Municipal Bonds

• Municipal bonds are issued by state and local governments to fund government operations and projects. Investors who buy municipal bonds earn interest that is exempt from federal income tax. If an investor buys bonds from her own state, the interest will also be exempt from state income tax. Double tax exempt bonds are common in high income tax states like California, New Jersey, New York, Oregon and Iowa.
  
  

Tax Brackets

• The tax equivalent yield is based on an investor's tax circumstances. Each investor will be in a certain marginal tax bracket based on his annual income and tax filing status. An investor considering municipal bonds will typically be in one of the four highest tax brackets at 25, 28, 33 or 35 percent. State tax rates may also be divided into brackets or may be a flat rate for all taxpayers in the state. State income tax rates can be as high as 11 percent.
  
  

Calculating Equivalent Yield

• Calculate the tax equivalent yield of a municipal bond investment by dividing the yield of the tax-free bond or fund by 1 minus the investor's marginal tax rate. Consider a municipal bond mutual fund with a 4 percent tax-free dividend yield. If an investor is in the 28 percent federal tax bracket, 1 minus the tax bracket is 1 minus 0.28 or 0.72. Dividing 4 by 0.72 gives a tax equivalent yield of 5.56 percent.
  
  

Tax Equivalent Considerations

• For double tax exempt investments, the state tax rate is added to the federal rate to calculate the equivalent yield. If the investor is buying a municipal bond from his own state and has a state tax rate of 8 percent, his marginal tax bracket is 36 percent, and the tax equivalent yield for a 4 percent investment would be 4 divided by 0.64, giving an equivalent yield of 6.25 percent. A taxable investment would have to pay a higher yield than this calculated rate to be a better investment than the municipal bond investment.