EXAMPLE:

Your client, Arthur, is in the 35 percent marginal income tax bracket. If he is considering a
corporate bond with a yield of 10 percent and a municipal bond with a yield of 7 percent,
which would be more beneficial, assuming they possess the same degree of risk? If we
plug the variables into the formula above, the result is as follows:

Tax-exempt yield ÷ (1 − Marginal income tax bracket) = Taxable equivalent yield
7% ÷ (1 − .35) = Taxable equivalent yield
7% ÷ .65 = 10.77%

The taxable equivalent yield of the municipal bond for Billy is 10.77 percent. If we reverse
the formula, it looks like this:

Taxable equivalent yield x (1 − Marginal income tax bracket) = Tax-exempt yield
10.77% x (1 − .35) = Tax-exempt yield
10.77% x .65 = 7%

What that means is that if Arthur buys a corporate bond that pays 10 percent, or $1,000,
after paying taxes on the $1,000 in the 35 percent marginal income tax bracket ($350),
the net yield on the taxable bond will be 6.5 percent, or $650 ($1,000 − $350 income tax).
Therefore, if all else is equal, the income-tax-free investment that yields a net of 7 percent
is more profitable for Arthur because the taxable corporate bond would have to pay 10.77
percent or more to outperform the municipal bond at the 35 percent marginal income tax
bracket.

Tax-free investments are a powerful retirement planning tool.