- U.S. Treasury bonds are exempt from state and local taxes. You still owe federal income tax on the interest paid.
- Municipal bonds, or munis, issued by your home state or city, are typically exempt from federal, state, and local taxes. They may be subject to the alternative minimum tax.
- Out-of-state municipal bonds are exempt from federal income tax, but you'll owe state and local tax and, potentially, the alternative minimum tax.
- Corporate bonds are fully subject to income tax at all government levels.
Note that you'll always owe taxes on any capital gains from your fixed-income investments.
Tax-equivalent yield factors
There are just two factors that affect tax-equivalent yield.
The first factor is your marginal tax rates for federal, state, and local income. This is the tax you'll pay on your next dollar of income, and it will differ from person to person. So, someone living in a high-tax state like California or Hawaii could have a higher tax-equivalent yield on Treasuries than someone in a state without an income tax.
The other factor involves tax exemptions for the security. Treasuries, in-state munis, and out-of-state munis all have different tax treatments, and not all municipal bonds will receive federal tax exemption.
With those two pieces of information, calculating the tax-equivalent yield is straightforward. You take the yield offered by the security and divide it by 1 minus your marginal tax rate.
In other words:
Tax equivalent yield = yield ÷ (1 – marginal tax rate)
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