# Yield Equivalence Definition

## What is performance equivalence?

The performance equivalence is the interest rate on a taxable security that would generate a return equivalent to the return of a tax exempt securityand vice versa.

### Key points to remember

• Yield equivalence is the rate of interest on a taxable security that would generate a return equivalent to the yield on a tax-exempt security, and vice versa.
• Yield equivalence is important for investors in municipal bonds, who want to know whether the tax savings from their bonds will offset the lower yields compared to taxable securities of similar duration.
• When calculating the return equivalence between tax-exempt investments and taxable investments, investors should be aware of prevailing tax rates.

## Understanding Performance Equivalence

Performance equivalence is important for municipal bond investors, who want to know if the tax savings from their bonds will offset the lower given compared to taxable securities of the same duration. Return equivalence is a comparison often used by investors when trying to determine whether they would get a better return from a tax-exempt investment or not than they would from a taxable alternative.

The performance equivalence can be calculated using the following equations:

﻿



Equivalence of taxable return

=

Tax-exempt return

1

Tax rate

\begin{aligned} &\text{Taxable Yield Equivalence} = \frac { \text{Tax-Exempt Yield} }{ 1 – \text{Tax Rate} } \\ \end{aligned}

Equivalence of taxable return=1Tax rateTax-exempt return﻿﻿﻿

and

﻿



Equivalent tax-exempt return

=

Taxable return

×

(

1

Tax rate

)

\begin{aligned} \text{Tax-Exempt Yield Equivalence} =& \ \text{Taxable Yield} \ \times \\ &( 1 – \text{Tax Rate} ) \\ \end{aligned}

Equivalent tax-exempt return= Taxable return ×(1Tax rate)﻿﻿﻿

To calculate the yield equivalence between tax-exempt securities and taxable securities, start by dividing the bond’s tax-exempt yield by 1 minus the investor’s yield. tax rate. For example, suppose you are considering investing in a 6% tax-exempt municipal bond, but want to know the interest rate on a taxable bond corporate bond should be giving you the same return. If you have a tax rate of 24%, you subtract 0.24 minus one, which gives a total of 0.76. Then you would divide 6, the tax-free return, by 0.76, which equals 7.9.

This calculation tells you that you would need a come back 7.9% on your taxable investment to match the 6% return on the tax-free investment. If, on the other hand, you were in the 35% tax bracket, you would need a 9.2% return on your corporate bond to match the 6% return on your muni investment.

Conversely, if you know your taxable rate of return, you can calculate the equivalent rate on a tax-exempt investment. This is done by multiplying the taxable rate by 1 minus your tax rate. So if your taxable return is 6% and your tax rate is 24%, you need a 4.6% return on a tax-exempt security to match the after-tax return on a taxable title.

## New marginal tax rates

The passage of the Tax Cuts and Jobs Act in late 2017 resulted in a number of changes marginal tax rates and income brackets starting in 2018.﻿﻿﻿﻿ The marginal tax rate is the rate of tax that taxpayers must pay for each additional dollar of Income. As the marginal tax rate increases, taxpayers end up with less money per dollar earned than they had withheld from previously earned dollars.

Tax systems employing marginal tax rates apply different tax rates at different levels of income; as income increases, it is taxed at a higher rate. It is important to note, however, that income is not taxed at one rate but at multiple rates as it moves across the marginal margin. tax rate schedule.

When calculating the return equivalence between tax-exempt and taxable investments, investors should be aware of these new tax rates and incorporate them into their return equivalence equations accordingly.

Income tax brackets 2021

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