Taxable-Equivalent Yields

Here's the formula for figuring the precise taxable-equivalent rate for any bond you consider: Subtract the federal marginal tax bracket percentage from the number one, and divide the tax-free rate by the result.

For example, assume you are in the 28 percent tax bracket and are offered a 5.75 percent tax-free bond. You would divide 5.75 by 0.72 (1 less 0.28) and find that the taxable-equivalent yield is 7.99 percent. In other words, you'd need a taxable investment paying more than 7.99 percent to beat the return on the 5.75 percent tax-exempt. In the 35 percent bracket, the divisor would be 0.65 (1 less 0.35) and the taxable-equivalent yield would be 8.85 percent.

There's a similar formula for figuring things the other way, to find the tax-exempt equivalent of a taxable yield: Subtract the federal marginal tax bracket percentage from the number one, and multiply the taxable rate by that number. The result is the tax-free rate.

Assume you are considering a taxable investment yielding 8 percent. If you are in the 28 percent tax bracket, multiply 8 by 0.72 (1 less 0.28). The result is 5.76, telling you that a 5.76 percent tax-free yield will put the same amount in your pocket, after tax, as an 8 percent taxable yield. In the 35 percent bracket, the multiplier would be 0.65 (1 less 0.35), so a tax-free yield of 5.2 percent will match a taxable yield of 8 percent.

In most states, there's an advantage to buying in-state municipals because these states tax the income on out-of-state bonds but give the tax-free nod to in-state obligations. A few states, though, give tax-free status to munis from all other states and a few others even tax some of their own munis. To know where you stand, check with a state tax official or a broker who sells munis. If you happen to face a city income tax, municipals can brag of triple tax-free status - shielded from federal, state, and local income tax.

Figuring taxable-equivalent yields gets more complicated if your investment dodges both state and federal tax. Because state income taxes paid are deductible on your federal return (if you itemize) you can't simply add the state rate to the federal rate in the formulas above. First, you must find the effective state tax rate - what you pay minus the tax savings of deducting that amount.

For example, if you are in the 5 percent state tax bracket and are in the 28 percent federal bracket, your effective state tax rate is 3.6 percent (the 5 percent state tax rate minus 28 percent of that rate). Thus, in the formula for figuring taxable equivalents, the tax rate used in the divisor would be the combination of your federal rate (28 percent) and your effective state rate (3.6 percent), or 31.6 percent. So the divisor is 1 less 0.316 or 0.684. If you are considering a 6 percent municipal bond that is exempt from both state and local taxes, you would divide 6 by 0.684 and find that the taxable equivalent is 8.77 percent.

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