (FAQs) Photo: Westend31 / Getty Images Definition Tax-equivalent yield is the pretax amount that a taxable bond must pay to provide investors with a return that is equal to the returns they’d earn from a tax-exempt bond. This calculation is used to help investors compare the potential returns on taxable bonds versus tax-exempt bonds. Key Takeaways Tax-equivalent yield is a calculation investors use to compare yields on a taxable bond versus a tax-exempt bond.Corporate bond interest payments are taxed as income.Treasury securities are subject to federal income tax but exempt from state and local taxes.Municipal bonds usually are exempt from federal taxes.To calculate tax-equivalent yield, divide the yield of a tax-exempt bond by one minus the investor’s marginal tax rate. How Does Tax-Equivalent Yield Work? Bond investors often look at yields when they determine which bonds to purchase to maximize their returns. However, a bond’s yield is only part of the picture of its profitability. Taxation can reduce the amount of returns you take in from interest rate payments. Some bond coupon payments are exempt from state or federal taxes, others are not. Tax-equivalent yield is a number that tells you how much a taxable bond needs to yield before taxes to provide an equal yield to a taxable bond. Because you'll be comparing a taxed bond to a tax-exempt bond to determine tax-equivalent yield, you'll need to factor in your personal income tax bracket. Afterall, that is how to calculate how much tax you'd be responsible for with a taxable bond. You'll want to know which government taxes a taxable bond is subject to so you can compare it to a tax-exempt bond. Interest on typically is taxed as ordinary income. However, government-issued bonds usually are exempt from some taxes. For example, interest on Treasury bills, notes, and bonds is taxable at the federal level but exempt from state and local taxes. Note Interest paid to municipal bond investors typically is exempt from federal taxes. It may also be exempt from state taxes if the investor lives in the state that issued the bond. That means a taxable bond needs to pay a higher pretax yield than a tax-exempt bond to provide the same yield to investors. How To Calculate Tax-Equivalent Yield The formula for tax-equivalent yield is the tax-free bond yield divided by one minus the investor’s marginal tax rate, or income tax bracket: Tax-equivalent yield = Tax-free bond yield / (1 – marginal tax rate) Example of Tax-Equivalent Yield Suppose you’re an investor whose tax bracket is 32%. You’re comparing a tax-free municipal bond that yields 5% to a taxable corporate bond. Using the tax-equivalent yield formula, it would only make sense to invest in the corporate bond if it yields at least 7.35%. 7.35% = 5% / (1 – 0.32) If the corporate bond only yielded 6%, you’d earn lower returns than you would have gotten from the municipal bond after accounting for taxes. Note Remember, you'll want to factor in your total tax rate for the taxes that apply to the bond. So if an investor is in the 32% federal tax bracket and lives in New York, where state income tax is 6.85%, then the tax rate to subtract from 1 would be 38.85%. Do I Need Tax-Equivalent Yield? If you’re an investor who’s comparing a taxable bond to a tax-exempt bond, you need to consider tax-equivalent yield. Using the formula will help maximize your after-tax yield. Comparing the yields of two bonds won’t give you the full picture of which bond would be more profitable, because yield alone doesn’t account for taxes. The formula is especially important for investors with high incomes because they’ll pay higher tax rates on interest earned from corporate bonds. What Tax-Equivalent Yield Means for Individual Investors Taxes are an important factor in any investment decision. Individual investors should consider tax-equivalent yield to maximize their after-tax returns. If you invest solely based on which bond pays the highest yield, you may lose a significant portion of your returns to taxes. Tax-equivalent yield helps you compare bonds to determine which is right for your tax situation. Tax-equivalent yield will vary for individual investors based on their federal, state, and local income tax rates. Frequently Asked Questions (FAQs) Why is tax-equivalent yield significant? Tax-equivalent yield is significant because it tells you the amount of interest a corporate bond must pay to provide the same after-tax yield as a tax-exempt bond. The calculation helps investors determine which bond provides the best after-tax returns. What is the formula for tax-equivalent yield? The formula for tax-equivalent yield is the yield of a tax-exempt bond divided by one minus the investor’s marginal tax rate, or: Tax-free bond yield / (1 – marginal tax rate) = Tax-equivalent yield. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. IRS. “Topic No. 403 Interest Received.” IRS. “Module B Introduction to Federal Taxation of Municipal Bonds Overview.” New York Life Investments. "The Power of Tax-Equivalent Yield."