SIE Ready🏙️ Municipal Securities · Lesson 2 of 5 · 6 min
Tax-Free Interest and the Tax-Equivalent Yield
🧮 Is a 3.5% muni better than a 5% corporate bond? For some investors, yes. One division tells you which.
💡 Key idea
TEY = muni yield ÷ (1 − bracket). Interest is federally exempt; capital gains are not.
🧠 Why it matters
Interest on most munis is EXEMPT from federal income tax. It is usually also exempt from state tax when you live in the ISSUING state (in-state advantage); out-of-state munis are generally taxed by your state. TAX-EQUIVALENT YIELD (TEY) = muni yield ÷ (1 − tax bracket). Mnemonic: divide by what you keep. A 3.5% muni for an investor in a 30% bracket: 3.5 ÷ 0.70 = 5.0%. The higher the bracket, the more the exemption is worth. Not everything is tax-free: CAPITAL GAINS on selling a muni are taxable, and market discount above a small DE MINIMIS amount is taxed as ordinary income. Interest on most PRIVATE ACTIVITY BONDS (financing private projects) is a preference item for the individual ALTERNATIVE MINIMUM TAX (AMT).
📈 In the real world
📊 Mr. Abebe, in a 40% combined bracket, compares a 3.0% in-state muni with a 4.5% corporate bond. His rep runs it: 3.0 ÷ 0.60 = 5.0%, so the muni's after-tax value is like a 5.0% taxable yield. The rep also notes that if Mr. Abebe later sells the muni at a gain, that gain is taxed.
📌 Takeaways
- Muni interest: federal-exempt; state-exempt usually only in the issuing state
- TEY = muni yield ÷ (1 − tax bracket): divide by what you keep
- Capital gains are taxable; private activity bond interest can trigger AMT
📖 Terms in this lesson
Tax-equivalent yield: The taxable yield matching a muni's tax-free yield: municipal yield divided by (1 minus the investor's tax rate).
Private activity bond: A municipal bond that mainly benefits a private user; interest on many of them counts toward the alternative minimum tax.
✅ Test yourself
An investor in the 20% bracket buys a muni yielding 4.0%. What is the tax-equivalent yield?
- 6.0%
- 3.2%
- 5.0%
- 4.8%
Answer: C · 5.0%
TEY = 4.0 ÷ (1 − 0.20) = 4.0 ÷ 0.80 = 5.0%. Multiplying instead (4.0 × 0.80 = 3.2%) gives the after-tax yield of a taxable bond, the reverse calculation. 4.8% adds 20% of the yield; 6.0% uses the wrong bracket.
Which part of a municipal bond investment is generally subject to federal income tax?
- Interest on a revenue bond for a city airport
- Interest from a GO bond of the investor's own state
- Interest from a bond issued by a U.S. city
- A capital gain when the bond is sold above cost
Answer: D · A capital gain when the bond is sold above cost
The federal exemption covers interest, not gains. Selling a muni above its cost basis creates a taxable capital gain. Interest on ordinary GO and governmental revenue bonds is generally federally exempt.
Interest on which type of municipal bond may be a preference item for the individual alternative minimum tax?
- A city water revenue bond
- A private activity bond
- A general obligation bond
- A tax anticipation note
Answer: B · A private activity bond
Interest on most private activity bonds, which finance projects that benefit private users, is an AMT preference item even though it is exempt from regular federal tax. GO bonds, TANs and governmental revenue bonds such as a city water system's are issued for public purposes and are not.
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