Municipal Bond Tax Equivalent Yield Calculator

Municipal Bond Tax Yield Calculators

This calculator can help you determine if a municipal bond would provide greater profits then a similar corporate investment. It's likely that you may be wondering if the tax you save from the municipal bond will compensate for its lower return. This is comparison is called taxable equivalent yield (TEY). The TEY provides an equal assessment among securities with different tax structures, like corporate and municipal bonds. Plus, be sure to find out how your annual income and AMT should influence your decision to invest.

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What is a municipal bond?
Municipal bonds, or munis, are bonds issued by states or municipalities. These bonds are used to finance different government projects in local counties. The developments could entail new schools and parks or create low-income housing. Beyond that investing in bonds could improve local roads or sewer systems.
Municipal bonds tend to offer smaller returns than other bonds that are taxable. As a trade-off, the earnings from a muni are typically exempt from federal and state taxes . That means by investing in a municipal bond, you could end up with double tax-free yields.
Returns and risks
No investment is without risk. Munis can provide modest returns that can vary from one year to another. The average yield on municipal bonds tends to be between 3% and 6%. Greater yields are paired with higher risk. The performance of a municipal bond depends on three main factors.
Credit risk . This factor entails the potential of default from the issuer. Credit risk could be influenced by any changes in the economy . Any municipality that receives substantial tax revenue will see a positive impact on its price. When the economy grows stronger, you can be more confident in the financial strength of a bond issuer.
Interest rate risk . The interest rate aspect pertains to bond market fluctuations. It refers to anything that can impact the performance of the muni in the bond market. Often such an impact can concern the yields on treasuries. In the past, as Treasury yields have fallen, bonds have improved. Meanwhile, Treasury yields that go up could negatively impact bond interest.
Headline risk . Municipal bond performance can be affected by recent news events. If a municipality has reported a fraud or bankruptcy, it can deter investors. Any crisis, whether a natural disaster or a financial scheme, could result in a wave of security sell-offs. But in some cases, headline risk has actually created better opportunities to buy municipal bonds.
Default Rates
Given these considerations, default risk on municipal bonds is reasonably low. In most cases, municipal bonds can deliver all the interest and principal payments as expected. Only 0.01% of high-quality bonds (rated Aaa or Aa) have defaulted in 40 years. Lower-rated bond issuers (A, Baa, Ba) have a slightly higher incidence of default, just shy of 7%. (Source: Moodys )
When selecting a bond, it can be helpful to see how the fund manager faired in times of distress. Pay attention to their track record and the quality of the securities that the fund is invested in. It helps to do extensive research before investing.
It stands to reason that you could mitigate your risk by only pursuing high-quality bonds with good ratings. A further consideration is to invest in projects with a low risk of default. According to the statistics, the vast majority of missed payments were for projects in the housing and healthcare sector. Combined these sectors accounted for 73% of all muni defaults. Since the issuers with the most stability are in water and sewer, special districts, and county projects, an investment may fair better here.
Is a municipal bond right for you?
There is a lot to think about when deciding if a muni is right for you. You have to take into account your tax situation and the fees involved. Beyond that, you should look at economic trends and if the fund has an AMT. See some essential considerations below:
Your income . Due to the tax-free nature of munis, issuers can attract buyers with a lower yield. Getting a smaller return in exchange for not paying taxes on earnings is most beneficial for high-income investors. Therefore, your tax bracket should impact your decision to buy. If you are in a lower tax bracket, it can make more sense to invest in a taxable bond with higher returns.
Your state taxes . All munis are exempt from federal taxes. Your earnings can also be shielded from state taxes if the bond is issued in your state. As a result, you should pay close attention to which municipality is issuing the bond. If you live in Florida and invest in California, you won’t receive any state or local tax breaks. That said, if you live in a state where taxes are low and are in a lower tax bracket, you might do better investing in a fully taxable fund.
The fund maturity . Munis, like other debt investments, move in the opposite direction of interest rates. As interest rates increase, the price of a municipal bond will fall. If you are uncertain about the future, you should consider the bond maturity. A fund with bonds that will mature in many years could be more vulnerable to interest rate changes. However, bonds with a shorter duration can subject you to capital gains taxes if you are not cautious.
The fees . The expense ratio of a muni should be a driving factor in your decision to purchase. Since munis have low yields, substantial fees can take up a significant portion of your earnings. It’s best to look for no-load funds and avoid broker commissions. Typically, the best municipal bonds have an expense ratio of less than 1%.
Alternative Minimum Tax (AMT) . Many municipal bonds can have an alternative minimum tax. If a bond is subject to AMT, it will offer higher yields then a non-AMT bond. The amount of AMT depends on your tax filing status and earnings. The AMT can also block many standard breaks and deductions you might usually claim. However, there are still many bonds available that avoid such liability.
While tax-free income sounds like a great idea, you should always read the fine print. A great way to see if a municipal bond is right for you is to calculate your tax equivalent yield. This TEY comparison can show you what type of taxable investment will provide similar returns to a municipal bond. That way you can consider all your investment options equally.
Using the calculator
The calculator is very simple to use. It is designed to work out your tax equivalent yield between municipal bonds and similar taxable bonds. The system is already programmed with the TEY formula. To get an accurate result, you just need to provide your primary bond and tax details. Let’s review this together.
Step 1 . On the first line of the calculator, add the annual yield of your municipal bond fund. You can use the arrow feature or your keyboard to make this input easier.
Step 2 . You can include your estimated taxable income on the second line of the calculator. This figure is your total income after exemptions, deductions, and adjustments. We use this, along with your filing status, to figure out your tax bracket.
Step 3 . On line three you should add your state income tax rate.
Step 4 . Finally, select your federal tax filing status from the multiple-choice selection.
Interpreting your results
Once your information has been added, you can view your results. Beside the inputs, you can see a smart prompt of your marginal tax rate. If this seems incorrect, please review the information you submitted.
Below the inputs, you can view your tax-equivalent yields. You can consider the bond implication if it were double tax-free investment in red, versus a federally exempt investment in blue. The fully taxable investment can be contrasted in green. The idea is that all three will provide the equivalent benefit based on how they would be taxed. A bond that may be worth 6% taxed could be more like receiving a 9% yield if it is double tax exempt.
As your income increases, there becomes a greater discrepancy between taxable and tax-exempt yields. This proves that high earners can benefit more from tax-exempt investments because of their tax consequences. However, your decision to buy into a municipal bond fund could go beyond the return.
If you found this page useful, you can promote us on social media by using the share feature. Remember to bookmark this calculator and save it to the home screen of your smartphone. You should return as you get other investment options or your income changes.