How to Calculate After Tax Yield

How to Calculate After Tax Yield
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The return on many investments, such as certificates of deposit (CDs) and bonds is often called yield. Basically the yield is just the annual percentage return you get on the money invested, and calculating yield is pretty straightforward. However, sometimes you need to know the after-tax yield. That would be the case if you were trying to compare the yields of corporate bonds or CDs to the yield of a tax-free municipal bond. The municipal bond probably has a lower yield but may be the better investment, depending on your tax bracket.

Find your maximum tax rate. Your tax rate depends on your income and the tax laws in your state. Your maximum tax rate is the total tax on the last dollar you earn and is the rate that will be used for any change in your income. Start by finding the top federal income tax bracket you are in. You can get this information from your previous year’s tax return. If you need to estimate the top tax rate for the current year, see the tax tables in IRS Publication 15 (see Resources).

Add the tax rates for other taxes (such as state income tax) to your federal tax rate. The total will be your maximum overall tax rate. For purposes of figuring after-tax yields, don’t include any taxes (like Social Security or Medicare) that you will pay even on tax-exempt earnings because this won't affect the comparative tax yields.

Find the pretax yield of the security. For some securities such as CDs, this is just the annual compounded interest rate. For bonds, it’s a little more complicated, because the yield depends on the price you pay for the bond, which varies according to the market. To find the yield on a bond, divide the coupon rate (the fixed sum of money the bond pays each year) by the price (expressed as a percentage).

Multiply the pretax yield by your maximum tax rate. This gives you the proportion of the pretax yield that will go to taxes. Subtract this from the pretax yield. The result is the after-tax yield. For example, if the yield on a bond is 8 percent and your maximum tax rate is 37.5 percent, multiply 8 times 37.5 percent, giving 3 percent. Subtract 3 percent from 8 percent, resulting in an after-tax yield of 5 percent.

Tips

  • Calculating yields can get complicated, so it’s usually easier to use a yield calculator (see Resources).