If you are looking for current income from an investment, it’s a pretty good bet that corporate or government bonds are high on your shopping list. Bonds provide a steady revenue stream to diversify your investment portfolio or to live on if you are retired. The after-tax rate of interest is the bottom line, of course, since that is the money you actually get to spend or reinvest.
Bonds and Yield
Bonds pay a fixed annual amount called the coupon rate. For example, a $1,000 face value bond might pay $60 per year, or 6 percent. Your yield, or effective rate of interest, is the coupon rate divided by the price you pay for the bond. If you buy a bond with a coupon rate of $60 for $900, your yield works out to 6.7 percent. However, corporate bond and Treasury bond interest is subject to federal income tax. Once that’s deducted, your after-tax rate of interest is considerably lower than the stated yield.
Tax Equivalent Yield
The interest earned by state and local government bonds (collectively called municipal bonds or munis), is usually exempt from federal income tax. This means a municipal bond with a lower stated yield than a corporate or Treasury bond may actually produce more after tax income. After-tax equivalent rate of interest, or tax equivalent yield, is the rate of interest a taxable bond must pay in order to produce as much after-tax income as a municipal bond paying a particular rate. Tax equivalent yield is thus a way of comparing taxable and non-taxable bonds to see which is the better investment.
To find the tax-equivalent yield of a taxable bond versus a muni, first subtract your marginal tax rate (the highest tax rate you pay on your income) from one. Divide the municipal bond yield by the result. This gives you the yield on a taxable bond you need to produce an after-tax yield equal to what you would get from the muni. Suppose a muni has a 5 percent yield and your marginal tax rate is 25 percent. You have 5 percent divided by (1 – 0.25), which works out to 6.7 percent. That 6.7 percent is the yield you need from a taxable bond to produce an after-tax rate of interest equal to what the municipal bond gives you.
States cannot tax income from U.S. Treasury bonds, but they can and do tax income from corporate bonds. However, munis are often exempt from state income taxes as well as federal tax, especially if you are a resident of the state where the bond is issued. If you won’t pay state income tax on municipal bond income, but will pay the state tax on income from a corporate bond, you will get a more accurate after-tax equivalent rate of interest by factoring in the savings on state income tax. To do this, simply add the state income tax rate percentage to your marginal tax rate and calculate the tax equivalent yield.
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