Estimating Tax Equivalent Yields
This calculator can estimate a bond’s taxable-equivalent yields that range from tax-free to fully-taxable. The calculator needs a total of five inputs, including:
- The bond’s current price on the secondary market
- The par value of the bond, also known as the bond’s face value
- The bond’s coupon rate, expressed as an annual percentage
- The user’s incremental federal income tax bracket. Note this is different than their average tax bracket. We’ll explain more about incremental versus average tax brackets later
- The user’s incremental state income tax bracket, if any
The calculator then provides the user with four outputs, including:
- An estimate of the bond’s fully-taxable yield
- An estimate of the bond’s state-exempt yield
- An estimate of the bond’s federally-exempt yield
- Finally, an estimate of the bond’s non-taxable yield
Why is Knowing Taxable-Equivalent Yields Important?
When an investment in the United States provides its owner with a source of income, that income may be subject to state and / or federal income taxes. Since the owner of the asset may be liable to pay income tax on the investment, that loss of income to taxes lowers the investment’s yield. Investors often have a choice between several investments, which is why it’s important that any comparison between yields take into consideration the effect taxes have on its yield.
Municipal, corporate, and even bonds offered by the US Treasury are offered with a variety of features, some of which might include income that is free of state and / or federal income taxes. This calculator allows the user to make fair comparisons of such offerings to other potential investments.
In this example, our investor has a number of choices. They can purchase common stocks, which they believe will provide a long-term rate of return of 7.000%. They could also purchase a bond with a par value of 1,000 for 900, carrying a coupon rate of 5.000%. In this example, the investor’s incremental federal income tax bracket is 24% and their state income tax rate is 5.00%. Since the bond’s Federally Tax-Exempt equivalent yield is 7.310%, the investor would be better off purchasing the bond since it’s equivalent yield is higher than 7.000%. The same comparison approach is used if the bond was free of state income taxes.
Incremental versus Average Tax Brackets or Rates
When using this calculator, it’s important to use your incremental tax bracket and not the average tax you pay. A single taxpayer making 100,000 per year might pay around 13,000 in federal income tax. That person’s average federal income tax rate would be calculated as 13,000 / 100,000, or 13%. However, someone making that much money would fall into the 24% incremental tax bracket, which means they would pay 0.24 for every 1 increment of income earned. Since an investment like a bond is providing this taxpayer with incremental income, they should evaluate their options using their incremental rate, not their average rate. That is why this calculator only allows the user with a choice of the incremental tax brackets – to avoid the mistake of using an average.