Comparing Taxable and Tax Exempt Bond Yields

Saving & Investing

The Internal Revenue Code allows individuals to treat interest income from most municipal obligations as tax exempt. This beneficial tax provision enables municipal entities to raise capital more cheaply to fund their development and operations.

For individuals, the benefit of tax-exempt interest income can be attractive if they are in a high-income tax bracket. To determine if the tax-exempt route is right for you, it is necessary for you to compare the after-tax yield of a taxable bond to the yield of a tax-exempt bond. It’s important to compare bonds of similar maturity dates and similar quality.

To calculate the after-tax yield of a taxable bond you can use the following formula:

AFTER TAX YIELD = YIELD - (YIELD times MARGINAL TAX RATE)

For example, here is the equation to calculate the after-tax yield of a taxable bond with a yield of 6% for someone in the 35% marginal tax bracket.

AFTER TAX YIELD

 = 6% - (6% X .32)

 

 = 6% - (1.92%)

 

 = 4.08%

Or you can use the following table:

Tax free yield

 

Equivalent taxable yield in these tax brackets

 

10%

12%

22%

24%

32%

35%

37%

3.0%

3.3

3.4

3.8

3.9

4.4

4.6

4.8

3.5%

3.9

4.0

4.5

4.6

5.1

5.4

5.6

4.0%

4.4

4.5

5.1

5.3

5.9

6.2

6.3

4.5%

5.0

5.1

5.8

5.9

6.6

6.9

7.1

5.0%

5.6

5.7

6.4

6.6

7.4

7.7

7.9

5.5%

6.1

6.2

7.1

7.2

8.1

8.5

8.7

The tax brackets are those in effect in 2022

According to the chart, a tax-exempt bond yielding 4.0% has an equivalent after-tax yield of 5.9% for someone in the 32% tax bracket. For that person, a taxable bond yielding more than 5.9% will produce a better after-tax return.

Remember, to get a true comparison, it is critical that the taxable and tax-exempt bonds have similar maturity dates and similar quality ratings.

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The information provided is not intended to be legal, tax, or financial advice or recommendations for any specific individual, business, or circumstance. TowneBank cannot guarantee that it is accurate, up to date, or appropriate for your situation. Financial calculators are provided for illustrative purposes only. You are encouraged to consult with a qualified attorney or financial advisor to understand how the law applies to your particular circumstances or for financial information specific to your personal or business situation.

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