How to Calculate Tax Equivalent Yield

Understanding Tax Equivalent Yield

The Tax Equivalent Yield (TEY) is a crucial metric for investors comparing the returns of taxable investments (like corporate bonds or stocks) with tax-exempt investments (like municipal bonds). It helps you determine what yield a taxable investment would need to offer to be equivalent to the after-tax return of a tax-exempt investment.

Why is TEY Important?

Tax laws can significantly impact investment returns. Investments that appear to offer lower yields might be more attractive after considering their tax advantages. The TEY allows for an "apples-to-apples" comparison, ensuring you make informed decisions based on your personal tax situation.

How to Calculate Tax Equivalent Yield

The core formula for calculating the Tax Equivalent Yield for a taxable investment, given a tax-exempt yield and your tax bracket, is as follows:

TEY = Tax-Exempt Yield / (1 - Marginal Tax Rate)

In this calculator, we consider your federal, state, and potentially local tax rates. The effective marginal tax rate is the sum of all applicable tax rates.

Calculator Formula Breakdown:

The formula used in this calculator accounts for multiple tax levels:

1. Calculate Total Marginal Tax Rate: Add your federal, state, and local (if applicable) tax rates together.
   Total Tax Rate (%) = Federal Tax Rate (%) + State Tax Rate (%) + Local Tax Rate (%)
2. Convert Rates to Decimals: Divide each percentage by 100 to get their decimal equivalents.
   Marginal Tax Rate (Decimal) = Total Tax Rate (%) / 100
3. Calculate Tax Equivalent Yield (TEY): Apply the TEY formula.
   TEY (%) = (Taxable Investment Yield (%) * (1 - Marginal Tax Rate (Decimal))) / (1 - Marginal Tax Rate (Decimal))
   
   Note: The formula for comparing a taxable yield to a tax-exempt yield is often phrased as finding the equivalent taxable yield for a tax-exempt investment. This calculator simplifies by taking a given taxable yield and calculating what its *after-tax* yield is, then expressing that as an equivalent *pre-tax* yield if it were tax-exempt.
   A more direct way to find the Tax Equivalent Yield for a tax-exempt bond to match a taxable bond would be:
   Equivalent Tax-Exempt Yield = Taxable Yield * (1 - Marginal Tax Rate)
   However, this calculator's purpose is to show what taxable yield is needed to match a given tax-exempt yield. Thus, if you input the yield of a tax-exempt investment and your tax rate, it calculates the taxable yield needed.
   
   The calculator actually computes:
   Equivalent Taxable Yield = Tax-Exempt Yield / (1 - Marginal Tax Rate)
   
   Let's adjust the inputs for clarity to reflect this standard comparison:

Revised Calculator Logic Explanation:

This calculator determines the Tax Equivalent Yield (TEY) of a tax-exempt investment. You provide the yield of a tax-exempt investment (like a municipal bond) and your combined marginal tax rate. The calculator then shows you what yield a taxable investment would need to offer to match the after-tax return of your tax-exempt investment.

1. Input Tax-Exempt Yield: This is the stated yield of your municipal bond or other tax-exempt security.
2. Input Your Marginal Tax Rates: Enter your federal, state, and local income tax rates. These represent the rate you pay on your last dollar earned.
3. Calculate Combined Marginal Tax Rate: Sum all applicable tax rates (federal + state + local).
4. Convert Tax Rate to Decimal: Divide the combined tax rate percentage by 100.
5. Calculate TEY: Use the formula:
   TEY = Tax-Exempt Yield / (1 - Combined Marginal Tax Rate Decimal)
   This formula effectively "grosses up" the tax-exempt yield to show the equivalent yield before taxes.

Example Scenario:

Suppose you are considering a municipal bond with a yield of 4.0%. Your marginal federal tax rate is 24%, your state tax rate is 5.0%, and your local tax rate is 1.5%.

• Combined Tax Rate: 24% + 5.0% + 1.5% = 30.5%
• Marginal Tax Rate (Decimal): 30.5 / 100 = 0.305
• TEY Calculation: 4.0% / (1 – 0.305) = 4.0% / 0.695 ≈ 5.755%

This means that to achieve an equivalent after-tax return to your 4.0% tax-exempt yield, a taxable investment would need to offer approximately 5.76%.

When to Use This Calculator:

• Comparing municipal bonds to corporate bonds or CDs.
• Evaluating different types of fixed-income investments with varying tax treatments.
• Making informed decisions about portfolio allocation based on your specific tax situation.