Tax-Equivalent Yield Calculator

Municipal bonds almost always look worse than corporate bonds on the screen. A muni fund quoting 3.6% next to a corporate fund quoting 5% appears to be a straightforward loss of 1.4 points. It usually is not, because the two numbers are not measured on the same basis: one is what you receive, the other is what you receive before tax takes a share.

Tax-equivalent yield restates the tax-free number into the taxable one, so the two become comparable. The mechanism is simple: if a taxable bond keeps only 71% of its yield after tax, a 3.6% tax-free yield is worth 3.6 ÷ 0.71, or about 5.07% of taxable yield. That is the number to put next to the corporate bond, and on that basis the muni is ahead.

The higher your marginal rate, the more the restatement moves. For someone in the 12% bracket a muni rarely makes sense. For someone in the 37% bracket paying state tax and the 3.8% surtax, the same bond can be worth well over 6% of taxable yield.

The textbook formula divides by one minus your federal rate. It is right about a third of the time, and the omissions all run in the same direction.

First, the 3.8% net investment income tax applies to taxable bond interest but not to municipal interest. Anyone above $200,000 single or $250,000 married is comparing against a rate 3.8 points higher than their bracket suggests, and municipal interest is excluded from net investment income entirely.

Second, an out-of-state municipal bond is only exempt federally. Your own state will generally tax the interest from another state's bonds at your full rate, which can erase most of the advantage in a high-tax state. This is the single most common error in muni comparisons.

Third, US Treasuries are exempt from state and local income tax. Comparing a muni to a Treasury is therefore a different calculation from comparing it to a corporate bond, and in a state like California or New York the gap between those two comparisons is substantial.

Yield is not risk. A municipal bond carries credit risk that varies enormously between a general obligation bond from a large state and a revenue bond from a single project, and the tax advantage says nothing about whether you will be repaid.

Nor does it capture liquidity. Individual municipal bonds trade in a fragmented market with wide spreads, and the price you can actually sell at is often well below the quoted valuation. Funds solve the liquidity problem but reintroduce interest rate risk on a portfolio you do not control.

One further wrinkle worth knowing: tax-exempt interest is added back when calculating how much of your Social Security is taxable, and it counts toward the modified AGI used for Medicare IRMAA surcharges. Municipal income is exempt from income tax but it is not invisible to the rest of the system.