Municipal bonds—those issued by state, county and local government entities—have an appealing feature for many investors. Their coupon (interest) payments are generally exempt from federal taxes. Depending on the issuer and where you reside, they may also be exempt from state and local taxes.

This feature means the quoted yield on a muni bond may be understated relative to a corporate bond with a similar duration and credit rating once federal taxes are factored in. Depending on the state tax treatment, the yield on a muni bond may be even higher. The same is true when the comparison is made between muni bonds and Treasury bonds at the federal tax level. (Interest from Treasury bonds is exempt from state taxes.)

You can determine which yield is more attractive by calculating the tax-equivalent yield. This is the yield you realize after taxes are considered. Put another way, it shows you how much interest income you get to keep on an aftertax basis.

Determining Tax-Equivalent Yield

It is very simple to calculate your tax-equivalent yield on a municipal bond. You just need to know what your marginal tax rate is and the bond’s yield.

Marginal Tax Rate

Your marginal tax rate is the percentage tax rate that you pay on your last dollar of taxable income. You may already know what it is. If you don’t, you can look at your taxable income on your latest return. Then match it with the brackets for the current year. Updated federal tax brackets can be found in our annual tax guide.

We are going to use the federal tax brackets for the remainder of this article, since state income tax rates vary, and some states don’t have an income tax.

The Bond’s Yield

The bond yield is the amount of annual interest a bondholder will receive relative to the par value of the bond. Bonds in the U.S. have a par (“face”) value of $1,000. This means that at maturity, an investor will receive $1,000 for each bond they hold. The coupon rate is how much interest the bond pays relative to its par value up until its maturity date.

A bond trading at par value with a coupon of 2% will provide annual interest income of $20 ($1,000 × 2% = $20) via semiannual payments. In this case, its yield will also be 2%. If the bond is trading at a discount, say at $950, then its yield will be 2.11% ($20 ÷ $950 = 2.11%). If the bond is trading at a premium, meaning a price above par, then its yield would be below 2%.

For bonds you hold to maturity, yield is determined by the price you paid to purchase the bond and its stated coupon. For bonds you are considering purchasing, yield is based on the current price.

Tax-Equivalent Yield Formula

With these two numbers in hand, you can calculate the tax-equivalent yield for a municipal bond. The formula is:

Tax-equivalent yield = Tax-exempt yield ÷ (1 – Your marginal tax rate)

When using this formula to obtain the taxable-equivalent yield, you should convert percentages to decimals—for example, if you are in the top 37% marginal federal tax bracket (0.37 in decimal form) and you are considering the purchase of a municipal bond with a 2.11% (0.0211 in decimal form) yield that is exempt from federal taxes, your calculation looks like this:

Tax-equivalent yield = 0.0211 ÷ (1 – 0.37)
= 0.0211 ÷ 0.63
= 0.0335
= 3.35%

In this example, a municipal bond with a yield of 2.11% is equivalent to a taxable bond with a yield of 3.35% for an investor in the 37% tax bracket. Because taxable bond interest is included in net interest income (NII), a 40.8% (37% + 3.8%) tax rate should be used. Doing so would result in a tax-equivalent yield of 3.56%.

For an investor in the 24% tax bracket, the tax-equivalent yield is 2.78%. A municipal bond with a yield of 2.11% is equivalent to taxable bond with a yield of 2.78%. The tax-equivalent yield is lower in this case because the tax savings are smaller (a lesser percentage of income is taxed).

Let’s say a taxable bond with a coupon rate of 3% was purchased. The bond pays $30 of interest each year. An investor in the top tax bracket will owe $12.24 in federal taxes, $30 × (37% + 3.8%) = $12.24, including the NII tax, each year on the coupon payments. If the investor was in the 24% federal tax bracket instead (and therefore not subject to the NII), they would owe $7.20 in taxes instead ($30 × 24%).

Table 1 shows the taxable-equivalent yields of tax-exempt yields ranging from 1% to 6% for the current federal income tax brackets as well as after the NII tax is factored in. Table 2 compares Treasury bonds to municipal bonds on a tax-equivalent basis.

Table 1. Taxable-Equivalent Yields

Adjusting the Tax-Equivalent Yield Formula for State Taxes

When state taxes are involved, you can either add the additional amount to your federal tax rate or calculate the state tax rate separately.

You’d want to combine your federal and state tax rates when the bond is fully taxable. An example would be corporate bonds, which are taxable at the federal level and the state level for many states.

If you are considering a muni bond offered from an entity within your state versus a muni bond offered by an entity located in another state, then you would just want to use your state tax rate. In this case, you would calculate the tax-equivalent yield for the in-state bond to compare to the out-of-state bond.

Adjusting the Tax-Equivalent Yield for Other Considerations

It may require a bit more work, but the tax-equivalent yield can also be adjusted for the Medicare Income-Related Monthly Adjustment Amount (IRMAA) and/or how much of your Social Security benefits will be taxed. In both cases, you will want to determine the additional amount you will owe and adjust the tax rate used in the tax-equivalent yield calculation accordingly.

Table 2. Treasuries Versus Munis on a Tax-Equivalent-Yield Basis

Tax-Equivalent Yield & Muni Bond Funds

The tax-equivalent yield can also be used for bond funds. There are over 900 no-load muni bond mutual funds available to individual investors. There are also 65 municipal bond exchange-traded funds (ETFs).

Unlike bonds, the tax-equivalent yield you realize on a muni bond fund or ETF will not be static because of portfolio changes made by the fund manager and because, with the exception of defined-maturity bond funds, these funds never mature. Nonetheless, calculating the tax-equivalent yield can be a useful gauge when comparing a muni bond fund against a taxable bond fund.

AAII members can find muni bond funds in our Mutual Fund Guide and our ETF Guide, respectively. A+ Investor and AAII Platinum subscribers can narrow their search for muni funds by using our Funds Screener and/or our ETF Screener. Screening can be helpful for identifying muni bonds targeting specific states such as California or New York.

When considering a muni bond fund, read the prospectus to ensure you understand the fund’s strategy and what it invests in.

All AAII members can track both mutual funds and ETFs in My Portfolio. The dollar amount invested in individual bonds can also be included in My Portfolio for tracking allocation.

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