Tax-Equivalent Yield: Guide to Understanding Its Meaning, Formula, and Significance in Investment Planning
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Last updated 03/21/2024 by
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Summary:
Tax-equivalent yield is a way for investors to calculate the pre-tax yield that a taxable investment must offer to match the after-tax yield of a tax-exempt investment. This measure allows investors to compare the after-tax returns of taxable and tax-exempt investments accurately. Tax-exempt investments such as municipal bonds are not subject to federal income taxes and may also be exempt from state and local taxes. The tax-equivalent yield is calculated by adjusting the pre-tax yield of a taxable investment to account for taxes. This adjusted yield represents the equivalent return that the investor would receive on a tax-exempt investment with the same risk and maturity. The tax-equivalent yield formula is TEY = Tax-free yield / (1 – Marginal tax rate), where the marginal tax rate is the highest tax rate an investor will pay on their income
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Definition of Tax-Equivalent Yield
Tax-equivalent yield refers to the rate of return on a taxable investment that an investor would need to receive to match the after-tax return of a tax-exempt investment. It is commonly used to compare the returns of taxable and tax-exempt investments.
The tax-equivalent yield is calculated by adjusting the pre-tax yield of a taxable investment to account for the taxes that the investor will have to pay on the investment income. This adjusted yield represents the equivalent return that the investor would receive on a tax-exempt investment with the same risk and maturity.
Understanding tax-equivalent yield
Investors must consider how taxes will affect their investment returns when comparing taxable and tax-exempt investments. Tax-exempt assets, like municipal bonds, are not subject to federal income taxes. Depending on the investor’s place of residency, may also not be liable to state and local taxes.
On the other hand, taxable investments, such as corporate bonds or stocks, are subject to federal income taxes, as well as state and local taxes, if applicable. To make an accurate comparison between taxable and tax-exempt investments, investors need to calculate the tax-equivalent yield of the tax-exempt investment.
The tax-equivalent yield represents the pre-tax yield that a taxable investment would need to offer to match the after-tax yield of a tax-exempt investment. The calculation of the tax-equivalent yield takes into account the investor’s tax rate and the type of tax-exempt investment.
For example, let’s say an investor is considering two bonds: a tax-exempt municipal bond with a yield of 3% and a taxable corporate bond with a yield of 4%.
The investor’s tax rate is 25%. To calculate the tax-equivalent yield of the municipal bond, the investor needs to adjust its yield to account for the taxes that would be owed on the corporate bond. The tax-equivalent yield is a measure that allows investors to compare the after-tax returns of taxable and tax-exempt investments.
By adjusting the pre-tax yield of a taxable investment to account for taxes, investors can determine the equivalent yield that would be required to match the return of a tax-exempt investment.
Tax-equivalent yield formula and calculation
Tax-equivalent yield (TEY) is the pretax yield that a taxable bond would need to earn in order to provide the same after-tax yield as a tax-free bond. The formula to calculate tax-equivalent yield is as follows:
TEY = Tax-free yield / (1 – Marginal tax rate)
Where:
Tax-free yield: the yield of the tax-free bond
Marginal tax rate: the highest tax rate that an investor will pay on their income
To calculate the tax-equivalent yield, you first need to determine your marginal tax rate. This is the highest tax rate that you pay on your income. Once you have your marginal tax rate, the formula above can be used to determine the tax-equivalent yield of a tax-free bond.
For example, let’s say you are considering investing in a tax-free municipal bond with a yield of 3%. Your marginal tax rate is 30%. Using the formula above, the calculation would be:
TEY = 3% / (1 – 0.30)
TEY = 4.29%
This means that the tax-equivalent yield of the tax-free bond is 4.29%. In other words, a taxable bond would need to have a yield of at least 4.29% in order to provide the same after-tax return as the tax-free bond.
The calculation of tax-equivalent yield is based on the current tax laws, which are subject to change, and investors should be aware of any potential changes to tax laws that could affect the calculation.
In addition, financial advisors who use tax-equivalent yield in their investment recommendations should be licensed and regulated by the appropriate regulatory bodies, such as FINRA in the United States.
When providing financial suggestions, they must also uphold their fiduciary commitment to operate in their client’s best interests.
To fully comprehend the tax ramifications of their investments and to ensure compliance with any applicable tax rules and regulations, investors should speak with a tax expert.
Tax-equivalent yield examples
Here are a few examples of how to calculate the tax-equivalent yield:
Example 1:
Let’s say you are considering investing in a tax-free municipal bond that has a yield of 3%. Your marginal tax rate is 25%. To calculate the tax-equivalent yield, you would use the formula:
TEY = Tax-free yield / (1 – Marginal tax rate)
TEY = 3% / (1 – 0.25)
TEY = 4%
This means that a taxable bond would need to have a yield of 4% in order to provide the same after-tax return as the tax-free municipal bond.
Example 2:
Suppose you are looking at a tax-free bond with a yield of 2.5%, and your marginal tax rate is 35%. Using the formula for tax-equivalent yield, we get:
TEY = Tax-free yield / (1 – Marginal tax rate)
TEY = 2.5% / (1 – 0.35)
TEY = 3.85%
This means that a taxable bond would need to have a yield of 3.85% in order to provide the same after-tax return as the tax-free bond.
Example 3:
Let’s say you are considering investing in a tax-free bond with a yield of 4%, and your marginal tax rate is 20%. Using the formula for tax-equivalent yield, we get:
TEY = Tax-free yield / (1 – Marginal tax rate)
TEY = 4% / (1 – 0.20)
TEY = 5%
This means that a taxable bond would need to have a yield of 5% in order to provide the same after-tax return as the tax-free bond.
Advantages and disadvantages of tax-equivalent yield
Here are the advantages and disadvantages of tax-equivalent yield listed below;
Advantages of tax-equivalent yield
- Helps to compare tax-free and taxable investments: The tax-equivalent yield helps investors to compare the after-tax yield of tax-free and taxable investments, making it easier to choose between them.
- More meaningful comparison for high tax bracket investors: Tax-equivalent yield is particularly useful for investors in higher tax brackets, as it allows them to see the true after-tax return of an investment.
- Provides a better understanding of the tax implications of investments: By calculating the tax-equivalent yield, investors can better understand the tax implications of their investments, which can help them make more informed investment decisions.
Disadvantages of tax-equivalent yield:
- Ignores other factors:Tax-equivalent yield only considers the impact of taxes on an investment’s yield. It ignores other elements like risk or liquidity that could have an impact on investment outcomes.
- Assumes no changes in tax laws: Tax laws are subject to change, and the tax-equivalent yield calculation assumes that the current tax laws will remain in place throughout the life of the investment.
- Can be misleading: Tax-equivalent yield can be misleading if it is used to compare investments with significantly different risk profiles or investment horizons.
- May be different for state and local taxes:Tax-equivalent yield only takes into account federal taxes and may not reflect the impact of state and local taxes, which can vary significantly by location.
Conclusion
In conclusion, tax-equivalent yield is a useful financial calculation that helps investors compare the after-tax yield of tax-free and taxable investments. By calculating the tax-equivalent yield, investors can better understand the tax implications of their investments and make more informed investment decisions.
The formula to calculate tax-equivalent yield is relatively simple, but investors should be aware of any potential changes to tax laws that could affect the calculation. Ultimately, investors should consult with a financial advisor and a tax professional to fully understand the implications of their investments and ensure compliance with any applicable regulations.
Key takeaways
- For the yield on a comparable tax-exempt bond, such as a municipal bond, to be equal to the yield on a taxable bond, that bond must produce the tax-equivalent yield.
- This sum is calculated either by adding share capital and retained earnings and subtracting treasury stock, or, alternatively, by subtracting total liabilities from total assets.
- Investors can use the computation to contrast the returns of a tax-free investment versus a comparable option that is subject to income tax.
- Generally speaking, tax consequences are both a challenging and significant component of any financial strategy and a component that is sometimes disregarded.
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