How this calculator works
Interest on a municipal or other tax-exempt bond is not taxed at the federal or provincial level, so a lower quoted yield can leave more after tax than a higher taxable yield. The taxable equivalent yield converts the tax-free yield into the taxable yield that would leave the same after-tax amount: divide by one minus the marginal tax rate. The reverse conversion multiplies a taxable yield by one minus the rate. Only the income tax that actually applies to the interest belongs in the rate. Because tax-exempt interest can affect other benefits and thresholds, the marginal rate may be higher than the headline bracket.
Formula
Taxable equivalent yield = tax-free yield / (1 - marginal tax rate). Tax-free equivalent yield = taxable yield x (1 - marginal tax rate).
Worked example
A tax-free yield of 3.2% with a 30% marginal rate is equivalent to a taxable yield of 3.2% / 0.70 = 4.5714%. Going the other way, a 4.8% taxable yield is worth 4.8% x 0.70 = 3.36% after tax, so the 3.2% tax-free bond is slightly behind it.
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Frequently asked questions
Which marginal tax rate should I use?
Use the combined federal, provincial or state and local rate that applies to the next dollar of interest income. If the bond is exempt only at one level of government, include only the taxes it avoids.
Does this account for capital gains?
No. It compares interest income only. Price changes, premium amortisation and the tax treatment of capital gains are separate and can change the ranking of two bonds.
Why can tax-exempt bonds still be a bad deal?
In a low tax bracket the tax saving may not compensate for the lower yield. The break-even marginal rate is the point where the taxable equivalent equals the taxable alternative.
Should fees be included?
This is a before-fee comparison. If the two bonds have different management or transaction costs, subtract them from the yields before comparing.