I’ve mentioned tax-equivalent yield in passing a couple of times. Today, I want to spend a few minutes expanding on the topic.
In general terms, whenever you hold a tax-exempt investment in a taxable account, you’re earning more (after taxes) than you would with an equivalent, taxable investment.
Said another way… All else being equal, if you were offered a choice between two investments, one taxable and one tax exempt, but both with the same yield, you’d jump on the tax free version. Right?
So how high would the taxable yield have to change your mind? The tax-equivalent yield of the tax-free version provides an answer to this question, allowing you to make a “fair” comparison between taxable and tax-free investments.
Here’s how to calculate it:
Tax-Equivalent Yield = Tax-Free Yield / (1 - (% Tax Bracket / 100))
So if you’re in the 25% tax bracket, you can simply divide your federally tax-free yield by 0.75 to get its tax-equivalent yield – i.e., the yield that you’d need for a taxable investment to be just as good.
As a real-world example, Admiral Shares of the Vanguard Intermediate-Term Tax Exempt Fund (VWIUX) currently have an SEC yield of 1.65%. Given that the earnings are exempt from federal income taxes, and assuming a tax rate of 25% on qualified dividends, that’s the equivalent of 2.2% if the dividends were fully taxable.
Similarly, the earnings from I-Bonds are exempt from state and local taxes. So, given the current rate of 1.18% and assuming a state tax rate of 6%, that’s the equivalent of a fully taxable 1.26% (i.e., 1.18% / 0.94).
Note: If you use your savings bonds proceeds to pay for college, the interest earnings will be completely tax free, so the effect could be even larger. Details can be found in IRS Publication 970.
Obviously, the difference between the stated yield and the tax-equivalent yield is greater as your tax rate increases. When running the numbers, just be sure to keep in mind that I used the qualifier of all qualifiers up above: all else being equal.
All else is rarely equal, so don’t just look at tax-equivalent yield when evaluating a tax-free investment option. Be sure to look at potential investments from all angles and evaluate their fit in your overall portfolio.