Tax Tips

When your state, city or local government issues you a municipal bond, the interest you earn is often tax-exempt. The taxable-equivalent yield measures what you would have to earn (yield) on a taxable investment to match what you would earn with a tax-exempt municipal bond, which helps you decide which is a better investment. Note that even when the interest earned on a municipal bond is tax-exempt, gain or loss on the disposition of the bond must be reported.

Figuring Taxable-equivalent Rate for a Bond

Here's the formula for figuring the precise taxable-equivalent rate for any bond: Subtract the federal marginal tax bracket percentage from the number 1, and divide the tax-free rate by the result.

For example, assume you're in the 28% tax bracket and are offered a 5.75% tax-free bond. You would divide 5.75 by 0.72 (1 less 0.28) and find that the taxable-equivalent yield is 7.99%. In other words, you'd need a taxable investment paying more than 7.99% to beat the return on the 5.75% tax-exempt. In the 35% bracket, the divisor would be 0.65 (1 less 0.35) and the taxable-equivalent yield would be 8.85%.

Figuring Tax-exempt Equivalent of a Taxable Yield

There's a similar formula for figuring finding the tax-exempt equivalent of a taxable yield: Subtract the federal marginal tax bracket percentage from the number 1, and multiply the taxable rate by that number. The result is the tax-free rate.

Assume you're considering a taxable investment yielding 8%. If you're in the 28% tax bracket, multiply 8 by 0.72 (1 less 0.28). The result is 5.76, telling you a 5.76% tax-free yield will put the same amount in your pocket, after tax, as an 8% taxable yield. In the 35% bracket, the multiplier would be 0.65 (1 less 0.35), so a tax-free yield of 5.2% will match a taxable yield of 8%.

Municipal Bonds & State Taxes

In most states, there's an advantage to buying in-state municipals because these states tax the income on out-of-state bonds but give tax-free status to in-state bonds.

However, a few states, give tax-free status to municipals from all other states and a few others even tax some of their own municipals. To know where you stand, check with a state tax official or a broker who sells municipals. If you happen to face a city income tax, municipals can have triple tax-free status — shielded from federal, state and local income tax.

Figuring taxable-equivalent yields gets more complicated if your investment dodges both state and federal tax. Because state income taxes paid are deductible on your federal return (if you itemize) you can't simply add the state rate to the federal rate in the formulas above. First, you must find the effective state tax rate — what you pay minus the tax savings of deducting that amount.

For example, if you're in the 5% state tax bracket and are in the 28% federal bracket, your effective state tax rate is 3.6% (the 5% state tax rate minus 28% of that rate). Thus, in the formula for figuring taxable equivalents, the tax rate used in the divisor would be the combination of your federal rate (28%) and your effective state rate (3.6%), or 31.6%. So the divisor is 1 less 0.316 or 0.684. If you are considering a 6% municipal bond that is exempt from both state and local taxes, you would divide 6 by 0.684 and find that the taxable equivalent is 8.77%.