Calculating Your Tax-Equivalent Yield Is Easy

By identifying your current tax bracket, you can quickly calculate whether a municipal bond offers a yield that's competitive with its taxable equivalent. The formula looks like this:

Here's an example: Consider a married couple that files joint taxes and earns somewhere between $89,450 and $190,750. Of the seven current federal tax brackets, this couple would fall into the 22.00% bracket (see FIGURE 1). Now, say the couple has found a municipal-bond issue with a quoted yield of 4.50% and a competing 5.15% corporate bond. Which yield would make the taxable corporate bond a clearly preferable choice over the municipal alternative?

After plugging the numbers into the tax-equivalent yield formula, it’s easy to see that the muni actually offers a more attractive yield:

Or: 4.50% ÷ (100 – 22%) = 5.77% 

The formula reveals that, for investors whose adjusted gross income (AGI) falls into the 22.00% tax bracket, a pre-tax corporate bond would have to yield at least 5.77% to be competitive against the municipal bond earning 4.50% with its built-in tax savings. As FIGURE 1 also shows, the tax-equivalent yields for tax filers in the two highest tax brackets offer the greatest potential to exceed the yields of comparable taxable bonds.

And Don’t Forget the 3.80% Net Investment Income Surcharge
As for those higher tax brackets, they’re worth a closer look. Officially, the four highest brackets, as determined by the Internal Revenue Service (IRS) for 2023, stand at 24.00%, 32.00%, 35.00%, and 37.00%. But because of an additional 3.80% federal tax surcharge that’s used to finance Medicare and other subsidies paid through the Affordable Care Act, the highest brackets actually end up being 27.80%, 35.80%, 38.80%, and 40.80%. The surcharge is officially known as the Net Investment Income Tax, and it nearly always applies to high-income earners who have either excess amounts of net investment income¹ or excess AGI (as determined by an IRS threshold). The surcharge is applied to whichever category of excess income is less.

If you’re wondering whether interest income from munis could be considered net investment income subject to the 3.80% surtax, the good news is that they’re not.² This is a potential positive to consider when weighing the potential advantages of muni bonds. But, as in most matters concerning taxes, your financial professional or tax professional can help you compare yields on tax-exempt municipals vs. taxable alternatives so that you’ll be less likely to confuse the apples from the oranges at tax time.

¹ In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments, or commodities and businesses that are passive activities to the taxpayer (within the meaning of section 469 of the Internal Revenue Code). To calculate net investment income, a taxpayer’s investment income is reduced by certain expenses properly allocable to the income. Source: IRS.gov.

² Although municipal-bond interest generally isn’t subject to federal taxes, the IRS does include income from such bonds in your modified AGI when determining how much of your Social Security benefit is taxable. Source: schwab.com.

All information provided is for informational and educational purposes only and is not intended to provide investment, tax, accounting, or legal advice. As with all matters of an investment, tax, or legal nature, you should consult with a qualified tax or legal professional regarding your specific legal or tax situation, as applicable. The preceding is not intended to be a recommendation or advice. Tax laws and regulations are complex and subject to change.

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Municipal securities may be adversely impacted by state/local, political, economic, or market conditions; these risks may be magnified if the Fund focuses its assets in municipal securities of issuers in a few select states. Investors may be subject to the federal Alternative Minimum Tax as well as state and local income taxes. Capital gains, if any, are taxable.