Tax Equivalent Yield Calculator - Evaluate if Municipal Bonds are Right for You
The start of this article is a quick introduction to the idea of an investment’s tax equivalent yield, which is a term used to describe the after-tax, or tax-adjusted, return a security (usually a bond, bond fund, or other fixed income security) returns for its investors. If you are already familiar with this concept, you can click here to jump down to our Tax Equivalent Yield Calculator.
Why Calculate Tax Equivalent Yields?
What investment will produce a higher return?
A corporate bond (or bond fund) that yields 3.5%? Or,
A Treasury bond (or bond fund) that yields 2.5%?
Depending on your income, the interest paid by the treasury bond could actually produce a higher after-tax return!
Knowing your investment’s tax-equivalent yield is very important.
For those readers also from Iowa, its even more important. Us Iowans are no stranger to a high state income tax. In fact, even with the reduced tax rates going into effect in 2019 (we have a post detailing the changes to Iowa’s 2019 tax law here), Iowans will still be one of the highest taxed in the nation.
That has broad implications for how Iowans should save and invest.
In fact, even with the reduced tax rates in 2019, a married household in Iowa with $75,000 in taxable income is taxed at the second highest rate in the nation (8.53%) - Behind only only Oregon (9%).
This means that a tax-focused investment strategy is very important to Iowans looking to save money for retirement.
Fixed Income Investing, Tax Rates, and After Tax Yields of Different Types of Bonds
Typically, the first place we at Hylland Capital Management look when starting to build a tax-efficient investment portfolio for a client is the fixed income portion of their investment portfolio.
A lot of times, investors (and investment advisors) will simply compare the yields of two different bond funds, and figure that the fund with the highest yield is the best. But that is hardly the case, because the interest payments of different types of bonds may be taxed at different rates by the Internal Revenue Service!
Just as an example on how fixed income gets so confusing from a tax equivalent yield prospective, consider how the following types of investments would be taxed:
The numbers below use the federal and state tax brackets for a married couple in Iowa with a taxable household income of $100,000:
Corporate Bond Fund - Corporate bonds are subject to federal income taxes and state taxes. For this Iowa couple, that means a 22% tax at the federal level, and a 8.53% tax at the state level.
Treasury Bond Fund - Treasury bonds give investors some tax benefits. Although the income from a treasury bond is taxed at the federal income tax rate, there are no state taxes due for interest earned from a treasury bond. So for our hypothetical Iowa investor, they would only be subject to a 22% federal tax.
From just those 2 examples, you may begin to see why knowing an investments tax equivalent yield (that is, the return of the investment after taxes) is so important. Even if a treasury bond has a lower yield that a corporate bond, after the effect of state taxes, a treasury bond may have a higher tax equivalent yield for an investor!
If our hypothetical Iowa couple is considering between a corporate bond fund that yields 3%, and a treasury bond fund that yields 2.9%, which one is better? Is the higher interest rate on the corporate bond worth the additional taxes due?
To find out, we do a calculation to find the tax equivalent yield of the two investments.
For the corporate bond fund with a 3% bond yield - we subtract the impact of federal and state taxation:
3% * (1 - 22%) * (1 - 8.53%)
This gives us an after tax yield of 2.14%. In other words, after considering the impact of taxes, this corporate bond fund returns 2.14% per year.
Now, lets consider the 2.9% yielding treasury bond fund:
2.9% * (1 - 22%)
(Remember, there are not state taxes applied to income from treasury bonds)
This gives the treasury bond fund an after-tax yield of 2.26%, higher than the corporate bond fund.
But there is more than just corporate bonds and treasuries. There are also municipal bonds:
Tax Equivalent Yields for Municipal Bonds
Municipal bonds (or simply - “Muni bonds”) are bonds that are issued by… a municipality. Typically cities, counties, and state run organizations. And these have even better tax breaks than treasury bonds:
Municipal bonds are exempt from federal taxes.
And, IF the municipal bond is issued from your state of residence, it is typically exempt from state tax. (The answer will depend on your state’s tax laws)
So now, let’s add another investment option to our choice above. Now we will consider a 3% corporate bond, a 2.9% treasury bond, and a 2.7% municipal bond fund.
We already found the after tax yields of the corporate bond to be 2.14%, and the treasury bond fund to be 2.26. But now, let’s look that the 2.7% municipal bond fund.
Unless you are able to find a bond fund that holds only municipal bonds in your state, most of the income from a municipal bond fund (Either an ETF or a mutual fund) will still be taxed at the state level (since the income comes from other state’s municipal bonds). We cover this in much more detail in our post here:
Looking for an Iowa Municipal Bond Fund? It Doesn’t Exist – Here’s How (and Why) We Invest in Iowa Municipal Bonds
To calculate the out of state municipal bond fund’s (or ETF’s) tax equivalent yield:
2.7% * (1 - 8.53%)
which gives us about 2.46% - a much higher yield than both the corporate bond fund and the treasury bond fund, despite the fact that the municipal bond fund had a much lower advertised yield.
So does that mean tax free income from municipal bonds is right for you?
Invest in Tax Efficient Municipal Bonds? Not An Easy Answer
However, you will be hard pressed to find a specific answer online about whether or not tax exempt bonds are right for you. That’s because the tax equivalent yield of these investments is different based on your tax rate.
For bond investors with a high income, municipal bonds may provide very high taxable equivalent yields. But for someone who has a low income, such as someone who has just retired, a municipal bond’s appeal may be lost since the tax savings dramatically decreases.
So, we built a calculator that helps you determine an investment’s tax equivalent yield based on your income and state of residence:
Tax Equivalent Yield Calculator
To use the calculator below, simply enter your income into the highlighted cell, then select your state from the dropdown menu.
The calculator will automatically determine your federal and state income tax brackets.
Then, in step 2, select between the different investment types in the drop down menu, and enter the yield for that type of investment.
For example, if you want to evaluate what interest rate you need to get from a municipal bond to get a tax equivalent yield of a 2.65% yielding CD from a bank, select ‘Checking, Savings, CD’ from the drop down menu and type 2.65 in the yield box.
Interpreting Results From the Calculator
Let’s say you enter in your information to the tax equivalent yield calculator and see this:
By selecting a corporate bond (or corporate bond fund) with a 3.00% yield, this calculator is showing the tax equivalent yields of other types of investments. For example, if you could find a treasury bond with a yield of 2.76% or higher, it would provide a better tax-equivalent, or tax-adjusted return.
Using the Tax Equivalent Yield Calculator
If you still have questions on how to use our tax equivalent yield calculator, here’s a brief walk-through:
Still have questions on how to determine if tax exempt muni bonds are the best type of bond investment for you based on your state of residence, or income? Reach out and contact us today to help you get the most “after-tax-bang” for your investment “buck”!