By Carmine Coppola
Making Smart Investment Decisions
When choosing between tax-free municipal bonds and taxable bonds, the decision isn’t as simple as picking the one with the highest yield.
Taxes play a huge role in your actual return. A taxable bond might look better on paper, but once taxes take a bite out of your earnings, a tax-free municipal bond could be the better option.
That’s where the Tax-Equivalent Yield Formula comes in. This simple formula helps investors compare bonds fairly and determine the best choice for their portfolio.
Let’s break it down.
Municipal Bonds vs. Taxable Bonds: The Key Differences
Municipal Bonds (“Munis”)
Issued by state and local governments
Tax-free interest at the federal level (and often state level, too)
Typically lower yields than taxable bonds
Ideal for investors in higher tax brackets
Taxable Bonds
Issued by corporations or the U.S. Treasury
Interest is subject to federal taxes
Generally offer higher yields than municipal bonds
May be better for lower-income investors who pay less in taxes
To determine which bond actually provides the better return, we need to factor in taxes.
The Tax-Equivalent Yield Formula
This formula converts a tax-free municipal bond yield into its equivalent taxable yield:
Tax-Equivalent Yield = Tax-Free Yield ÷ (1 – Tax Rate)
This allows you to compare a tax-free bond with a taxable bond on an equal basis.
Example Calculation
Let’s assume a municipal bond offers a 3 percent yield and your federal tax rate is 32 percent.
Using the formula:
3% ÷ (1 – 0.32) = 3% ÷ 0.68 = 4.41%
This means a taxable bond must yield more than 4.41 percent to be a better investment than the tax-free municipal bond.
Real-World Example: Comparing After-Tax Returns
Let’s say you’re choosing between:
A municipal bond with a 3 percent tax-free yield
A taxable bond with a 5 percent yield
A 32 percent federal tax rate
Step 1: Calculate the Income from Each Bond
Municipal Bond: $10,000 x 3% = $300 tax-free income
Taxable Bond: $10,000 x 5% = $500 gross income
Step 2: Subtract Taxes from the Taxable Bond
Since the taxable bond’s interest is subject to a 32 percent federal tax, the tax owed is:
$500 x 32% = $160 in taxes
After-tax income from the taxable bond:
$500 – $160 = $340
Step 3: Compare the After-Tax Returns
Municipal Bond: $300 tax-free
Taxable Bond: $340 after taxes
In this scenario, the taxable bond provides a higher after-tax return.
What If You’re in a Higher Tax Bracket?
Now, let’s assume you are in the highest federal tax bracket (37 percent) and also pay 8 percent in state taxes, for a total tax rate of 45 percent.
Using the same $10,000 taxable bond investment, the taxable income remains:
$500 gross income
Step 1: Calculate Taxes Owed
$500 x 45% = $225 in taxes
After-tax income from the taxable bond:
$500 – $225 = $275
Step 2: Compare Again
Municipal Bond: $300 tax-free
Taxable Bond: $275 after taxes
Now, the municipal bond provides the better after-tax return.
Key Takeaway
The higher your tax bracket, the more valuable tax-free municipal bonds become. Investors in high-income brackets should strongly consider municipal bonds to reduce their tax burden.
How to Choose the Right Bond for Your Portfolio
- Your Tax Bracket: If you’re in a lower tax bracket, taxable bonds may provide higher after-tax returns. If you’re in a higher tax bracket, municipal bonds often provide better value due to tax-free interest.
- Your Investment Goals: If your priority is maximizing income, taxable bonds may offer higher overall returns. If your goal is tax efficiency and risk reduction, municipal bonds could be the better choice.
- Your State’s Tax Policy: Some states exempt municipal bond interest from state taxes, further increasing their appeal.
- Diversification Strategy: Many investors hold both types of bonds to balance tax efficiency and yield.
Make an Informed Bond Investment
Choosing between municipal and taxable bonds isn’t just about comparing interest rates—it’s about understanding how taxes impact your bottom line.
By using the Tax-Equivalent Yield Formula, you can accurately determine which bond offers the better after-tax return.
Key Takeaways
- Municipal bonds offer tax-free income, making them attractive for high earners.
- Taxable bonds often provide higher yields, but taxes can erode returns.
- The higher your tax bracket, the more valuable municipal bonds become.
- The Tax-Equivalent Yield Formula helps you make an informed decision.
Before making any bond investment, consult with a financial professional to ensure your strategy aligns with your long-term financial goals.
For personalized wealth management solutions, reach out today. And, for more information watch the video above and subscribe to our YouTube channel.
Strata Capital is a wealth management firm serving corporate executives, professionals, and entrepreneurs in the New York Tri-State Area, focusing on corporate benefits and executive compensation. Co-founded by David D’Albero and Carmine Coppola, the firm specializes in making the complex simple to ensure clients feel confident in their financial decisions. They can be reached by phone at (212) 367-2855, via email at carmine@stratacapital.co, or by visiting their website at stratacapital.co.
Cornerstone Planning Group, Inc., (“CSPG”) is an SEC registered investment advisory firm. The information contained herein should not be construed as personalized investment advice and should not be considered as a solicitation for investment advisory service. The information (e.g., tax ) provided is believed to be accurate however CSPG does not guarantee or otherwise warrant such information. For more information regarding CSPG you can refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov) and review our Form ADV Brochure and other disclosures.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.