How do I compute after-tax yield and compare municipal bonds to taxables?

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AcadiFi · Accepted Answer

After-tax yield = pre-tax yield × (1 − marginal tax rate). For tax-exempt municipal bonds (federal, and sometimes state), the quoted yield is already after federal tax. Compare by computing the taxable-equivalent yield of the muni: TEY = muni yield / (1 − marginal tax rate). Example: Solvia Valley GO munis yield 3.80% (federal tax-exempt). An investor in the 37% federal bracket computes TEY = 3.80% / (1 − 0.37) = 6.032%. Compare to a Drayfield Corp bond yielding 5.60% — after-tax = 5.60% × (1 − 0.37) = 3.528%. The muni wins (3.80% > 3.528%) for this investor. For an investor in the 22% bracket: muni after-tax = 3.80%; corporate after-tax = 5.60% × (1 − 0.22) = 4.368%. Corporate wins. State tax complications: in-state munis are usually also state-exempt; out-of-state munis are not. An investor in California (13.3% top bracket) buying a California muni at 3.80% has TEY vs taxable = 3.80% / (1 − 0.37 − 0.133 × (1 − 0.37)) = 3.80% / 0.5462 = 6.957%. Triple-tax-free munis (federal, state, local) have even higher TEY. Other considerations: (1) alternative minimum tax (AMT) can claw back tax exemption on private-activity munis; (2) Medicare surtax of 3.8% on net investment income applies to taxables; (3) capital gain vs ordinary income differs (original-issue discount accrues as ordinary income). Always check effective marginal rate, not headline bracket.

How do I compute after-tax yield and compare municipal bonds to taxables?

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