What is a ‘Fully Taxable Equivalent Yield’
Fully Taxable Equivalent Yield is the return that would have to be earned on a taxable bond to equal the yield on a comparable tax-free municipal bond.
This calculation is a useful tool for investors, especially those in high tax brackets, to compare potential results of a tax-free investment to a taxable alternative.
BREAKING DOWN ‘Fully Taxable Equivalent Yield’
Fully taxable equivalent yield is the yield on a taxable bond that an investor would have to earn to match the return on a comparable tax-free municipal bond. It is not, however, the end of the story and some additional tax considerations can come into play when making such a comparison. While municipal bonds are free of federal taxes, some states do charge taxes on their earnings.
Depending on an investor’s tax bracket, a municipal bond may not be the best decision for their portfolio. An investor’s tax bracket will depend on their filing status and income. According to the Tax Foundation, tax brackets are between 10 and 37 percent for 2018.
To calculate the taxable equivalent yield of a tax-free municipal bond, use the following formula and be sure to include any state taxed along with your federal tax rate.
Return(tax-exempt) = (tax-exempt interest rate)/(1 – tax rate)
An Example of Fully Taxable Equivalent Yield
An investor in the 25% tax bracket owns a tax-free municipal bond with a 10% coupon rate. To calculate the yield that a taxable bond would have to earn to match the municipal bond’s yield, use the above formula.
R(te) = .10/(1 – .2) = .125 = 12.5%
A taxable bond would have to earn a 12.5% yield to match the performance of the investor’s tax-free municipal bond. A second investor in a higher tax bracket would have a separate calculation, and their fully taxable equivalent yield would be higher than 12.5%.
This formula can be reversed to determine the tax-free equivalent yield of a municipal bond that would match the return on a taxable bond.
Why are Municipal Bonds Tax-Free?
Interest earned on state and local bonds has been tax-exempt since the introduction of the federal income tax in 1913. Initially, this was because many people felt that the federal government should not infringe on the borrowing powers of municipalities. Since then, the constitutional justification for tax exclusion by a more pragmatic idea: local infrastructure projects serve the common good, and federal tax policy should support those projects.
Municipal bonds are not always tax-free. Federal taxes may apply to a municipal bond if the IRS does not interpret a project as being for the good of the entire public. Taxable municipal bonds are rare but can be issued for projects such as a sports stadium or a pension shortfall. Also, the IRS can treat municipal interest income as taxable if a bond is purchased at a significant discount to par value if that bond is subject to the alternative minimum tax, or to calculate social security tax. A mutual fund comprised of tax-free bonds is still subject to capital gains tax.