Tax equivalent yield tells you the taxable yield needed to match the income from a tax-exempt investment after accounting for a specified tax rate. It helps answer a practical question: is a lower municipal bond yield actually more valuable than a higher taxable yield?
For example, a 4% tax-exempt yield has a tax equivalent yield of about 5.26% when the relevant marginal tax rate is 24%. That is an income comparison under specific assumptions, not a promise of a 5.26% investment return.
This guide explains the formula, walks through dollar examples and shows what to check before using the result to compare bonds. All yields and tax rates below are hypothetical. They are not current market quotes or a recommendation to buy a particular security.
What Is Tax Equivalent Yield?
Tax equivalent yield, often abbreviated TEY, converts tax-exempt income into a comparable pretax taxable yield. A taxable investment must earn that amount before the specified income tax to leave the same income afterward.
Municipal bonds are a common setting for this calculation. Many pay interest that is exempt from federal income tax, which can make their stated yields look lower than taxable alternatives. However, the tax treatment must be verified for the actual bond and investor.
TEY is personal to the tax assumptions. Two people looking at the same bond can calculate different results because their marginal tax rates differ. If you are learning the broader process, start with our guide to how investing works before treating any single yield as a decision rule.
The Tax Equivalent Yield Formula
Tax equivalent yield = Tax-exempt yield ÷ (1 − marginal tax rate)
Enter the tax rate as a decimal. A 24% rate becomes 0.24, so the denominator is 0.76. You can enter a 4% yield as 0.04 and convert the answer back to a percentage:
0.04 ÷ (1 − 0.24) = 0.0526316, or approximately 5.26%
The formula appears in Fidelity’s municipal bond education materials. In its basic federal-only form, it assumes the municipal interest is fully exempt from the federal tax being modeled and the comparison income is fully subject to that same rate.
Use the marginal rate applicable to the additional taxable income, rather than dividing your total tax bill by total income to get an average rate. If additional income crosses a bracket or affects other taxes or benefits, one simple rate may not capture the whole result. Ask a tax professional to refine the calculation when those effects matter.
A Dollar Example: $10,000 Invested
Assume an investor puts $10,000 into an investment yielding 4%, with all $400 of annual interest exempt from the federal income tax in this example. Ignore state taxes, price changes, transaction costs and other tax effects.
A taxable alternative needs to produce approximately $526.32 before tax to leave $400 after a 24% tax:
- Pretax income: $10,000 × 5.26316% = about $526.32.
- Federal income tax: $526.32 × 24% = about $126.32.
- Income remaining: $526.32 − $126.32 = $400.
The calculation does not increase the municipal investment’s cash payment. It still pays $400 under these assumptions. The 5.26% figure describes what the taxable alternative would need to yield to match that income.
Tax Equivalent Yield Table
The following table holds the tax-exempt yield at 4% and changes only the assumed marginal tax rate. These are illustrative rates, not a table of income thresholds or filing-status rules.
| Assumed marginal rate | Tax-exempt yield | Tax equivalent yield |
|---|---|---|
| 12% | 4.00% | 4.55% |
| 22% | 4.00% | 5.13% |
| 24% | 4.00% | 5.26% |
| 32% | 4.00% | 5.88% |
| 37% | 4.00% | 6.35% |
As the assumed tax rate rises, a taxable investment must earn more to match the same exempt income. That mathematical advantage does not settle whether the municipal investment is suitable or fairly priced.
Compare Taxable Income in the Other Direction
You can also calculate the after-tax yield of the taxable alternative:
After-tax yield = Taxable yield × (1 − marginal tax rate)
With the same 24% rate, a 5% taxable yield becomes 3.80% after tax: 5% × 0.76. A 5.50% taxable yield becomes 4.18%. Against a fully exempt 4% yield, the first produces less after-tax income and the second produces more, assuming comparable yield measurements and no other differences.
On $10,000, those figures represent $380, $418 and $400 respectively. A difference of $18 a year between the latter two choices is small enough that fees, purchase price and investment characteristics deserve close attention.
For a separate recordkeeping overview, read our guide to brokerage account taxes. A yield comparison does not replace reviewing the transactions and tax information in your own account.
Confirm Which Taxes Actually Apply
Federal exemption is not automatic
Do not assume every municipal bond pays tax-exempt interest. The Municipal Securities Rulemaking Board’s tax treatment guide explains that taxable municipal securities also exist. Review the security’s official statement, including its tax-status discussion and bond counsel opinion.
State taxes and AMT can change the answer
State exemptions depend on state rules and the security. An in-state bond and an out-of-state bond may receive different treatment. Some municipal interest can also be subject to the federal alternative minimum tax even when exempt under the ordinary federal income tax calculation.
Do not simply add a state rate to a federal rate and assume that sum is correct for every comparison. Identify the taxes applying to each investment, then model their actual interaction. Keep a federal-only comparison clearly labeled if you have not included state or other effects.
Interest exemption does not cover every possible gain
The IRS’s Publication 550 explains that selling state or local obligations can produce a capital gain or loss even when their interest is exempt. The basic TEY formula compares interest income; it does not calculate the tax on a sale or the investment’s complete lifetime tax bill.
Use Comparable Yields Before Calculating
Write down what each quoted yield measures and its date. A coupon rate describes interest relative to a bond’s face value; it is not automatically the yield on the price you pay. Likewise, do not treat a fund’s distribution figure and an individual bond’s yield to maturity as interchangeable inputs.
Before running a comparison, ask the broker or fund provider:
- Are both yields measured on a comparable basis and over a comparable period?
- Does the figure already include ongoing expenses, or do costs still need to be considered?
- Are you comparing income yield, yield to maturity or a measure reflecting an early call?
- Could distributions include amounts with a different tax treatment?
TEY cannot fix mismatched inputs. If you cannot explain what the displayed numbers represent, get that clarification before using the formula to choose between investments.
What Tax Equivalent Yield Leaves Out
A higher TEY does not make two investments equally safe. Investor.gov’s municipal bond risk bulletin highlights credit, call, interest rate and liquidity risks.
- Credit: Can the issuer make the promised payments?
- Interest rates: How could a rate change affect the price if you sell before maturity?
- Calls: Can the issuer repay early, changing your expected income period?
- Liquidity: Can you sell when needed at an acceptable price?
Also compare maturity, concentration and costs. Tax treatment alone is a weak reason to take a much longer commitment or concentrate heavily in one issuer. Consider whether the money belongs in an investment at all: our guide to saving money versus investing explains how goals and access needs fit into that decision.
A Simple Worksheet to Keep With Your Comparison
Record the following details together so you can revisit the decision when yields or your tax situation change:
- Investment and date: Identify each security or fund and when the quote was obtained.
- Yield definition: Note the measurement, assumptions and whether expenses are included.
- Tax status: Identify federal, state and AMT considerations separately.
- Tax rate: Record the marginal rate used and why it applies.
- Calculation: Divide the exempt yield by one minus the rate, then cross-check the taxable alternative’s after-tax income.
- Other differences: Write down maturity, call provisions, credit quality, liquidity and costs.
For example, write “4% exempt; federal-only; 24% assumed marginal rate; TEY 5.26316%.” That is more useful than saving “5.26%” without context. Keep extra decimals while calculating and round only the displayed answer to avoid small inconsistencies.
Frequently Asked Questions
Is tax equivalent yield the same as after-tax yield?
No. TEY translates an exempt yield into the pretax taxable yield needed to match it. After-tax yield starts with a taxable yield and estimates what remains after the modeled tax. Under the same assumptions, the two calculations provide a useful cross-check.
What happens if the assumed tax rate is zero?
The denominator becomes one, so a 4% exempt yield has a 4% TEY. There is no tax adjustment in that calculation. Whether another investment is preferable still depends on its yield and other characteristics.
Does a 6% TEY mean the bond pays 6%?
No. The bond pays according to its actual terms. TEY is a comparison figure based on a specified tax rate. It is neither an extra payment nor a guarantee against losses.
Is the investment with the highest TEY always best?
No. Use TEY to compare income under clear tax assumptions, then evaluate the actual investment. A result that looks attractive on paper may come with risks, costs or access restrictions that do not fit your needs.
This article provides general education for U.S. readers. Confirm the tax treatment of a specific security and your own circumstances before relying on a calculation.