Taxable Equivalent Yield

Not all investments are taxed equally. Since taxes affect the ultimate net return on a given investment, investors need a simple way to make fair comparisons. The following formula makes fair comparisons possible.

Example: Pretend an investor has the choice of investing in a tax-free municipal bond paying 5% or buying a taxable corporate bond that pays 6.5%. Her federal tax bracket is 28%. Which bond will pay her the higher net return after taxes?

Use the formula to calculate the answer:

Taxable Equivalent Yield = 6.94%

For this taxpayer, a nontaxable bond paying 5% (6.94% taxable equivalent) will actually yield a higher net return than a taxable bond paying 6.5%.

This formula has application in settlement planning because IRC Section 104–qualified periodic payments are fully nontaxable. You cannot make final decisions responsibly without taking taxes into account.