As an avid investor, you are probably always combing the market place to try to capture the most amount of return with the least amount of risk. Since different securities will yield different rates of return, the question then becomes: “holding everything else constant, what security will generate the best return for me?” For the answer, one needs to turn to the tax equivalent yield formula or chart.
The tax equivalent yield formula is:
Tax-free interest rate divided by (1-tax bracket rate)= Tax Equivalent Yield
So let’s say that you are looking at a municipal bond that generates 5% tax-free and you are wondering what would be equivalent to that security in the taxable arena. Furthermore, your tax bracket is 28%. Plugging in all the numbers we get:
5 divided by (1 minus.28), which becomes 5 divided by.72, which equals 6.94, which is the tax equivalent yield. In plain language, this means that you would need a taxable security that throws off at least 6.94% in order for it to be equivalent to a tax-free security that throws off 5%.
As you can see from the formula, as an investor’s tax bracket begins to rise, they will need to own a security that throws off a higher rate of return in order to meet or beat the return from a tax-free security.
Another way to look at it is this: the tax equivalent yield is the rate of return that is required from a taxable investment in order to see if it meets or beats the rate of return from a tax-free investment. After you compare fixed income securities using this formula, I think you will conclude that investing in municipal securities can be very rewarding. Furthermore, since the historical default rate of municipal securities is less than 1%, you will also conclude that theses securities can also be a safe place to invest your hard-earned money.
Finally, you should know that investing in tax-free securities such as municipal bonds, can and should be done inside of a non-retirement account. This is because of the fact that you do not need the tax-deferred sheltering that retirement accounts, such as an IRA or a 401k, offer.
If you are fortunate enough to save the maximum amount of money inside your IRA and or 401k, and you still have the ability to save even further, then you should consider opening a standard brokerage account. Investing inside this non-retirement account is where you will make the most use of a tax equivalent yield chart for comparing investments. Once you retire, you would start to take your distributions from this account before touching your tax-deferred accounts, as this will allow for the greatest amount of growth inside the tax-deferred accounts.