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How to Calculate Equivalent Tax Return (And Why Investors Should Do It)

SmartAsset: What is the equivalent tax return?

Bonds can provide passive income, some of which may be tax-free if you’re investing in municipal bonds. The tax-equivalent yield formula can be a useful tool for comparing taxable and tax-exempt bond investments. The tax-equivalent yield indicates the amount of return a taxable bond would need to generate to equal the yield of a tax-exempt bond.

A financial advisor can help you build a balanced portfolio with a mix of bonds and other types of investments.

What is tax equivalent return?

The tax equivalent yield is a calculation that investors can use to compare taxable and tax-exempt bonds. To understand how this works, it is first useful to know a little about bond yields.

Bond yield measures the return an investor can expect to get from it. A bond’s coupon yield, or coupon rate, is the annual interest rate set when the bond is issued. The current yield on a bond is the coupon yield, divided by the current market price.

Investors can use bond yields to evaluate how much return they could get from investing in a particular bond. The yield doesn’t take into account what you might pay in taxes on the interest generated by the bond. Municipal bonds can be an attractive option for investors looking to maximize their returns as interest is exempt from federal taxes.

Equivalent tax yield can help you understand how much a taxable bond needs to yield, before taxes are considered, to put it on par with the yield generated by a tax-exempt bond.

What does the tax equivalent yield tell investors?

SmartAsset: What is the equivalent tax return?

Placing a taxable bond side by side with a tax-exempt bond and focusing solely on yield can create a misleading picture of its profitability. Again, taxable bond yields don’t take into account the impact of the taxes you have to pay on the interest you earn.

If you choose bond investments based only on yield, this could belie a larger-than-expected tax liability. By factoring in the tax-equivalent yield, it becomes easier to compare bonds and get a more accurate picture of what kind of yield you can expect.

This is useful if you’re weighing the benefits of municipal bonds versus something like corporate bonds or high-yield bonds. While municipal bonds may offer higher yields than other types of bonds, they may not always match the yields of corporate or high-yield bonds. Calculating your tax-equivalent return can tell you whether the promise of higher returns is worth it, once taxes are taken into account.

How is bond interest taxed?

Bonds can generate interest income for investors. Whether you pay taxes on that interest depends on the type of bond.

Here’s how bond interest is taxed:

  • Interest on corporate bonds is always taxable.

  • Interest on municipal bonds is generally tax exempt at the federal level, although some municipal bonds are taxable.

  • Interest on municipal bonds may be tax exempt at the state level if the bond is issued by the state in which you file.

  • Treasury bills are subject to federal tax but exempt from state and local taxes.

Bond interest must be included in your tax return, even when it is not taxable.

When you sell bonds for more than what you paid, the end result can be a taxable gain. This is a scenario you may encounter if you sell a bond before its maturity date. Capital gains are subject to the capital gains tax rate.

The short-term capital gains tax rate applies to investments held for less than one year. The more favorable long-term capital gains tax rate applies to investments held for more than one year.

How to calculate the equivalent tax return

SmartAsset: What is the equivalent tax return?

To find the tax return, little information and a simple formula are enough. Specifically, you’ll need to know the yield on a tax-exempt bond and what federal income tax bracket it falls into. Your tax bracket tells you what marginal tax rate applies.

If you have these details, you can apply the equivalent tax return formula:

Tax Equivalent Yield = Tax Free Bond Yield / (1 – Marginal Tax Rate)

Here is an example of how the tax equivalent return works. Suppose you want to compare a taxable bond that offers a 5.0% yield with a tax-exempt bond that offers a 4% yield. You are in the 28% tax bracket. Your calculation would look like this:

4% / (1 – 0.28) = 5.56%

What does this mean? The equivalent tax yield of the tax exempt bond is 0.56% higher than the yield of the taxable bond.

Your income and resulting tax bracket can influence the yield needed to generate a taxable bond to keep pace with tax-exempt bond yields. The higher your income and the higher the yield on the tax-free bond, the higher the yield on a taxable bond.

Are municipal bonds or taxable bonds better?

Municipal bonds may be attractive to investors looking to minimize the amount of tax they are obligated to pay on interest income. If you’re in a higher tax bracket, then you may appreciate the tax-free income that muni bonds can generate.

However, it is important to consider the investment as a whole when choosing bonds. For example, you would also like to see what is happening with interest rates.

Bonds and interest rates have an inverse relationship. When interest rates fall, bond prices rise and bond yields fall. If interest rates go up, bond prices go down but bond yields go up. How interest rates move at any given time can determine the kind of return you can make with taxable or tax-free bonds.

It’s also a good idea to weigh the credit risk of bond issuers. Municipal bonds are issued by state and local governments, which means the chances of default are low. High yield bonds, on the other hand, are usually issued by companies with lower credit ratings. So while you may be able to get a higher yield than municipal bonds, there’s also a higher risk that the issuer could default, leaving you with nothing.

The bottom line

Equivalent tax yield can be a useful metric for comparing bond investments. Along with stocks, investing in bonds can allow you to build a comprehensive portfolio. Understanding how taxable and tax-free bonds compare from a tax perspective can make it easier to decide which types of bonds make the most sense for your goals.

Tax planning tips

  • Calculating and planning based on equivalent tax yield considerations can be complex. A financial advisor can help you. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can interview your advisors at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you reach your financial goals, get started now.

  • A financial advisor who specializes in tax planning can help you lower your taxes by collecting tax losses. This means that you will be able to use your investment losses to reduce capital gains or income taxes.

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The post What is the equivalent tax return? first appeared on the SmartAsset Blog.

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