TEY: Taxable Equivalent Yield
Comparing tax-free municipal bonds to other fixed income securities is made more difficult because the yields that are quoted on municipal bonds don’t take into account your particular tax situation. It may be more helpful to use the Taxable Equivalent Yield (TEY) on municipal bonds when comparing rates on similar taxable bonds.
The TEY is the yield which you would have to earn on a taxable bond in order to realize the same amount of “after tax” income as on the tax-free municipal bond.
The taxable equivalent yield will vary depending upon your income tax bracket–the higher the tax rate, the higher the TEY. To calculate the Taxable Equivalent Yield, subtract your income tax rate from 1, and then divide that number into the tax-free yield.
TEY = Tax Free Yield ÷ [1 – (Your Income Tax Rate)]
For example, for a 2.5% tax free yield for an investor in the 35% income tax bracket, tis is what the calculation would look like:
- TEY = 2.50% ÷ (1 – .35)
- TEY = 2.50% ÷ .65
- TEY = 3.84%
This assumes that the municipal bonds are not subject to the Alternative Minimum tax (the AMT), as interest earned on those municipal bonds is taxable when owned by an investor who is subject to the AMT.
State and local taxes may also affect your specific situation.
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