What is Tax Equivalent Yield?

Tax Equivalent Yield means how much yield (pre-tax returns) you would earn if you need to pay taxes on your tax-free investments. This will help you compare the yield between a tax-free investment and a taxed investment, and you would be able to find out whether the taxed investment is a good deal or not.

Tax Equivalent Yield Formula

Here’s the formula –

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As you can see, the formula compares the tax-free yield and the taxed yield. In the formula, there are thus two components.

  • The first component is the tax-free yield. To find out the tax-free yield, all you need to do is look at the yield of municipal bondsMunicipal BondsA municipal bond is a debt security issued by a national, state, or local authority to finance capital expenditures on public projects related to the development and maintenance of infrastructures such as roads, railways, schools, hospitals, and airports.read more. The government generally issues these bonds, and you don’t need to pay any tax for the return you earn from your investment.The second component of the formula is (1 – Tax rate). (1 – Tax rate) would help you find out the yield if it is being taxed. We use this in the denominator to find out how beneficial it is to invest in taxed investments.

Examples

  • Tax Equivalent Yield = Tax Free Yield / (1 – Tax Rate)Or, Tax Yield = 8% / (1 – 35%)Or, Tax Yield = 0.08 / (1 – 0.35)Or, Tax Yield = 0.08 / 0.65 = 0.1230 = 12.3%.

From the above calculation, we see that Mrs. Olivia certainly needs to invest in tax-free investments and not taxed investments.

Uses of Tax Yield Equivalent

Investors should use this formula to determine whether it is prudent to pay higher taxes for investing in taxed investments.

Let’s understand this by using a simple example.

Let’s say that Mr. Ramesh has decided to look at both taxed investments and tax-free investments. The idea is to reduce the tax payment as much as he can.

He finds out that the taxed investment offers a 9% yield. And a tax-free investment offers him a 6% yield. And let’s say that the tax rate is 40%.

To find out, he uses the tax yield.

  • Tax Yield = Tax Free Yield / (1 – Tax Rate)Or, Tax Yield = 6% / (1 – 40%)Or, Tax Yield = 0.06 / (1 – 0.40)Or, Tax Yield = 0.06 / 0.60 = 0.1 = 10%.

So, Mr. Ramesh finds out that taxed investment isn’t a good deal, and he should go for tax-free investments.

Tax Equivalent Yield Calculator

You can use the following Calculator.

Tax Equivalent Yield Formula in Excel (with excel template)

Let us now do the same example above in Excel.

It is very simple. You need to provide the two inputs of Tax Yield and Tax Rate.

You can easily find out the tax-equivalent in the template provided.

Tax Equivalent Yield Formula Video

This has been a guide to Tax Equivalent Yield and its meaning. Here we discuss the formula for calculating tax-equivalent yield, its uses, and practical examples. We also provide you with a Tax Yield Equivalent Calculator with a downloadable excel template. Here are the other suggested articles –

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