Comparing a tax-free bond with a taxable one
A municipal bond paying 3.5% tax-free and a corporate bond paying 5% taxable cannot be compared on their coupons. The tax-equivalent yield converts the tax-free rate into the taxable rate that would leave the same money after tax — one number against another, at your own bracket.
The formula
Worked example: 3.5% tax-free, 32% bracket
- Tax-equivalent yield: 3.5 / (1 − 0.32) = 5.15%
- A taxable bond must pay more than 5.15% to beat the municipal one
The answer depends on the bracket
| Marginal rate | Tax-equivalent yield of 3.5% | Beats a taxable 5%? |
|---|---|---|
| 12% | 3.98% | No |
| 22% | 4.49% | No |
| 24% | 4.61% | No |
| 32% | 5.15% | Yes |
| 35% | 5.38% | Yes |
| 37% | 5.56% | Yes |
The same municipal bond is a poor deal for someone in the 12% bracket and a good one at 32%. This is why municipal bonds sit almost entirely in high-bracket portfolios and why a retiree in a low bracket is usually better off in taxable bonds.
Which rate to use
The marginal rate, not the effective one — the tax on the next dollar, which is what the bond interest is. Add state income tax if the municipal bond is from your own state, since in-state munis are typically exempt from both; a 32% federal and 9.3% California filer should use about 41%, which lifts the equivalent yield to 5.93%. Out-of-state munis are usually taxed by your state.
High earners should also add the 3.8% net investment income tax that applies to taxable interest above $200,000 of income, but not to municipal interest.
What the yield does not capture
Credit risk and liquidity. Investment-grade munis default rarely, but the comparison should be like for like: a AA muni against a AA corporate. And the tax-free status can be lost if the bond finances private activity, or if it triggers the alternative minimum tax.
What this calculator leaves out
State tax, the NIIT, capital gains on bonds bought at a discount, and the fact that brackets change — a bond held twenty years crosses several.
Related calculators
- Bond yield calculator — the current yield to put into this one
- Federal tax bracket calculator — finding your marginal rate
- Bond equivalent yield — putting different bond quotes on one basis