The yield of an investment is usually subject to tax, reducing the amount the investor actually obtains. Tax equivalent yield measures the pre-tax yield that an investment has to generate so that the after-tax yield is a certain value. This measure allows investors to compare between taxable investments and tax-free investments.
Some investments are tax-free; for example, in the US, federal taxes and sometimes state taxes don't apply to income from municipal bonds. Municipal bonds usually generate a lower interest percentage. The investor can keep all the income municipal bonds generate, so the low interest rate is often actually comparable to higher interest rates on income from taxable investments. Tax equivalent yield lets investors find out the extent to which a tax-free investment is comparable to a taxable investment.
To calculate tax equivalent yield, an investor needs to know the yield of a tax-free investment and his or her tax rate. The investor then needs to perform simple calculations using the following formula: tax-free yield / (1 - tax rate). A taxable investment would have to generate a higher yield than the calculated tax equivalent yield to be more attractive than the tax-free investment.
For example, consider an investor who has to pay 25 percent in taxes and is choosing between a taxable investment and a tax-free municipal bond that yields 20 percent. Using the formula, the investor calculates his or her tax equivalent yield to be 26.7 percent (20% / (1 - 25%)). The investor then should only consider choosing the taxable investment if its yield is at least 26.7 percent.
Investors who fall into different tax brackets pay different rates on taxes. Investors with higher incomes pay higher taxes and require taxable investments with higher yields to obtain a certain after-tax yield. In other words, investors who fall into higher tax brackets require higher tax equivalent yields from taxable investments to get the same yields as they could get from tax-free investments.
For example, consider another investor who only has to pay 20 percent in taxes and is choosing between a taxable investment and the tax-free municipal bond yielding 20 percent. His or her tax equivalent yield is only 25 percent (20% / (1 - 20%)). This investor pays less in taxes and therefore only has to earn an extra 5 percent instead of 6.7 percent on a taxable investment for it to become as attractive as the municipal bond.
The investor should also consider factors other than the tax equivalent yield when choosing an investment. For example, a lower yield with less risk could be more attractive to a conservative investor. The tax equivalent yield also does not consider capital gains tax, which is the tax that an investor has to pay on profits from price increases of any type of bond. Other factors to consider include tax deductions, market discount or premium and other types of taxes.