Tax-Equivalent Yield for Munis
Tax-Equivalent Yield for Munis
The tax-equivalent yield (TEY) converts a muni's tax-exempt yield to an equivalent taxable yield, allowing direct comparison with taxable bonds. It is the single most important calculation for deciding whether a municipal bond deserves a place in your portfolio.
Key takeaways
- Tax-equivalent yield = muni yield ÷ (1 − marginal tax rate); it shows what taxable yield you need to match a muni's after-tax return
- You must use your true marginal tax rate: federal + state + local combined
- If a muni's TEY exceeds available taxable bond yields, munis are attractive; if not, taxable bonds are superior
- TEY assumes you hold the bond to maturity and receive all interest; early sales or capital gains complicate the analysis
- High-income earners in high-tax states benefit most; low-income earners and those in low-tax states benefit little
The core calculation
The tax-equivalent yield formula is simple:
Tax-Equivalent Yield = Muni Yield ÷ (1 − Marginal Tax Rate)
A municipal bond yielding 3.5% for an investor in the 37% federal tax bracket has a TEY of:
3.5% ÷ (1 − 0.37) = 3.5% ÷ 0.63 = 5.56%
This means the muni's after-tax return is equivalent to a 5.56% taxable bond for that investor. If you can buy a 10-year Treasury at 4.2% or a 10-year muni at 3.5%, the muni is superior because its after-tax equivalent (5.56%) exceeds the Treasury yield.
Conversely, a middle-income earner in the 24% federal bracket looking at the same 3.5% muni has a TEY of:
3.5% ÷ (1 − 0.24) = 3.5% ÷ 0.76 = 4.61%
If the same Treasury yields 4.2%, the muni is still attractive, but the advantage is smaller.
An investor in the 12% bracket (very low income or substantial deductions) sees:
3.5% ÷ (1 − 0.12) = 3.5% ÷ 0.88 = 3.98%
If the Treasury yields 4.2%, the taxable bond is superior.
Determining your marginal tax rate
The marginal tax rate is the tax rate on your last dollar of income. It is the rate you apply to the next $1 of income, not an average across all income.
For 2024, the federal marginal tax brackets are:
- 10%: up to $11,600 (single) / $23,200 (married)
- 12%: $11,601–$47,150 (single) / $23,201–$94,300 (married)
- 22%: $47,151–$100,525 (single) / $94,301–$201,050 (married)
- 24%: $100,526–$191,950 (single) / $201,051–$383,900 (married)
- 32%: $191,951–$243,725 (single) / $383,901–$487,450 (married)
- 35%: $243,726–$609,350 (single) / $487,451–$731,200 (married)
- 37%: over $609,350 (single) / over $731,200 (married)
If you are married and file jointly with $350,000 in income, you are in the 35% federal bracket (the rate on your last dollar of income).
But your true marginal rate includes state and local taxes. If you live in California (13.3% state income tax) and earn $350,000, your combined marginal rate is 35% + 13.3% = 48.3%. If you live in Texas (no state income tax), it is 35% + 0% = 35%.
This matters enormously for the TEY calculation:
California resident, 35% federal + 13.3% state = 48.3% combined marginal rate:
3.5% muni ÷ (1 − 0.483) = 3.5% ÷ 0.517 = 6.77% TEY
Texas resident, 35% federal + 0% state = 35% combined marginal rate:
3.5% muni ÷ (1 − 0.35) = 3.5% ÷ 0.65 = 5.38% TEY
The California resident sees a much larger tax benefit. This is why high-income residents of high-tax states are the primary buyers of municipal bonds.
Building your comparison
Once you have your marginal rate and the TEY, the buy-or-skip decision is straightforward:
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Identify a muni candidate: A 10-year muni yielding 3.5%, issued by a creditworthy municipality.
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Calculate TEY: Using your marginal rate, determine what taxable yield it is equivalent to.
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Compare to available taxable bonds: What do 10-year Treasuries yield? What do 10-year corporates (of similar credit quality) yield?
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Decide: If the TEY exceeds the taxable alternative by a small margin (say, 0.1%), munis may not be worth the illiquidity and complexity. If the TEY is significantly higher, munis are attractive.
Example (May 2024 hypothetical rates):
- 10-year Treasury: 4.2%
- 10-year investment-grade corporate: 4.8%
- 10-year muni (A-rated): 3.5%
- Your marginal rate: 37% federal + 8% state = 45%
- Muni TEY: 3.5% ÷ (1 − 0.45) = 6.36%
Since 6.36% > 4.8%, the muni is superior to the taxable corporate and the Treasury. A purchase makes sense (assuming credit quality is acceptable).
State-specific adjustments
If you are buying out-of-state munis, the TEY calculation is more complex. You do not get state income tax exemption for out-of-state bonds (in most states).
A New York resident buying a California muni:
- Federal tax exemption: yes
- New York state tax exemption: no (California bond)
- California state tax: not applicable (resident doesn't owe CA income tax if not a resident)
So the marginal rate for the out-of-state muni is just federal + New York local (if applicable) — not the full 37% + 9.65% (NY state) rate.
The muni is still tax-exempt federally, making it more attractive than a taxable bond, but less attractive than a same-state muni. For this reason, residents of high-tax states benefit most from in-state munis.
Duration and reinvestment assumptions
The TEY calculation assumes you hold the bond to maturity. If you sell before maturity, the calculation becomes more complex because the price you receive depends on interest rate changes.
The calculation also assumes you reinvest each coupon payment at the yield you calculated. In reality, reinvesting at the same yield is difficult — you will likely reinvest at different rates. Over a 20-year bond, reinvestment risk is substantial.
For simplicity, most investors use the TEY as a rough decision tool, not as a precise prediction of returns. It answers the yes-or-no question: "Should I consider munis?" If the TEY is significantly higher than taxable alternatives, the answer is yes.
Callable munis and call risk
Many munis are callable — the issuer can redeem the bond early if rates decline. A callable bond has embedded optionality that reduces its effective yield.
If you buy a callable 30-year muni at 3.5%, and rates fall to 2%, the issuer will almost certainly call the bond and refinance at lower rates. You lose the upside, but you also lose the coupon income you expected. The effective yield is lower than the stated 3.5%.
Callable bonds are less liquid and require deeper analysis. For simplicity, many investors avoid individual callable bonds and prefer mutual funds or laddered non-callable bonds.
Amortization of premiums and discounts
If you buy a bond at a premium (above par), the premium is amortized over the bond's life, reducing your basis and your taxable gains. For munis, the premium amortization is generally tax-free (you reduce the cost basis without creating taxable income), but the details vary by issue date.
If you buy a bond at a discount, the discount accretes to par. For original issue discount (bonds issued below par), the accretion is tax-free. For market discount (bonds purchased below par in the secondary market), the tax treatment is more complex.
These considerations are secondary to the basic TEY calculation, but they matter for precision in high-net-worth portfolios.
Real-world example: muni vs. corporate bond decision
Let's walk through a full decision:
Investor Profile:
- Married, filing jointly, $400,000 taxable income
- Reside in Massachusetts (5.05% state income tax)
- Federal marginal rate: 35%
- Combined marginal rate: 35% + 5.05% = 40.05%
Available bonds (hypothetical, 10-year maturity):
- Treasury: 4.2% yield
- AA-rated corporate: 5.0% yield
- Massachusetts muni (A-rated): 3.6% yield
Muni TEY calculation: 3.6% ÷ (1 − 0.4005) = 3.6% ÷ 0.5995 = 6.00%
Decision:
- Muni TEY (6.00%) > Corporate (5.0%) ✓
- Muni TEY (6.00%) > Treasury (4.2%) ✓
- The Massachusetts muni is the best after-tax choice
If you allocate $100,000 to this bond, the muni provides approximately $6,000 in annual interest, all of which is tax-free, saving you $2,400 in taxes (vs. the corporate's $5,000 in taxable interest, costing you $2,000 in tax). The muni saves about $400 per year in taxes on this allocation.
Over 10 years, that compounds to significant tax savings.
Decision tree for muni vs taxable
Next
The tax-equivalent yield is the foundation of muni investing. But not all munis are tax-free in the same way. Some fall into a special category called private activity bonds, which are subject to the Alternative Minimum Tax. In the next article, we'll explore this nuance and how it affects your buy-or-skip decision.