When evaluating taxable fund returns vs. tax-free fund returns, you have to compare the numbers on common ground. The tax-equivalent yield formula can help you decide if a tax-free money fund will give you a better yield than a taxable fund. The formula states the tax-free yield in terms of what you’d need to earn on a taxable fund to have the same return after taxes. The tax-equivalent yield will be higher for investors in the higher tax brackets.
Tax-equivalent yield = Tax-free yield / (1 – your federal tax bracket)
Suppose the yield on a taxable fund is 1.50 percent, while the yield on a tax-free fund is 1 percent. Your federal tax bracket is 28 percent (1 – 0.28 = 0.72).
1 / 0.72 = 1.38
Tax-equivalent yield is 1.38 percent; the taxable fund, at 1.50 percent, would be the better deal.
If the spread between the two funds were smaller, the situation changes. Say the tax-free yield is 1.25 percent.
1.25 / 0.72 = 1.74
The tax-equivalent yield of the tax-free fund is 1.74 percent, nearly a quarter-percentage point higher than the taxable fund’s yield of 1.50 percent. In other words, a taxable fund would have to yield 1.74 percent just to equal the return of the tax-free fund yielding 1.25 percent.