How to Calculate Tax Equivalent Yield

Earlier this week, I wrote about Vanguard’s Tax Exempt Money Market Fund (VMSXX). In case you missed it, this fund was paying 4.53% APY, and the earnings are exempt from federal income taxes. I went on to argue that, for people in the 30% tax bracket, this works out to a tax-equivalent yield of 6.47% (things have changed a bit, see below). Over the past couple of days, I’ve gotten a couple of question about what that means, and how to calculate it, so I thought I’d put together a quick article explaining things…

What is tax-equivalent yield?

In short, tax-equivalent yield is the rate that you would have to earn in taxable investment to equal the return that you’re getting in a tax-exempt investment. If you were given the choice between two investments with the same rate of return, but one of them was tax free, you jump on it, right? So how high would the taxable return have to be to change your mind? Tax-equivalent yield allows you to make a fair comparison between taxable and tax-free returns.

How do you calculate tax-equivalent yield?

The equation for calculating tax-equivalent yield is very simple:

Tax Equivalent Yield = Tax-Free Yield / (1 – (% Tax Bracket / 100))

Unfortunately, the yield has dipped a bit on the Tax Exempt Money Market Fund since I first wrote about it. It’s now down to 3.94% which means that, for someone in the 30% federal income tax bracket, the numbers look like this:

3.94% / (1 – 0.30) = 5.63%

The higher your tax bracket, the greater the effect.

Vanguard also has a Treasury Money Market Fund (VMPXX) which is exempt from state income tax brackets. In this case, however, the numbers aren’t nearly attractive, as the APY currently stands at 1.38%. Adjusting this for our state income tax bracket (6%) results in the following:

1.38% / (1 – 0.06) = 1.47%

Finally, we have the Vanguard Prime Money Market Fund (VMMXX), which is fully taxable. In this case, there’s no adjustment for tax breaks, so the yield (2.57%) is the yield. As you can see, even after the drop in yield from earlier this week, the Tax Exempt Money Market Fund is trouncing the other options, and is also light years ahead of the best high yield savings accounts.

Note: The rates listed in this article are based on data from 10/16/2008. While the rates may change, the underlying calculations will remain the same.