What is Tax-Equivalent Yield?

Tax-equivalent yield (TEY) is a way to compare municipal bonds (which are often tax-free) with taxable bonds on an equal footing. It tells you what yield a taxable bond would need to offer to match the after-tax return of a tax-free municipal bond. This is especially useful for investors in higher tax brackets, where the tax savings on muni bonds can make them more attractive than they initially appear.

Municipal vs Taxable Bonds

Municipal bonds are debt securities issued by state and local governments. Interest from most municipal bonds is exempt from federal income tax, and if you live in the state where the bond was issued, it may also be exempt from state and local taxes. Taxable bonds (like corporate bonds or Treasury bonds) pay interest that is subject to federal and state income taxes. The TEY calculation helps you determine which type of bond offers a better after-tax return for your specific tax situation.

Why Marginal Tax Rate Matters

Your marginal tax rate (the rate you pay on your last dollar of income) is what matters for this calculation, not your average or effective tax rate. This is because bond interest is typically considered additional income that would be taxed at your highest bracket. The higher your marginal tax rate, the more valuable tax-free municipal bonds become relative to taxable bonds.

State Tax and NIIT Considerations

In addition to federal tax, you may also pay state income tax on bond interest. For in-state municipal bonds, this tax is often waived, making them even more attractive. High earners may also be subject to the Net Investment Income Tax (NIIT), which adds an additional 3.8% tax on investment income (but generally not on municipal bond interest). This calculator allows you to include these factors to get a more accurate comparison.

Limitations of This Calculator

This is a simplified, educational tool that does not account for many real-world factors that affect bond investing, including: bond pricing and market values, credit risk and default probabilities, liquidity differences, call provisions, Alternative Minimum Tax (AMT) treatment, state-specific rules and surcharges, phase-outs, timing of interest payments, and other tax complexities. Actual investment decisions should consider all these factors and consult with a qualified financial advisor or tax professional.