• Products
  • Insights
  • Practice Management
  • Resources
  • About Us

It’s easy to spot the difference between apples and oranges at your local market. For investors attempting to discern the advantages of tax-free municipal bonds over taxable corporate bonds, it’s more like apples to apples. And it takes more than a simple eye test to ensure a fair and accurate comparison.

After all, municipal bonds (“munis” for short) and investment-grade corporate bonds share many common attributes. Both fixed-income types can offer attractive yields, boast relatively high credit quality, and can help diversify equity-heavy portfolios. But since the income earned on munis is generally exempt from federal income taxes, a careful investor needs a reliable tool for sizing up the tax advantages of munis, especially when, at first glance, it might appear that taxable bond yields are superior.

That’s why learning how a municipal bond’s tax-equivalent yield is calculated could be a useful thing to know.

A tax-equivalent yield is the return calculation that puts a taxable bond and tax-exempt muni on equal footing. Computing the tax-equivalent yield helps investors understand how much a tax-exempt bond may save them in taxes. This provides a fairer way to compare the potential tax-free benefits a muni investor could receive vs. taxable alternatives whose yields are quoted pre-tax.


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:


Tax-Equivalent Yield =

Tax-Free Municipal Bond Yield
 100 - Tax Bracket


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:


Tax-Equivalent Yield =

Tax-Free Municipal Bond Yield
 100 - Tax Bracket

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.


Single and Married Filers: Finding the Tax-Equivalent Yield That Matches Your Tax Bracket

Single and Married Filers - Finding the Tax-Equivalent Yield That Matches Your Tax Brackets

* Includes additional 3.80% net investment income tax surcharge that may be imposed on single filers with modified AGI in excess of $200,000 or married joint filers with AGI in excess of $250,000. Single = tax brackets shown for single tax filers; Married = tax brackets shown for couples who are married and filing jointly. For illustrative purposes only. Source: IRS.gov.


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.


Talk to your financial or tax professional to help you assess the potential advantages of municipal bonds.


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. 

CCWP131 2933091

The material on this site is for informational and educational purposes only. The material should not be considered tax or legal advice and is not to be relied on as a forecast. The material is also not a recommendation or advice regarding any particular security, strategy or product. Hartford Funds does not represent that any products or strategies discussed are appropriate for any particular investor so investors should seek their own professional advice before investing. Hartford Funds does not serve as a fiduciary. Content is current as of the publication date or date indicated, and may be superseded by subsequent market and economic conditions.

Investing involves risk, including the possible loss of principal. Investors should carefully consider a fund's investment objectives, risks, charges and expenses. This and other important information is contained in the mutual fund, or ETF summary prospectus and/or prospectus, which can be obtained from a financial professional and should be read carefully before investing.

Mutual funds are distributed by Hartford Funds Distributors, LLC (HFD), Member FINRA|SIPC. ETFs are distributed by ALPS Distributors, Inc. (ALPS). Advisory services may be provided by Hartford Funds Management Company, LLC (HFMC) or its wholly owned subsidiary, Lattice Strategies LLC (Lattice). Certain funds are sub-advised by Wellington Management Company LLP and/or Schroder Investment Management North America Inc (SIMNA). Schroder Investment Management North America Ltd. (SIMNA Ltd) serves as a secondary sub-adviser to certain funds. HFMC, Lattice, Wellington Management, SIMNA, and SIMNA Ltd. are all SEC registered investment advisers. Hartford Funds refers to HFD, Lattice, and HFMC, which are not affiliated with any sub-adviser or ALPS. The funds and other products referred to on this Site may be offered and sold only to persons in the United States and its territories.

© Copyright 2024 Hartford Funds Management Group, Inc. All Rights Reserved. Not FDIC Insured | No Bank Guarantee | May Lose Value