Tax-Equivalent Yield

A 3.5% tax-free municipal bond isn't comparable to a 5% taxable bond. Convert both to the same tax basis to compare fairly.

Key takeaways

• Tax-equivalent yield makes municipal bonds (tax-free) comparable to taxable bonds
• Formula: tax-free yield / (1 − marginal tax rate) = taxable equivalent
• Use it to decide: should I buy a municipal bond or a corporate bond?
• Higher-bracket investors find munis attractive; lower-bracket investors often don't
• The yield advantage of munis depends on your tax bracket, not on the bond's quality

The comparison problem

You see two bonds:

• Municipal bond: 3.5% yield (tax-free)
• Corporate bond: 5% yield (taxable)

Which is better? Impossible to tell without knowing your tax bracket. If you're in the 10% federal bracket, the corporate bond's after-tax yield is 5% × (1 − 0.10) = 4.5%, and the municipal's 3.5% tax-free yield is inferior. But if you're in the 37% + 3.8% NIIT bracket (40.8% combined federal), the after-tax corporate yield is 5% × (1 − 0.408) = 2.96%, and the municipal's 3.5% is better.

Tax-equivalent yield solves this by converting the tax-free yield to its taxable equivalent, so both bonds are on the same footing.

The formula

Tax-equivalent yield = tax-free yield / (1 − marginal tax rate)

This answers: "What taxable yield would I need to earn the same after-tax return as this tax-free yield?"

Example:

• Municipal bond yield: 3.5% (tax-free)
• Your federal + NIIT marginal rate: 40.8%
• Tax-equivalent yield: 3.5% / (1 − 0.408) = 3.5% / 0.592 = 5.92%

To earn the same 3.5% after-tax from a taxable bond, you'd need a 5.92% yield. If taxable bonds are only offering 5%, the municipal is the better deal.

Including state and local taxes

The calculation above used only federal + NIIT. But state and local taxes apply too. The full marginal rate is:

Full marginal rate = federal rate + NIIT + state and local rate

Example:

• Federal: 32%
• NIIT: 3.8% (for high earners)
• New York State: 10% (top rate)
• Full marginal rate: 45.8%

Tax-equivalent yield: 3.5% / (1 − 0.458) = 3.5% / 0.542 = 6.46%

In a high-tax state, a 3.5% municipal bond is equivalent to a 6.46% taxable bond. That's a huge gap, which is why wealthy New Yorkers and Californians love munis.

Out-of-state vs. in-state munis

One subtlety: a municipal bond issued by a state is exempt from federal tax everywhere, but is exempt from that state's tax only if you live in the state.

Scenario: You live in California (top state rate ~13.3%) and can buy:

• A California municipal bond at 3.2% (exempt from federal, CA state, and CA local taxes)
• A Texas municipal bond at 3.5% (exempt from federal taxes only; you owe CA state tax)

For you, the California bond's tax-equivalent yield is 3.2% / (1 − 0.458) = 5.91%.

The Texas bond's tax-equivalent yield is 3.5% / (1 − 0.408) = 5.76%, where 0.408 = 0.32 federal + 0.088 NIIT (CA doesn't let you deduct NIIT, so it's just 32% federal).

Wait, that's not quite right. Let me recalculate: the Texas bond yields 3.5% taxable to you in CA, so:

3.5% × (1 − 0.32 − 0.133) = 3.5% × 0.547 = 1.91% after-tax.

That's worse than it looks because you pay both federal and state on the out-of-state bond.

The California muni at 3.2% is cleaner: 3.2% after-tax (fully exempt), equivalent to 3.2% / (1 − 0.458) = 5.91% taxable.

So in-state munis are more valuable for residents of high-tax states.

When munis don't make sense

Not every investor benefits from munis. If your marginal rate is low (say, 12%), a 3.5% muni is equivalent to only 3.5% / (1 − 0.12) = 3.98% taxable. Most taxable bonds yield more than 3.98%, so you're leaving money on the table.

Munis make sense when:

1. Your marginal tax rate is 35% or higher (federal + NIIT + state/local).
2. You live in a state with high income tax and can buy in-state munis.
3. You're retired and can't use tax losses to offset muni income.

For investors in low-tax states with moderate incomes, taxable bonds often win.

The muni math over time

Suppose you're comparing a 20-year holding:

Option A: California municipal bond

• 3.2% yield, fully tax-free for CA residents
• After-tax yield: 3.2%
• $10,000 growing at 3.2% for 20 years: $18,685

Option B: Corporate bond

• 5% yield, taxable
• Your marginal rate: 45.8% (CA resident, high earner)
• After-tax yield: 5% × (1 − 0.458) = 2.71%
• $10,000 growing at 2.71% for 20 years: $15,364

The muni wins by $3,321 on a $10,000 investment, purely due to tax efficiency. Over millions of dollars, that's meaningful wealth.

This is why California and New York have thriving muni markets and high-income residents are muni buyers.

Flowchart: choosing between taxable and municipal bonds

Quality matters too

Tax-equivalent yield helps you decide between equal-quality bonds. But if the municipal is lower-rated (higher default risk), you're comparing apples to oranges.

A 3.5% AAA muni is not the same as a 3.5% BB muni. The BB muni should yield more to compensate for credit risk. When comparing, match bonds of similar credit quality first, then use tax-equivalent yield.

Credit spreads and munis

Municipal bonds have their own yield curve and credit-spread dynamics. During financial stress (2008, 2020), muni spreads widened dramatically as demand fell. High-income investors who "bought the dip" and added munis to their portfolios in 2008 made excellent returns as spreads tightened again.

Tax-equivalent yield doesn't change this, but it's useful context: munis become more attractive when spreads widen, which often happens when bonds overall are selling off.

Muni bond funds vs. individual munis

Many investors buy muni bonds through mutual funds or ETFs (MUB, VWAHX) rather than individual bonds. The tax-equivalent yield logic still applies to the fund's yield. A muni fund yielding 3% tax-free has the same tax-equivalent yield to a 3% individual municipal bond, assuming the same maturity and credit quality.

Funds offer diversification and professional management; individual bonds offer certainty about maturity and no managers to pay. Both are valid; tax-equivalent yield helps you evaluate either.

Summary: the apples-to-apples comparison

Municipal bonds and taxable bonds serve different purposes. Munis are valuable for high-income, high-tax-bracket investors. But a 3.5% muni isn't automatically better than a 5% taxable bond — it depends on your tax situation.

Tax-equivalent yield is the tool to make the comparison fair. Convert the muni to its taxable equivalent and compare it directly to the taxable bond's yield. Whichever is higher, after accounting for credit quality and duration, is the better value for your situation.

Related concepts

• ./17-after-tax-yield.md
• ./05-current-yield-formula.md
• ./06-yield-to-maturity-ytm.md

Next

We've now adjusted yield for inflation, taxes, and holding periods. The yield you observe in the market includes premiums for different risks. In the next article, we break down the yield spread — the extra return you earn for taking on credit, liquidity, and other risks — and learn to read what the market is pricing in.