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The equivalent taxable yield is the yield which would need to be returned from an investment with taxable interest in order to be equivalent to an investment with tax-free interest. It is used as a basis for comparison when determining which investments would be the most financially sound. For example, on the surface if one investment yields two percent and the other yields three, the three percent investment sounds like a more sound investment, but if the two percent is tax-free and the three percent investment is not, the investment with the two percent yield may actually be a better deal.
Very few investments are tax free. Municipal bonds are a common example; they are provided tax free to encourage people to invest, as the stated yield is usually not a very big incentive. Depending on the region where one is investing, it is important to note that “tax free” can be misleading. For example, people may be exempt from national taxes, but not from regional ones, with such investments.
Although tax free investments appear to have low yields, sometimes their performance is better than people realize, because they pocket all of the money the investment yields, rather than being forced to hand some over to tax agencies. As a result, when people are looking at investments, they need to determine what the equivalent taxable yield is for a taxable investment to break even with a tax free one.
Only a few numbers are needed to determine the equivalent taxable yield. To calculate this number, it is necessary to know the investor's tax bracket, as the rate at which someone is taxed will impact the equivalent taxable yield. It is also necessary to know the interest being offered on a tax free investment. People can also solve the problem the other way, using the known interest on a taxable investment to find the point at which a tax-free investment would be equivalent. This information can be used to compare available investment options to determine which would be the wisest buy.
The formula to find equivalent taxable yield is relatively simple. It involves dividing the tax free yield by 1, then subtracting the investor's tax bracket. To find, for example, the equivalent taxable yield for an investment in a municipal bond yielding four percent by an investor in the 30% tax bracket, one would divide four by .70, which returns 5.71; a taxable investment would need to return at least 5.71% for it to beat the municipal bond. The higher someone's tax bracket, the higher the equivalent taxable yield for investments will be.
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