It is often the things we don’t know that can cost us the most…
Tax Equivalent Yield is one of those things most investors don’t know or think about, but it can cost you plenty. The good news? Tax Equivalent Yield is monitored by InvestorKeep.
Tax-equivalent yield (or return) is the pretax return a taxable bond should provide for its return to be equal to that of a tax-free municipal bond. In other words, it is the return you’d have to receive for your taxable bond to be equal to a non-taxable bond. Using tax-equivalent yield allows for an apples-to-apples comparison between the yield of a tax-free bond to that of a taxable bond.
For example, your financial professional may give you two options. A corporate bond that pays you 6% or a municipal bond that pays you 4.5%. Naturally, you would want the higher rate, but the corporate bond requires you to pay taxes. Assuming equal risk, what are the implications of tax treatment? We can compare the corporate bond to the municipal bond using the tax equivalent yield formula:
Assuming a 30% tax rate: 4.5%/ (1-.3) = 6.43%. The municipal bond has a better return than the corporate bond due to taxes. The .43% difference on $100,000 is $430! These small changes in returns, reinvested add up to significant increases over the lifetime of an investment.