Why a municipal yield cannot be compared directly with a corporate yield
Interest on most bonds issued by states, cities, counties and their agencies is excluded from gross income for federal purposes under section 103 of the Internal Revenue Code. Interest on a corporate bond is not. So a quoted municipal yield is money you keep, and a quoted corporate yield is money you have to share.
Tax-equivalent yield puts the two on the same footing by asking a single question: what would the taxable bond have to pay so that, after your taxes, it left you with what the muni leaves you? If your combined rate is 40% and the muni yields 3.6%, the taxable bond has to yield 3.6 ÷ 0.60 = 6.0%. Anything less and the muni is the better instrument at your rates.
The phrase at your rates carries the whole argument. The same bond is a good deal for someone in the top bracket in a high-tax state and a poor deal for someone in the 12% bracket in a state with no income tax. Municipal yields are set by a market clearing largely against the demand of high-bracket investors, which is why they look unattractively low to everyone else.
The three taxes that go into the denominator
Getting the combined rate right matters more than any other part of this calculation, because the answer is a division by one minus that rate and the result is convex — a percentage point of tax rate moves the answer much further at 40% than at 15%.
Federal marginal rate. Use the rate on your next dollar of ordinary income, not your effective rate. Bond interest stacks on top of your other ordinary income, so the marginal rate is the correct one. The statutory schedule under section 1 of the Code runs 10, 12, 22, 24, 32, 35 and 37 percent; our marginal versus effective tax rate calculator shows the difference between the two if you are not sure which figure you are holding.
The 3.8% net investment income tax. Section 1411 imposes an additional 3.8% on the lesser of net investment income and the excess of modified adjusted gross income over $200,000 (single) or $250,000 (married filing jointly). Taxable bond interest is net investment income; tax-exempt municipal interest is expressly excluded. That asymmetry is worth several tenths of a point of yield to a high earner and is the most frequently forgotten term in the stack.
State and local income tax. This one has two independent switches. First, most states exempt their own bonds and tax everybody else's, so an out-of-state muni loses part of its exemption. Second, Treasury interest is exempt from state and local income tax under 31 U.S.C. §3124 — so if you are comparing a muni against a Treasury rather than a corporate bond, the state rate drops out of the denominator entirely and the muni's advantage narrows.
A fourth wrinkle applies only if you itemise: state income tax paid can be deducted on the federal return, which lowers the effective state rate to state × (1 − federal). Since the state and local tax deduction is capped, many filers exhaust the cap on property tax alone, so the advanced checkbox that models this defaults to off.
Worked example: a 3.6% in-state muni for a top-bracket investor
You live in a state with a 6% marginal income tax, you are in the 35% federal bracket, your modified AGI puts you above the NIIT threshold, and you are choosing between an in-state general obligation bond yielding 3.60% and a corporate bond yielding 5.20%.
- Build the combined rate on the corporate bond. 35% federal + 3.8% NIIT + 6% state = 44.8%. You are not itemising above the state and local tax cap, so the state rate goes in undeducted.
- Check what the muni loses to state tax. The bond is in-state, so nothing. After-tax municipal yield = 3.600%.
- Divide. TEY = 3.60 ÷ (1 − 0.448) = 3.60 ÷ 0.552 = 6.522%. A taxable bond would have to yield 6.522% to match this muni.
- Compare directly. The corporate bond's after-tax yield is 5.20 × 0.552 = 2.870%, against 3.600% for the muni. The muni wins by 3.600 − 2.870 = 0.730 percentage points, or 73 basis points.
Now change one thing: suppose the bond is issued by another state. Your state taxes the interest, so the muni keeps 3.60 × (1 − 0.06) = 3.384%, the TEY falls to 3.384 ÷ 0.552 = 6.130%, and the advantage narrows to 3.384 − 2.870 = 0.514 points, or 51 basis points. Same bond, same investor, 22 basis points of difference from residency alone.
And change one more: suppose the taxable alternative is a Treasury at 5.20% rather than a corporate. Treasuries escape the 6% state tax, so the rate applied to them is 35 + 3.8 = 38.8%, they keep 5.20 × 0.612 = 3.182%, and the in-state muni's advantage shrinks from 73 basis points to 3.600 − 3.182 = 42 basis points.
How to use the answer
Compare the tax-equivalent yield with the yield actually available on taxable bonds of the same credit quality and the same maturity. That constraint does most of the work. A 10-year AA-rated general obligation bond belongs beside a 10-year AA-rated corporate, not beside a 2-year Treasury and not beside a high-yield fund. Comparing a muni's TEY against a longer or riskier taxable bond is the most common way people talk themselves into a bond they should not own.
The break-even is easy to carry in your head: the muni wins whenever the muni-to-taxable yield ratio exceeds one minus your combined tax rate. At a 44.8% combined rate, a muni yielding more than 55.2% of the comparable taxable yield is the better after-tax buy. Municipal-to-Treasury yield ratios are published daily, so you can make this comparison from a single number with no arithmetic at all.
Three situations make the tax-equivalent yield the wrong tool. In a tax-deferred account — a 401(k), a traditional IRA, a Roth — the exemption is worthless, because nothing inside the account is currently taxable; holding munis there simply gives up yield. If your marginal rate is low, the arithmetic rarely favours munis at prevailing ratios. And if you are buying a muni at a discount in the secondary market, part of your return arrives as accreted market discount, which is taxed as ordinary income — so a discount muni's yield to maturity is not entirely tax free, and the TEY computed from the quoted yield overstates its advantage.
Tax-equivalent yield of a 3.5% in-state municipal bond
| Federal marginal rate | TEY without NIIT | TEY with 3.8% NIIT |
|---|---|---|
| 10% | 3.889% | 4.060% |
| 12% | 3.977% | 4.157% |
| 22% | 4.487% | 4.717% |
| 24% | 4.605% | 4.848% |
| 32% | 5.147% | 5.452% |
| 35% | 5.385% | 5.719% |
| 37% | 5.556% | 5.912% |
Add your state rate to the federal rate before dividing if the comparable bond is fully taxable and you hold an in-state muni. The NIIT applies only above $200,000 modified AGI single or $250,000 married filing jointly.
Tax-exempt is not the same as tax-free
Three things a municipal bond can still be taxed on. Capital gains on a sale are fully taxable, at the same rates as any other bond — the exemption covers interest, not price appreciation, and our capital gains tax calculator handles that side. Private activity bonds pay interest that is a preference item for the alternative minimum tax, so AMT payers can owe federal tax on a bond marketed as tax-exempt; check the official statement for the AMT designation. Social Security recipients include tax-exempt interest in the provisional-income test that determines how much of their benefit is taxable, so muni interest can raise a tax bill without itself being taxed.
Mistakes that make a tax-equivalent yield wrong
- Using your effective rate instead of your marginal rate. Interest stacks on top of your other income, so the correct rate is the one on your next dollar — usually several points higher than your average rate.
- Leaving out the 3.8% NIIT. It applies to the taxable bond and never to the muni, so omitting it understates the muni's advantage for anyone above the modified AGI thresholds.
- Applying the state rate to an out-of-state bond's denominator instead of its numerator. State tax on an out-of-state muni reduces what the muni keeps; it does not change what the taxable bond keeps.
- Comparing against a Treasury without removing state tax. Treasuries are state-exempt, so the correct denominator for a Treasury comparison excludes the state rate entirely.
- Comparing different maturities or credit qualities. A tax-equivalent yield tells you about tax and nothing else. It says nothing about duration risk, call risk or default risk.
- Holding munis in an IRA or 401(k). The exemption has no value inside a tax-deferred account, so you accept a lower yield for nothing.
- Ignoring the market discount rules on a secondary-market bond bought below par. Accreted market discount is taxed as ordinary income at maturity or sale, so the yield to maturity is not entirely exempt.
Where this sits among the other bond calculations
Tax-equivalent yield is a comparison tool, not a pricing tool. It takes a yield you have already computed and restates it in taxable terms. To get the yield in the first place, start from the price: our yield to maturity calculator solves for the discount rate that makes the present value of coupons and principal equal the price, and the current yield calculator gives the simpler income-only measure. For a bond bought away from par, the premium and discount amortisation calculator shows how book value grinds back toward par.
For funds rather than individual bonds, use the SEC 30-day yield as the input here. It is a standardised, net-of-expenses figure computed under a Securities and Exchange Commission formula, and it is the only fund yield designed for exactly this kind of comparison. Distribution yield is not, because it reflects what was recently paid rather than what the portfolio currently earns.
Finally, remember what the calculation is silent on. The tax-equivalent yield assumes your marginal rate stays where it is. If you are two years from retirement and expect your bracket to drop, the muni's advantage shrinks over the holding period even though today's arithmetic favours it. Bond decisions run for a decade; tax brackets rarely hold still that long.