 Personal Finance PowerPoint Presentation Tax Equivalent Yield Prepare to get financially fit by practicing personal finance. Most of this information can be found at Investopedia Tax Equivalent Yield, which you can find online. Take a look at the references, resources, continue your research from there. This by James Chen, updated February 23rd, 2021. In prior presentations, we've been taking a look at investment goals, investment strategies, investment resources, and now keeping that in mind, we're asking, what is the tax equivalent yield? The tax equivalent yield is the return that a taxable bond would need to equal the yield on a comparable tax-exempt municipal bond. So we've talked about different kinds of bonds that could have tax implications. In other words, oftentimes, if you buy some type of bond that's issued by the government, they can give you a little bit more incentives by making the return on it, the return in the form typically of interest, something that's going to be tax-exempt. So of course, when you look at that from a market perspective, now you've got to consider, okay, what's the benefit that I'm getting over and above the return of the interest, given the fact that it's tax-exempt, and when I compare that type of bond to other types of bonds where I have to pay the tax on the returns, then how can I compare those two things? How can I make those two Apple and Orange is non-comparable items into the comparable items, given the fact that, of course, when you think about the market conditions, you would expect then that the market to kind of even these things out, meaning if you get an added benefit because something has a tax benefit to it, then you're going to see the prices adjust to it. It's not exactly that easy as well because of the fact that the tax implications will be different for different people because we have a progressive tax system. Therefore, taxes are going to be higher for higher income individuals because they are at higher income tax rates, so it gets a little bit confusing to think about the taxes. They always confuse things. So the calculation is a tool that investors can use to compare the returns between tax-free investment and taxable alternative. Understanding tax-equivalent yield, tax implications, in general, are a complicated and important part of financial strategy. So clearly, again, taxes always kind of complicate things. We've got to keep them in the mix. We've got to put them in the picture. We've got to look at taxes as they reflect on us in particular, given the fact that the tax rates are not just a simple flat tax, but there are these progressive tax rates, which means they impact people differently. So as well as on often overlooking parts. So oftentimes people overlook the tax implications, which can be significant. So the tax-equivalent yield calculation is a useful tool for investors, especially those in higher tax brackets. So again, as you go through your earnings cycle, oftentimes people start off not earning a whole lot of money. They're going to be at a low tax bracket, and typically then we're all not earning much. We're like, tax the rich and give it to me for crying out loud. And then people start earning money and then you get more money. You're like, man, they're taking a lot of money from my taxes. And then, of course, at that point in time, when you're earning more money, then you're going to have to think about, you know, the taxes are going to be more significant in your investment strategies because you'll be at those higher tax brackets, possibly. So the tax-equivalent yield is the yield on a taxable bond that investor would have to earn to match the return on a comparable tax-free municipal bond. So municipal bonds generally have a lower expected return. So the full impact of investing in them due to tax savings is not often quantified completely. So the calculation helps an investor to decide whether to select a taxable investment or a tax-free investment such as a tax-free municipal bond. And this information is crucial because the tax-free advantage that municipal bonds offer can be hard to match with other investments. So, however, it is not the end of the story. Some additional tax considerations can come into play when making such comparison. While municipal bonds are free of federal taxes, some states do tax the earnings. So when we think about types of investments that have a tax incentive to them, it's not always the straightforward to say that all tax is gone. Or even if it was that straightforward, we might have multiple taxes that otherwise would have been imposed depending on the states that we are in and how the states are going to do the taxation. So we've got federal taxes, which is probably the bigger tax obligation that we first think of if there was tax obligations to it. But then we also could have our state tax obligations. And if we live in high cost of living, high tax states, then of course that could be significant as well. So the liquidity of municipal bonds may also be limited. So tax equivalent yield formula, depending on an investor's tax bracket, a municipal bond may not be the best investment decision for their portfolio, and investor's tax bracket will depend on their filing status and income. So when you think about your taxes, you can actually look at your tax return. Oftentimes, the software or your tax preparer will provide you a summary of taxes. You'll usually see one that's going to be your marginal tax rate, your highest tax rate, and then your average tax rate, kind of the average you're paying. Because remember that everybody is paying on different levels of taxes. So the more money you earn, the last dollar that you earned in theory is paid at the higher bracket, the first dollar you earned paid at, in essence, like a lower bracket. So the federal income tax brackets for 2020 and 2021 are 10%, 12%, 22%, 24%, 32%, 35%, 37%. Again, that doesn't mean that if you're in like the 35% tax bracket, that all of your income is taxed at 35%, but your last dollars are taxed at 35%. So the next decision that you make on the next dollars, making the decision on the margin, as economists say, will typically be taxed at the highest tax bracket, the 35%, even though you're paying multiple tax brackets on your income. So to calculate the taxable equivalent yield of a tax-free municipal bond, use the following formula and be sure to include any state tax along with your federal tax rate. So here's the formula we've all been waiting for, the return TEY equals return TX divided by brackets one minus the tax rates bracket. So where the return TEY return on fully taxable equivalent yield, the return TX is the return on tax exempt investments, and T is the investor's marginal tax rate. So if we break that down, we got the return, the TEY return on fully taxable equivalent yield. That's what we're looking for is equal to the return on the tax exempt investment, what we would get from the tax exempt investment over or divided by one minus the tax rate. And when we're looking at the tax rate, we're looking at the marginal tax rate because we're making this decision on the margin, which is the highest tax rate, not kind of like the average tax rate that you're paying. So this formula can be reversed to determine the tax-free equivalent yield of a municipal bond that would match the return on a taxable bond. So you can also look at it and basically rework the algebra that way if you so choose. Example of tax equivalent yield formula calculation, an investor's tax rate plays a significant role in the resulting tax equivalent yields. So you can see then, if you look at this formula, you're going to be seeing, well, look, if I'm at a higher marginal tax bracket, meaning I'm a higher income earner, this kind of tax incentive will be better for me, more incentivizing towards me. And you would think that then more wealthy individuals would be influencing the market in that case. So then your income level might have a significant impact in terms of how much you would want to be investing in bonds that have that tax benefit for you. So if the example, assume there is a tax-free bond that is yielding 7%, a decision to invest in this particular bond, or any of the many taxable choices available greatly depend on the investor's marginal tax bracket. Their higher tax rate, which is dependent in part on their income level. And the United States as of 2020, there are several different marginal tax brackets, 10%, 12%, 22%, 24%, 32%, 35%. The tax equivalent yield calculation for these brackets are as follows. So for the 10% bracket, if we run in our equation here, we've got the 7%, well, it comes out to 7.78. If we have the 12%, we've got the 7.95. At the 22% tax bracket, that would be your highest marginal rate. We've got the 8.97%. And at the 24%, the 9.21%. And then the 10.929 at the 32%, 35%, 10.77%. And then if we're at the marginal tax bracket of the 37%, the highest one, then we've got the equivalent of the 11.11%. So if we're thinking about basically comparing the tax benefit that we are getting here to another type of investment similar in nature that doesn't have the tax benefit you can see that we would have to get a return at the lower at the 10%. We're getting a return of 7% before the tax taken into consideration, the tax benefit. If we take into consideration the 10% tax that we have then we're at the 7.78%. So we would have to find another investment that didn't have the tax benefit. In other words, the income or interest would be taxable providing the 7.78, which might be something that would be more likely to be cleared if the investment on the tax free was 7%. Whereas if you're at the 37% marginal tax bracket and you could take that into consideration, then to buy an equivalent type of investment, they would have to have a return of 11.11% to equal the tax benefit. So you can see obviously as your tax brackets go up, then the tax benefit would be greater and to find another return that is going to be beneficial after the tax benefit would be more difficult. So the taxes obviously will have a bigger impact at the higher income level. So given this information, assume there is a taxable bond that is yielding 9.75% and this situation investors in the first four marginal tax brackets would be better off investing in the taxable bond. So you're saying, okay, I got the bond that was tax free, it's got the 7% return, but I can buy another similar bond and it's at the 9.75%. So even though it's on the taxable kind of basis here, you're getting into the higher tax brackets where that would not be beneficial. So you'd say, yeah, I would want to be purchasing the taxable bond in that case because the tax benefit that I'm getting is not sufficient to outweigh the fact that I can get a higher return on the taxable investment because even after paying their tax liability, they will still earn more than a 7% non-taxable bond. So investors in the highest three brackets would be better off investing in the tax free bond. So now, of course, if you have that higher tax bracket, then you're saying, okay, now they're over that 9.7% and they're going to want the tax free bond given the fact that even though you're getting the 7%, you got that tax free component. So note, however, that none of this is investment advice, a tax or financial advisor should be considered. So clearly there's other things that are taken into consideration here because obviously you might have different levels of risk with the different bonds if you're buying government bonds versus non-government bonds. But the idea here would be that they're kind of on an equal risk level, but they have different returns given the fact that you've got this tax difference. So example of tax equivalent yield, an investor is in the 22% federal income tax bracket. So that's going to be, we're going to say that's their highest bracket, the marginal tax rate. And those state taxes owns a tax-exempt musical bond with an 8% coupon rate. So it's giving the 8%, but you also have the tax benefit on it. The calculation to calculate the fully taxable equivalent yield that a taxable bond would have to earn to match the municipal bonds yield use the above formula. So in other words, a taxable bond would have to earn an equivalent yield of 10.26 where after taxes are deducted, it would match the 8% return of the tax free municipal bond. So here's our formula that we looked at. So we've got the 8% divided by one minus the 22%. That's going to give us our 10.26%. If the marginal tax rate is higher, the required fully taxable equivalent yield will also be higher than the 10.26%. So if all else remains the same with the only difference being that the investor is in the 37% tax bracket, the fully taxable equivalent yield would have to be the 12.7%. So why are municipal bonds tax-exempt? So interest earned on state and local bonds has been tax-exempt since the introduction of the federal income tax in 1913. Initially, this was because many people felt the Constitution prevented federal government from taxing this income. So obviously there's going to be questions on what kind of taxation is required and what can the state do versus the Fed. So notice that it's kind of an interesting dynamic because oftentimes on the Fed side of things you would be thinking, well, the Fed should not be influencing what the state does because the state is independent to finance and the Fed originally was there to finance the military to keep us safe from foreign invasion and stuff like that. The states were there to finance other stuff. So if the state's doing stuff to finance, then the Fed shouldn't be coming in and earning revenue on it. It's kind of weird the way it worked out because now the Fed seems like they kind of use state taxation and the deductibility of state taxation possibly to favor different states that are higher tax states and lower tax states. So it's kind of a weird dynamic. But in any case, since then the justification for tax exclusion has been supported by the idea that local infrastructure projects serve the common good and therefore federal tax policies should support those projects. So you can see what the incentive would be that if you get a tax benefit from it, then really you can see how that can kind of increase these kind of the projects that could happen, which are kind of at this point getting subsidized from the Fed, which is an interesting dynamic. So municipal bonds are not always tax free. Federal taxes may apply to a municipal bond if the Internal Revenue Service IRS does not interpret a project as good for the entire public. So taxable municipal bonds are rare, but they can be issued for projects such as sports stadiums or a pension shortfall. So it's always a kind of, and that's another kind of funny one. You always say, ah, you're building roads, you're building the sewer system, whatever. And then sports, we need the tax dollars for a stadium. You know, it's kind of a weird one. The IRS can also treat municipal interest income as taxable if a bond is purchased at a significant discount to par value. So a mutual fund composed of tax free bonds is still subject to capital gains tax. So in other words, when you look at the taxes on the bonds, typically you have the tax benefit related to the earnings that you have on the bonds, the interest. But if you sell the bonds on the secondary market, then you might sell them, say, for more than you purchased them for, and that would be similar to selling stocks, for example. And you might have then, again, that game could then still be subject to capital gains tax.