Tax Equivalent Yield Formula

Tax Equivalent Yield Formula (Table of Contents)

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Tax Equivalent Yield Formula

The first question may be why should you use this formula? And the answer is this formula will help you compare the yield between a tax-free investment and a taxed investment.

Here’s the formula –

Example of Tax Equivalent Yield Formula

Let’s take another example to Tax Equivalent Yield Calculation.

Mrs. Olivia is new in the investment world. She wants to find out whether she should go for taxed investments or tax-free investments. She finds out that the taxed investments pay out the yield of 12% on an average. On the other hand, tax-free investments pay 8% on an average. The prevalent tax rate is 35%. You need to guide Mrs. Olivia by choosing which investment would be more beneficial for her.

By using the formula, we get –

• 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 are clear that Mrs. Olivia certainly needs to invest in tax-free investments and not taxed investments.

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Explanation

As you can see the formula compares between 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 to look at the yield of municipal bonds. These bonds are generally issued by the government 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. The reason we use this in the denominator is to find out how beneficial it is to invest in the taxed investments.

By using the formula, you will understand actually how much yield you would earn if you need to pay taxes on your tax-free investments. That will keep the yield at a similar level (both investments are taxed) and you would be able to find out whether the taxed investment is a good deal or not.

 

Use of Tax Yield Equivalent Formula

Investors should use this formula to find out whether it is prudent to pay higher taxes for investing in the 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 6% yield. And let’s say that the tax rate is 40%.

To find out, he uses the tax yield.

By using the formula, he gets –

• 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 Tax Equivalent Yield Calculator.

Tax Equivalent Yield Formula in Excel (with excel template)

Let us now do the same example above in Excel.

This 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 

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This has been a guide to Tax Equivalent Yield formula, its uses along with practical examples. Here we also provide you with Tax Yield Equivalent Calculator with downloadable excel template. Here are the other suggested articles –

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