Tax-Equivalent Yield Calculator
Tax-Equivalent Yield
—
Tax Savings per $10,000
—
How Tax-Equivalent Yield Works
Tax-equivalent yield (TEY) is the pre-tax return a taxable investment must earn to match the after-tax return of a tax-exempt municipal bond. Municipal bonds, issued by state and local governments, pay interest that is generally exempt from federal income tax and often from state tax as well. According to the Municipal Securities Rulemaking Board (MSRB), the U.S. municipal bond market exceeds $4 trillion in outstanding securities, making it one of the largest fixed-income markets in the world. The TEY formula helps investors compare the true economic value of tax-free municipal bonds against taxable alternatives like corporate bonds, Treasury securities, and CDs.
The formula is: TEY = Tax-Free Yield / (1 - Combined Tax Rate). For example, a 3.5% municipal bond yield for someone in the 24% federal bracket with 5% state tax has a combined rate of approximately 27.8%, producing a TEY of 3.5 / (1 - 0.278) = 4.85%. This means a taxable bond would need to yield at least 4.85% to deliver the same after-tax income. The higher your tax bracket, the more valuable the tax exemption becomes. For investors in the 37% federal bracket, the same 3.5% muni has a TEY of approximately 6.35%. Use our bond calculator and investment calculator for broader fixed-income analysis.
The Tax-Equivalent Yield Formula
TEY = Tax-Free Yield / (1 - Combined Tax Rate)
Where Combined Tax Rate = Federal Rate + State Rate - (Federal Rate x State Rate / 100). This formula accounts for the fact that state taxes are deductible from federal taxes for itemizers. Worked example: Muni yield = 3.5%, federal bracket = 32%, state rate = 6.5%. Combined rate = 0.32 + 0.065 - (0.32 x 0.065) = 0.3642 (36.42%). TEY = 3.5% / (1 - 0.3642) = 3.5% / 0.6358 = 5.51%. A taxable bond must yield at least 5.51% to match this muni after taxes.
Key Terms
- Municipal Bond (Muni): A debt security issued by a state, city, or county to finance public projects. Interest is typically exempt from federal and sometimes state income tax.
- Tax-Equivalent Yield: The pre-tax yield a taxable investment needs to match a tax-free muni. Higher tax brackets produce higher TEYs.
- Marginal Tax Rate: The tax rate applied to your last dollar of income. Use this rate (not your effective rate) for TEY calculations.
- General Obligation Bond: A muni backed by the full taxing power of the issuer. Considered safer than revenue bonds.
- AMT (Alternative Minimum Tax): A parallel tax system that can make some private activity municipal bond interest taxable.
TEY by Federal Tax Bracket
| Muni Yield | 12% Bracket | 22% Bracket | 24% Bracket | 32% Bracket | 37% Bracket |
|---|---|---|---|---|---|
| 3.0% | 3.41% | 3.85% | 3.95% | 4.41% | 4.76% |
| 3.5% | 3.98% | 4.49% | 4.61% | 5.15% | 5.56% |
| 4.0% | 4.55% | 5.13% | 5.26% | 5.88% | 6.35% |
| 4.5% | 5.11% | 5.77% | 5.92% | 6.62% | 7.14% |
| 5.0% | 5.68% | 6.41% | 6.58% | 7.35% | 7.94% |
Table assumes federal tax rates only (no state tax). Adding state tax increases the TEY further. Source: IRS 2024 tax brackets.
Practical Examples
Example 1 -- High-income investor in California: Federal bracket 37%, California state rate 13.3%. Combined rate ≈ 45.4%. A 4.0% CA muni (exempt from both federal and state tax) has TEY = 4.0% / (1 - 0.454) = 7.33%. A corporate bond would need to yield over 7.33% to compete.
Example 2 -- Middle-income investor: Federal bracket 22%, state rate 0% (Texas, no state income tax). TEY = 3.5% / (1 - 0.22) = 4.49%. With Treasury bonds yielding 4.5%, the taxable Treasury is slightly better in this case. Use the income tax calculator to determine your marginal bracket.
Example 3 -- Tax savings on $100,000 investment: Investing $100,000 in a 3.5% muni yields $3,500 tax-free. The same $100,000 in a 4.85% corporate bond yields $4,850 but after 27.8% combined taxes, nets $3,503. Nearly identical after-tax income -- confirming the TEY calculation.
Tips and Strategies
- Use your marginal rate, not effective rate: The TEY formula requires your marginal (top bracket) tax rate, since muni interest avoids tax at that rate.
- Consider state tax benefits: In-state municipal bonds are typically exempt from state income tax, adding significant value in high-tax states like California, New York, and New Jersey.
- Compare credit quality: Municipal bonds are not risk-free. Compare muni yields to similar-credit taxable bonds, not just Treasury yields. AAA-rated munis should be compared to AAA-rated corporates.
- Hold munis in taxable accounts only: Tax-free bonds in IRAs or 401(k)s waste the tax benefit. Use retirement accounts for taxable bonds instead.
- Watch for AMT exposure: If you are subject to the Alternative Minimum Tax, some private activity municipal bond interest becomes taxable. Check bond documents carefully.
Frequently Asked Questions
What is tax-equivalent yield?
Tax-equivalent yield (TEY) is the pre-tax return a taxable bond must offer to equal the after-tax return of a tax-exempt municipal bond. It allows investors to make apples-to-apples comparisons between municipal bonds and taxable investments like corporate bonds or Treasury securities. The higher your marginal tax rate, the more valuable the tax exemption becomes. For a taxpayer in the 37% federal bracket, a 4% municipal bond has a TEY of 6.35%, meaning a taxable bond would need to yield at least 6.35% to match the muni after taxes.
How is TEY calculated?
TEY = Tax-Free Yield / (1 - Combined Tax Rate). The combined tax rate includes your federal marginal rate and state income tax rate, adjusted for the federal deduction of state taxes. If your federal rate is 24% and state rate is 5%, the combined rate is approximately 27.8% (accounting for the interaction). So a 3.5% muni yield has a TEY of 3.5 / (1 - 0.278) = 4.85%. This formula assumes the municipal bond interest is fully exempt from both federal and state taxes, which is true for in-state bonds.
Who benefits most from municipal bonds?
High-income taxpayers in the 32-37% federal brackets benefit most because the tax exemption is worth more at higher tax rates. According to the Municipal Securities Rulemaking Board (MSRB), approximately 72% of municipal bonds are held by individual investors, predominantly those in higher tax brackets. Residents of high-tax states like California (13.3% top rate), New York (10.9%), and New Jersey (10.75%) gain additional benefit from in-state munis that are exempt from both federal and state taxes. Investors in the 10-12% brackets typically find taxable bonds more attractive.
Are all municipal bonds tax-free?
Not all. General obligation and revenue bonds from state and local governments are typically exempt from federal income tax. If the bond is issued by your state of residence, it is usually exempt from state income tax as well. However, private activity bonds (used to finance projects like airports or stadiums) may trigger the Alternative Minimum Tax (AMT). Some municipal bonds are fully taxable, such as Build America Bonds. Always check the bond's tax status in the offering documents before purchasing, and consult a tax advisor for your specific situation.
How do municipal bond yields compare to Treasury yields?
Municipal bond yields are typically lower than Treasury yields of similar maturity because of their tax advantage. The ratio of municipal to Treasury yields (the muni/Treasury ratio) historically averages around 80-85%. When this ratio exceeds 90-100%, munis are considered particularly attractive because investors are getting close to the same yield as Treasuries while also receiving the tax benefit. As of recent market data, 10-year AAA municipal bonds yield approximately 3.0-3.5%, compared to 4.0-4.5% for 10-year Treasuries. After taxes, munis often provide superior after-tax income for high-bracket investors.
Should I hold municipal bonds in a tax-advantaged account like an IRA?
Generally no. Municipal bonds should be held in taxable (non-retirement) accounts where their tax exemption provides value. Holding munis in an IRA or 401(k) wastes the tax benefit because withdrawals from these accounts are taxed as ordinary income regardless of the source. In retirement accounts, taxable bonds typically offer higher pre-tax yields and are more appropriate. The exception might be if municipal bonds offer better risk-adjusted returns than available taxable alternatives, but this is uncommon. Use your retirement accounts for taxable bonds and your taxable accounts for munis.