What is Tax Equivalent Yield?
Tax Equivalent Yield means how much yield (pre-tax returns) you would earn if you need to pay taxes on your tax-free investments. This will help you compare the yield between a tax-free investment and a taxed investment, and you would be able to find out whether the taxed investment is a good deal or not.
Tax Equivalent Yield Formula
Here’s the formula –
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For eg:
Source: Tax Equivalent Yield (wallstreetmojo.com)
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 taxed investments.
Examples
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 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.
Uses of Tax Yield Equivalent
Investors should use this formula to find out whether it is prudent to pay higher taxes for investing in 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 a 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 Calculator.
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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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