As investors, we all want to maximize our returns while minimizing the amount we lose to taxes. Because some investments -- namely, municipal bonds -- offer tax-exempt interest, they're an appealing choice for those looking to profit without increasing their taxable income. But the average tax-free bond typically has a lower yield than its taxable counterparts, so it's important to consider the tax savings involved by calculating the tax-equivalent yield. The tax-equivalent yield is the pre-tax yield that a taxable bond must offer in order to equal the yield of a tax-free bond.
Taxable vs. tax-free bonds
Whenever you receive interest payments from a corporate bond, those payments are taxed as ordinary income. So if you typically lose 28% of your income to taxes, you'll also fork over 28% of each interest payment to the IRS rather than keep the whole thing. (While you won't be taxed up front on those payments, you'll need to report them as income on your tax return and pay the IRS its appropriate share.)
When you receive interest from a municipal bond, your payments are automatically exempt from federal taxes. Furthermore, if you buy municipal bonds issued by the state in which you reside, you won't pay any state or local taxes, either. If you're in a high tax bracket, municipal bonds can be a good way to generate income without increasing your tax burden.
Which option is right for you?
One of the main reasons investors might shy away from municipal bonds is that they tend to offer lower interest rates than corporate bonds with comparable ratings. (Keep in mind that lower-rated bonds tend to offer higher yields across the board because of the added risks involved.) But because the interest you'll receive from municipal bonds isn't subject to taxes, you should measure your potential returns not just by your bonds' yield, but by the amount you stand to save on taxes. This tax-adjusted return is known as the tax-equivalent yield, and you can calculate it using this handy tool:
This calculator lets you put in the yield of the tax-free bond you're looking at, as well as your federal marginal tax bracket and your state marginal tax bracket. Once you enter that information, the calculator will let you know what type of yield you'd need to get from a taxable bond to break even.
To refresh your memory, your marginal tax bracket is the rate at which your last, or highest, dollar of income is taxed. So let's say you're looking at a tax-free bond with a 5% yield, your federal marginal tax bracket is 25%, and your state marginal tax bracket is 7%. In this case, your tax-equivalent yield would be 7.168%, which means paying taxes on a bond with that yield would be the same as getting 5% interest tax-free.
Always compare apples to apples
While it's a good idea to calculate your tax-equivalent yield when evaluating different investment options, you should also make sure to compare bonds with similar credit ratings. Typically, the lower a bond's rating, the higher its yield is going to be because of the added risk. If you're trying to choose between a municipal bond and a corporate bond, keep the issuer's rating in mind when making your decision. Remember, it's not just about the money you stand to make from interest and the tax implications involved; the risk factor should just as well play a role in your ultimate investment strategy.