What is the Taxable Equivalent Yield based on?

The Taxable Equivalent Yield is determined by taking the tax-exempt yield and dividing it by one minus your marginal tax rate. This calculation provides the equivalent yield that a taxable investment would need to offer in order to match the after-tax return of a tax-exempt investment.

To understand why this calculation is used, consider that the Taxable Equivalent Yield accounts for the fact that tax-exempt investments, such as municipal bonds, provide returns that are not subject to federal income tax. Since the investor does not have to pay taxes on these earnings, these investments can often offer lower nominal interest rates while still being attractive.

By dividing the tax-exempt yield by (1 - your marginal tax rate), you effectively adjust for the impact of taxes, giving you a clear picture of what a taxable investment must yield to be competitive. For example, if your marginal tax rate is 25%, using this formula properly adjusts the yield to account for the tax liability, allowing a direct comparison with taxable investments. Understanding this concept is crucial for evaluating different investment options and making informed decisions about where to allocate resources.