Tax-Equivalent Yield

Definition

Tax-equivalent yield (TEY) is the yield a *taxable* investment would need to pay to leave you with the same after-tax income as a *tax-free* investment. It solves a comparison problem: yields come in different tax flavors, and lining up the raw numbers is apples-to-oranges.

A municipal bond fund quoting 3.5% pays interest that is generally exempt from federal income tax. A corporate bond fund quoting 5% pays interest taxed at your full ordinary rate. Which leaves more money in your pocket? You cannot tell from the headline numbers alone — you have to translate one into the other's terms. Tax-equivalent yield does that translation:

tax-equivalent yield = tax-free yield ÷ (1 − your marginal tax rate)

The result answers a precise question: "what taxable yield equals this tax-free yield *for me*?" The "for me" part is the whole point. Because the formula divides by your own marginal rate, the same muni yield is worth more to a high-bracket investor than to a low-bracket one. There is no single correct TEY for a fund — only a TEY *at a given tax rate*.

The same logic runs in reverse. To pull a taxable yield down to what you actually keep:

after-tax yield = taxable yield × (1 − your marginal tax rate)

Both formulas are two views of one comparison; use whichever direction is easier, but always compare yields on the same side of the tax line. Everything in this article is educational and illustrative — it is not tax advice — and your real rates depend on your full situation, so confirm the details with a tax professional.

Why It Matters

Income investing is ultimately about what you keep, and the tax code treats different income streams very differently. As covered in tax-efficient income investing, the same dollar of "yield" can be taxed at your full ordinary rate, at the lower qualified-dividend rate, or not at all. Ranking funds by their headline SEC yield — without translating for taxes — can put the wrong fund at the top of your list.

Tax-equivalent yield matters most in three situations:

• Municipal bonds vs everything else. Muni interest is generally federal-tax-exempt, so muni funds always *look* low-yielding next to taxable bond funds. TEY reveals whether the lower headline number is actually a higher take-home number for you. Broad muni ETFs like MUB and VTEB are the usual vehicles.
• The state-tax layer. Interest from U.S. Treasuries — including T-bill ETFs like SGOV and BIL — is generally exempt from state and local income tax, a wrinkle introduced in our money market funds article. In a high-tax state, that quietly boosts a Treasury fund's effective yield over a same-headline corporate fund.
• Qualified dividends. Dividend income from funds like SCHD that is qualified is taxed at capital-gains rates (0%, 15%, or 20%) instead of ordinary rates — a structural discount that makes it more competitive after tax than its headline yield suggests.

The unifying insight: your marginal tax rate is a lens, and every yield looks different through it. A comparison that is obvious for one investor can be exactly backwards for another, which is why generic "munis vs corporates" answers are useless without a bracket attached.

Key point: always use your marginal rate — the tax on your *next* dollar of income — not your average (effective) rate. New investment income stacks on top of everything you already earn, so it is taxed at the margin.

Example

All numbers below are illustrative, not live quotes — they are chosen to make the mechanics clear. Suppose you are choosing between a national muni bond ETF with a 3.5% tax-free yield and a corporate bond fund with a 5.0% taxable yield.

Investor A is in the 32% federal bracket. Translating the muni:

TEY = 3.5% ÷ (1 − 0.32) = 3.5% ÷ 0.68 = 5.15%

For Investor A, the 3.5% muni is equivalent to a 5.15% taxable yield — it beats the 5.0% corporate fund. Check it from the other direction: the corporate's after-tax yield is 5.0% × 0.68 = 3.40%, which loses to the muni's 3.5% tax-free. Same answer either way.

Investor B is in the 12% federal bracket. Same muni, different lens:

TEY = 3.5% ÷ (1 − 0.12) = 3.5% ÷ 0.88 = 3.98%

For Investor B, the muni is only equivalent to a 3.98% taxable yield — it loses to the corporate fund, whose after-tax yield is 5.0% × 0.88 = 4.40%. Investor B gives up real income by holding the muni.

That is the central lesson: municipal bonds are a high-tax-bracket tool. The exemption is worth a lot when it shields income from a 32% rate and very little at 12%. The muni market prices this in — muni yields sit below comparable taxable yields precisely *because* high-bracket buyers bid them up — so low-bracket investors buying munis are usually paying for a tax shield they barely use.

Federal, State, and the Qualified-Dividend Wrinkle

Federal tax is only the first layer. A fuller comparison stacks three tax treatments:

• Municipal bond interest — generally exempt from federal tax. A bond issued in your own state is often exempt from state tax too ("double-exempt"); an out-of-state muni usually is not.
• Treasury interest — fully taxable federally, but generally exempt from state and local tax — the SGOV/T-bill angle from the money market funds article.
• Qualified dividends — taxed federally at 0%, 15%, or 20% depending on income, though most states tax them as ordinary income.

When both federal and state taxes apply to the taxable alternative, the formula extends naturally. For an in-state, double-exempt muni against a fully taxable bond, a simplified combined version is:

TEY ≈ tax-free yield ÷ (1 − (federal rate + state rate))

Illustrative: 3.5% ÷ (1 − (0.35 + 0.05)) = 3.5% ÷ 0.60 = 5.83%

(The precise math can differ slightly where state taxes are federally deductible; the simplified version is fine for a first pass.)

Here is how four illustrative income sources rank for two very different investors: one paying 12% federal and no state tax, one paying 35% federal plus a 5% state tax and holding an *out-of-state* muni. Every figure is illustrative.

How the cells are computed: the muni pays no federal tax either way (3.50%; the out-of-state 5% state tax leaves 3.5% × 0.95 = 3.33%). The Treasury is state-exempt, so it pays only federal (4.5% × 0.88 = 3.96%; 4.5% × 0.65 = 2.93%). The corporate pays every layer (5.0% × 0.88 = 4.40%; 5.0% × 0.60 = 3.00%). The qualified dividend pays 0% federal in the 12% bracket (3.80%), and 15% federal plus 5% state at the top (3.8% × 0.80 = 3.04%).

Notice the ranking flips completely. In the 12% bracket the fully taxable corporate fund wins and the muni finishes *last*. In the 35%-plus-state bracket the muni jumps to *first* — and would be stronger still (a full 3.50%) as an in-state, double-exempt fund. The qualified dividend fund also climbs from third to second: its 3.8% headline trails a broad taxable bond fund like BND on paper, yet after tax it beats both the corporate and the Treasury for the high-bracket investor. Same four funds, opposite conclusions — the only thing that changed was the tax lens.

Common Mistakes

• Comparing raw yields across tax flavors. A tax-free 3.5%, a state-exempt 4.5%, a fully taxable 5.0%, and a qualified 3.8% are four different units. Convert everything to after-tax (or everything to tax-equivalent) before ranking.
• Using your average tax rate instead of your marginal rate. Investment income stacks on top of your existing income, so it is taxed at the margin. Averaging in your lower brackets flatters taxable yields and skews the comparison against munis.
• Buying munis in a low bracket. The exemption you are paying for via the lower yield is worth little at 10-12% rates; a plain taxable bond fund usually keeps more — see bond basics for the building blocks.
• Ignoring the state layer. Treasuries and T-bill ETFs are generally state-tax-exempt; in-state munis are often double-exempt; corporate and bank interest are exempt from nothing. In a high-tax state these gaps move real money.
• Forgetting the NIIT. High earners (above certain income thresholds) may owe an extra 3.8% net investment income tax on interest, dividends, and capital gains. It raises your effective marginal rate — and, since muni interest is generally exempt from it, makes munis *more* attractive at the top. Fold it into your rate if it applies to you.
• Running TEY math on tax-sheltered accounts. Inside an IRA or 401(k), interest is not taxed as earned, so a muni's exemption buys you nothing — the TEY comparison is moot, and taxable bonds almost always win there. Account location changes everything; see Roth vs traditional IRA for where each asset belongs.
• Treating TEY as the whole decision. Muni, Treasury, and corporate funds carry different credit risk, duration, and liquidity. TEY levels the *tax* playing field; it says nothing about the *risk* playing field.

FAQ

What is tax-equivalent yield?

Tax-equivalent yield is the yield a taxable investment would need to offer to match a tax-free investment after taxes. The formula is tax-free yield ÷ (1 − your marginal tax rate). At an illustrative 32% marginal rate, a 3.5% tax-free muni yield is equivalent to a 5.15% taxable yield (3.5% ÷ 0.68 = 5.15%). It lets you compare municipal bonds against taxable bonds on a level, after-tax footing instead of eyeballing headline numbers that are taxed differently.

Are municipal bonds worth it in a low tax bracket?

Usually not. Munis are priced *for* high-bracket buyers: their yields sit below comparable taxable yields because the federal exemption is valuable to investors paying 32-37% rates. In an illustrative 12% bracket, a 3.5% muni is only equivalent to a 3.98% taxable yield, which loses to a 5.0% taxable bond fund keeping 4.40% after tax. A low-bracket investor is paying, through the lower yield, for a tax shield they barely use. Run your own numbers — but be prepared for the taxable fund to win.

Are Treasuries state-tax free?

Generally yes. Interest from U.S. Treasury securities — including the income passed through by T-bill ETFs like SGOV and BIL — is exempt from state and local income tax, though fully taxable federally. In a state with a meaningful income tax, that exemption gives a Treasury fund an after-tax edge over a corporate fund with the same headline yield; the money market funds article covers how this plays out for cash. Confirm treatment in your state, as details vary.

What marginal tax rate should I use in the formula?

Use the combined marginal rate that would actually apply to the *taxable* income you are comparing against: your federal bracket, plus your state rate if the taxable alternative is state-taxable, plus the 3.8% NIIT if your income exceeds its thresholds. Do not use your average (effective) rate — new investment income is taxed at the margin, on top of what you already earn. If you are unsure of your bracket, check with a tax professional before acting; this article is education, not tax advice.

Does tax-equivalent yield matter inside an IRA or 401(k)?

No. In tax-advantaged accounts, interest and dividends are not taxed as earned, so a muni's exemption provides no benefit there — you would be accepting a lower yield for a shield you do not need. Taxable bonds generally belong in sheltered accounts, while munis and qualified-dividend funds make more sense in taxable accounts. See tax-efficient income investing for the account-location framework.

How do qualified dividends fit into a tax-equivalent comparison?

Qualified dividends are taxed federally at 0%, 15%, or 20% instead of ordinary rates, so a qualified-dividend fund like SCHD keeps more of its headline yield than a bond fund with the same number. Convert it the same way: multiply the yield by one minus *its* applicable rate (qualified rate plus any state tax), then compare after-tax yields. In the illustrative table above, a 3.8% qualified yield beat a 5.0% corporate yield after tax for a high-bracket investor. See qualified dividends for what makes a dividend qualify.