What is an Equivalent Taxable Interest Rate?
An equivalent taxable interest rate (also called equivalent taxableinvestment to make it equal to the return on a tax-exempt investment. The equivalent taxable interest rate is commonly used when evaluating municipal bond returns.
How Does an Equivalent Taxable Interest Rate Work?
The formula for equivalent taxable interest rate is:
R(te) = R(tf) / (1 - t)
R(te) = equivalent taxable interest rate for the investor
t = investor's marginal tax rate
For example, let's assume Investor A, who is in a 28% tax bracket, is considering whether to invest in a municipal bond with a 10% coupon rate. Using the formula above, we can calculate that, for this investor, the municipal bond's equivalent taxable interest rate is:
R(te) = 0.10 / (1 - 0.28)
R(te) = 0.1389 = 13.89%
Therefore, a taxable bond would have to return a yield greater than +13.89% to become more profitable to this investor than the municipal bond.
The tax-free advantage of municipal bonds can make a tremendous difference in an investor's yield, especially if the investor is in a high tax bracket. For example, let's assume another investor, Investor B, only has a marginal tax rate of 20% and is considering whether to invest in that same 10% municipal bond. Using the formula above, we can calculate that Investor B's equivalent taxable interest rate for the same bond is:
R(te) = 0.10 / (1 - 0.20)
R(te) = 0.125 = 12.5%
For Investor A, a taxable bond would have to return more than +13.89% to become more favorable than the 10% municipal bond. But Investor B's lower tax bracket means that a taxable bond would only have to return more than +12.5% to become more favorable than the same 10% municipal bond.
Why Does an Equivalent Taxable Interest Rate Matter?
Municipal bonds usually offer lower returns than similar taxable corporate bonds. But how does the investor know if the tax savings from the municipal bond will make up for its lower return? The equivalent taxable interest rate can help investors decide, because it facilitates apples-to-apples comparisons among securities with different tax consequences.
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