Taxable vs. Tax-Free vs. Tax Exempt

To more fully understand the advantages of tax-favored investing, let's first discuss how to compute taxable versus tax-free versus tax-deferred returns.

Tax-Equivalent Yields

The interest rate that must be received on a taxable investment to provide the investor the same after-tax return as that earned on a tax-exempt investment is called the taxable equivalent yield. Because interest earnings are not subject to federal income taxation, a tax-exempt investment does not have to yield as much as a taxable investment to produce an equivalent after-tax yield. The taxable equivalent yield varies according to the investor's federal income tax bracket (tax-equivalent yields are higher for investors in the higher tax brackets), and any applicable state tax. The formula for determining the taxable equivalent yield is:

Tax-Equivalent Yield = Tax-Free Yield

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(1 - Investor's Federal Tax Bracket)

The formula calculates the tax-free yield in terms of what must be earned on a taxable fund to have the same return-after taxes.

Example: The yield on a taxable investment is 1.5 percent, while the yield on a tax-exempt investment is 1 percent. The investor's federal tax bracket is 28 percent (1 - 0.28 = 0.72). 1 / 0.72 = 1.38

The investor's tax-equivalent yield is 1.38 percent; the taxable investment, at 1.5 percent, would be the better choice.

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