Tax-Equivalent Yield

The tax-equivalent yield (TEY) shows what return a taxable investment must offer to match the after-tax return of a tax-exempt investment (commonly a municipal bond). It helps investors compare taxable and tax-free bonds on an apples-to-apples basis.

How it works

Because interest from most municipal bonds is exempt from federal income tax (and sometimes state tax), a lower nominal yield on a municipal bond can be equivalent to a higher yield on a taxable bond once taxes are considered. TEY converts the tax-free yield into the pre-tax yield a taxable investment would need to provide the same after-tax return.

Formula

TEY = Tax-exempt yield / (1 − t)

Where:
* TEY = tax-equivalent yield (pre-tax yield needed on a taxable bond)
* t = investor’s marginal tax rate (use combined federal + state marginal rate if state taxes apply)
* Tax-free yield = yield on the municipal bond (expressed as a decimal in the formula)

Rearranged to find the tax-free equivalent of a taxable yield:
Tax-free equivalent yield = Taxable yield × (1 − t)

Practical examples

Example 1 — 7% municipal bond:
If a municipal bond yields 7%, the TEY for various federal marginal tax brackets is:

• 10% → 7% / (1 − 0.10) = 7.78%
• 12% → 7% / (1 − 0.12) = 7.95%
• 22% → 7% / (1 − 0.22) = 8.97%
• 24% → 7% / (1 − 0.24) = 9.21%
• 32% → 7% / (1 − 0.32) = 10.29%
• 35% → 7% / (1 − 0.35) = 10.77%
• 37% → 7% / (1 − 0.37) = 11.11%

If a taxable bond yields 9.75%, taxpayers in the 10%, 12%, 22%, and 24% brackets would get a higher after-tax return from the taxable bond than from the 7% municipal bond; taxpayers in the 32%, 35%, and 37% brackets might prefer the municipal bond.

Example 2 — 8% municipal bond:
* For a 22% marginal tax rate: TEY = 8% / (1 − 0.22) = 10.26%
* For a 37% marginal tax rate: TEY = 8% / (1 − 0.37) = 12.70%

A taxable bond must yield at least these TEYs to match the municipal bond’s after-tax return for those brackets.

Key considerations

• Include state taxes when applicable: if your state taxes municipal interest (or you own out-of-state municipals), use the combined marginal rate in the formula.
• Some municipal bonds are taxable: these are less common and are typically issued for special projects; treat them as taxable securities.
• U.S. Treasury interest is exempt from state and local taxes but taxed federally.
• Capital gains and purchase discounts:
• If a municipal bond is bought at a significant discount to par, some of the income may be taxable.
• Mutual funds holding municipal bonds can generate capital gains, which are taxable.
• The TEY calculation assumes interest is taxed at ordinary income rates; special tax situations (AMT, tax-deferred accounts, itemized deductions) can affect the outcome.

Bottom line

TEY is a simple, useful tool for comparing taxable and tax-exempt bonds. Use the formula TEY = tax-exempt yield / (1 − combined marginal tax rate) to determine whether a municipal bond’s tax advantage makes it the better choice for your situation. Always factor in federal and state tax rules, possible capital gains, and your personal tax situation when making the final decision.