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Tax Equivalent Yield
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. Tax-equivalent yield = (Muni bond yield)/(1-tax rate). Doing the math here shows that 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.