Tax equivalent yield (TEY) refers to the yield on a taxable investment that is equal to the yield of a tax-exempt bond. The purpose of calculating TEY is to help investors weigh their options between tax-exempt investments, like municipal bonds, and taxable investments, such as corporate bonds. By knowing how these yields compare on a pre-tax basis, investors can make an informed decision on which type of investment would be more lucrative under their particular taxation circumstances. In this article, we will explore the steps to determine tax equivalent yield.

Step 1: Understand the Concept

Before calculating TEY, it’s important to understand its basis. Tax equivalent yield considers the effect of taxes on investment returns and allows investors to compare taxable and non-taxable investments on an equal footing. Since different investments are taxed at various rates based on factors like income level and tax bracket, using TEY as a metric helps level the playing field.

Step 2: Gather Necessary Information

To calculate TEY, you will need three pieces of information – your current federal income tax rate, the yield from the tax-exempt investment (usually a municipal bond), and any state or local taxes that may apply.

Step 3: Calculate the Tax Equivalent Yield

Once you have gathered all necessary information, apply the following TEY formula:

TEY = Tax-Exempt Yield / (1 – Tax Rate)

Where:

– TEY represents Tax Equivalent Yield

– Tax-Exempt Yield is the annual interest rate earned from your tax-free investment

– Tax Rate is your federal income tax rate (expressed as a decimal rather than percentage)

For example, let’s assume an investor has a marginal federal tax rate of 24% and is considering investing in a municipal bond that offers an annual yield of 4%. To calculate the corresponding TEY for this investor:

TEY = 0.04 / (1 – 0.24)

TEY = 0.04 / 0.76

TEY = 0.05263

The tax equivalent yield for this investor is approximately 5.26%.

This means, in order to receive an after-tax return equal to a tax-exempt bond yielding 4%, the investor would need to invest in a taxable bond yielding at least 5.26%.

Conclusion:

Tax equivalent yield is an essential tool for evaluating how the effects of taxation impact different types of investments. It allows investors to compare investment options with diverse taxation rates and make informed decisions about their investment portfolios.

By understanding the method to calculate tax equivalent yield and comparing it to the yields of various investments, you can make a more informed choice when selecting different bonds that better suit your financial goals and tax profile.