How Your Tax Bracket Affects Your Taxable Equivalent Yield

Taxable equivalent yield helps you compare the total returns of taxable and tax-free bonds. As you might expect, the comparison changes with your tax bracket.

If you plug different tax brackets into the formulas for taxable equivalent yield, you will see that the higher your tax bracket, the higher the taxable equivalent yields will be. Therefore, the higher your tax bracket, the more you will profit from municipal bonds. This is why municipal bonds are very popular among high-income investors. If you used the 35 percent tax bracket instead of the 25 percent rate to find the taxable equivalent yield on a 6 percent municipal bond, your taxable equivalent yield would be 9.23 percent. At a bracket of only 15 percent, your taxable equivalent yield would be only 7.06 percent.

In short, the more tax bite you're subject to, the more tax-free bonds make sense. If you are in a lower tax bracket, however, the higher coupon rates of taxable bonds might overcome the tax savings you are losing.

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