Taxable equivalent yield

🇺🇸

Tax-equivalent yield (TEY) is a method to compare the after-tax return of fixed-income investments that have different rates of taxation.

When buying fixed-income securities (Treasuries, in-state and out-of-state municipal bonds, corporate bonds, CDs, etc) or bond or money market funds in taxable accounts, you want to compare yields on an taxable-equivalent basis, since each of these may be taxed differently. What matters is the yield you have left to spend after you pay income taxes. Of course inflation is a factor too, but this article discusses only tax equivalence.

You can compare either after tax yield (ATY), or equivalent before tax yield, which is called taxable-equivalent yield (TEY). The convention seems to be to do the latter, probably because most quoted yields are taxable yields.

For example, sometimes short-term US Treasury bonds have lower rates than High Yield Savings Accounts (HYSAs) but are not subject to state and local income tax. So, if you pay state income tax, the $$TEY$$ of a short-term Treasury could be higher than the $$TEY$$ of the HYSA, even though the HYSA interest rate is higher than the Treasury yield. To compare a product with a lower interest rate but subject to lower tax to a product that has a higher interest rate but higher taxes, you can calculate a $$TEY$$.

Calculate using either a calculator or the following formulas. For derivations of these formulas, see: User:Daw007/Tax equivalent yield (math).

Definitions

 * $$ATY$$ - After Tax Yield
 * $$Ym$$ - Out-of-state municipal bond yield
 * $$Yt$$ - Treasury yield
 * $$f$$ - Total federal marginal tax rate, include NIIT, AMT, and any other items that affect your marginal tax rate. Your marginal tax rate is not necessarily the same as your top tax bracket.
 * $$s$$ - Total state marginal tax rate. Include state AMT and any other items that affect your actual marginal tax rate.
 * $$TEY$$ - Tax Equivalent Yield

In-state municipal bond
If not itemizing deductions:
 * $$TEY = \frac{Ym}{(1 - f - s)}$$

If itemizing deductions, and you can fully deduct state income tax:
 * $$TEY = \frac{Ym}{(1-f) \times (1-s)}$$

Out-of-state municipal bond
If not itemizing deductions:
 * $$TEY = \frac{Ym \times \left(1 - s\right)}{1 - f - s}$$

If itemizing deductions, and you can fully deduct state income tax:
 * $$TEY = \frac{Ym}{1-f}$$

US Treasury bonds
If not itemizing deductions:
 * $$TEY = \frac{Yt \times \left(1 - f \right)}{1 - f - s}$$

If itemizing deductions, and you can fully deduct state income tax:
 * $$TEY = \frac{Yt}{1-s}$$

Taxable bonds or high yield savings account
No $$TEY$$ formula is required for fully taxable fixed income (e.g., HYSA, fully-taxable money market fund), since the $$TEY$$ is just the stated yield.
 * $$TEY = Y$$ (for fully taxable fixed income)

Top tax bracket vs total marginal tax rate
Your top tax bracket is not necessarily the same as your total marginal tax rate when using these formulas. For more, see: marginal tax rate. In brief, you may need to factor in some of the following to determine your total marginal tax rate:


 * Itemized deductions
 * Additional Medicare Tax
 * ACA net investment income tax
 * State Alternative Minimum Tax
 * Federal Alternative Minimum Tax

General rules

 * Higher income tax brackets obtain more benefit from tax-advantaged products. While tax-advantaged fixed income products and municipal bonds may advertise TEY, the AFTER tax yield is most important as each individual's marginal tax rate is different.
 * Computing the TEY becomes more complex if you are near the top of a tax bracket and any additional income would be split across two or more tax brackets. This is where "what if" financial spreadsheet modeling for households can be really valuable for evaluating potential investments.
 * US Treasury bonds are exempt from state and local income taxes but subject to federal income taxes.
 * In-state municipal bonds are exempt from federal, state, or local income taxes.
 * Out-of-state municipal bonds are exempt from federal income tax but subject to state and local income taxes.
 * Taxable bonds or high yield savings account are subject to federal, state, and local income taxes.