Tax-Equivalent Yield Formula Explained
Tax-equivalent yield (TEY) converts a tax-free municipal bond yield into the taxable yield you would need to earn the same after-tax income. The formula: TEY = Municipal Yield ÷ (1 − Marginal Tax Rate). If you hold a 3.5% muni bond and your combined federal-plus-state marginal rate is 35.22%, the math is 3.5% ÷ (1 − 0.3522) = 5.40%.
That 5.40% is the hurdle rate. Any taxable bond, CD, or savings account must yield more than 5.40% before taxes to put more money in your pocket than the 3.5% muni. The higher your marginal rate, the higher the hurdle—and the more attractive munis become. At the top 37% federal bracket with a 5% state rate, the TEY of a 3.5% muni jumps to 5.83%.
When Municipal Bonds Make Sense by Tax Bracket
Municipal bonds are not equally valuable to every investor. The tax advantage scales directly with your marginal rate. Below is the tax-equivalent yield for a 3.5% muni bond at each federal bracket, assuming no state tax.
| Federal Bracket | Tax-Equiv Yield | Income on $100K | Verdict |
|---|---|---|---|
| 10% | 3.89% | $3,500 | Skip munis |
| 12% | 3.98% | $3,500 | Skip munis |
| 22% | 4.49% | $3,500 | Maybe |
| 24% | 4.61% | $3,500 | Competitive |
| 32% | 5.15% | $3,500 | Strong buy |
| 35% | 5.38% | $3,500 | Strong buy |
| 37% | 5.56% | $3,500 | Strong buy |
Based on a 3.5% AAA-rated municipal bond yield with no state tax. Actual yields vary by credit rating, maturity, and market conditions.
State Tax Considerations
If you buy municipal bonds issued by your home state, the interest is typically exempt from both federal and state income tax. This double exemption significantly boosts the effective tax-equivalent yield. A California resident in the 32% federal bracket with a 9.3% state rate buying California munis has a combined marginal rate of roughly 38.3%—pushing the TEY of a 3.5% muni to 5.67%.
Not all states tax muni interest the same way. Seven states have no income tax at all (Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming), so the state exemption is irrelevant there. Illinois, Iowa, Kansas, and Wisconsin exempt interest on all munis, not just in-state bonds. New York and California only exempt interest from bonds issued within their borders. Always check your state's rules before assuming double tax exemption.
For high-tax states like New York (combined rate up to 12.7% for NYC residents) or California (up to 13.3%), the state exemption alone can add 1.5–2.5% to the tax-equivalent yield. That often makes munis the clear winner over corporate bonds, CDs, and even some dividend stocks.
Municipal Bonds vs. Other Fixed-Income Investments
Corporate bonds typically yield 1–2% more than munis of the same maturity and credit quality. But that spread disappears once you account for taxes. A 5% corporate bond in the 32% bracket nets only 3.40% after tax—below the 3.5% muni. Treasury bonds are exempt from state tax but not federal, so they sit between munis and corporates in after-tax yield for high-bracket investors.
High-yield savings accounts and CDs are fully taxable at your ordinary income rate. A 4.5% HYSA in the 32% bracket nets 3.06% after tax. That 3.5% muni beats it by 0.44% annually—$440 per $100,000 invested—with no state tax to worry about if you buy in-state bonds. Munis also carry lower default risk than corporate bonds, especially general obligation bonds backed by a municipality's taxing power.
The tradeoff: munis are less liquid than savings accounts, have interest rate risk if sold before maturity, and require larger minimum investments (typically $5,000). For investors in the 22% bracket or below, taxable alternatives usually win. For 32% and above, munis deserve a serious look.
To see how your full income is taxed across all seven federal brackets, use the income tax calculator. If you're evaluating investment gains alongside muni income, try the capital gains calculator.