Taxable bonds—such as those issued by corporations—typically have relatively high yields, but you have to pay tax each year on the interest you earn, assuming you hold the bonds in a taxable account. Municipal bonds offer yields that are usually lower, but the interest should be tax-free. So which should you buy?
Imagine you are in the 24% marginal federal income tax bracket and a 6% state income tax bracket, for a combined marginal rate of 30%. You’re considering buying a municipal bond that yields 4%, and that yield will be tax-free for you at both the federal and state level. How much would a taxable bond have to pay to give you the same after-tax yield?
First, you have to convert your marginal tax bracket into a decimal by dividing it by 100. That turns your 30% to 0.3.
Next, you subtract this 0.3 from 1, giving you 0.7.
Finally, you divide the municipal bond’s 4% yield by 0.7, giving you 5.71%. This 5.71% is the yield that a taxable bond would have to offer to give you the same after-tax yield as the 4% municipal bond.
What if you’re considering buying munis from an out-of-state issuer, so they would be tax-free at the federal level, but not the state level? In the above example, instead of adjusting for a 30% marginal rate, you would use 24%. Result: To find the tax-equivalent yield, you would divide the municipal bond’s yield by 0.76, so the tax-equivalent yield for a 4% muni would be 5.26%.
What if you’re starting with a taxable bond—and trying to figure out how much a municipal bond would need to pay to be competitive? Instead of dividing the taxable bond’s yield by 0.7 or 0.76, you would multiply it by these figures. Suppose you are looking at a taxable bond that’s yielding 5%. If you multiply this 5% by 0.7, you would get 3.5%, which would be your after-tax yield from the taxable bond—and which is the amount that an in-state municipal bond would have to pay to give you the same yield.
Even if municipals deliver a higher after-tax yield than taxable bonds, they aren’t necessarily your best bet, as we discuss in the chapter on taxes.
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