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Tax Equivalent Yield
Sometimes comparing bonds is like comparing apples and oranges—especially when you're dealing with bonds that have different tax breaks. When that's the case, you can compare them by calculating the tax equivalent yield. Here's the equation:
(Muni bond yield) / (1 – tax rate).
You have a choice between buying a corporate bond and a muni bond. The muni bond pays 5%, but the income is tax-free, while the corporate bond pays 10%, but is fully taxed. You are in the 30% tax bracket. Which bond should you buy?
Answer: The bond that puts the most dollars in your pocket on an after-tax basis. The tax-equivalent yield for the 5% muni bond is 7.14%. In other words, you should be indifferent to buying a 5% muni bond or a 7.14% corporate bond if your tax rate is 30% because you'll have the same amount of money after tax.
With our example, the 10% corporate bond is the way to go.