So I was poking around in my Fidelity account, and looking at a muni index fund (FTABX) which is specifically desirable (for some) because the interest earned is exempt from federal taxes. Fine.
I note the yield on the fund is listed as 3.62% and the “Tax Equivalent Yield” is given as 5.93%
But how can Fidelity put a number on that without knowing the investor’s marginal rate? What am I missing?
Interestingly, every other item in that table provides a definition if you hover over it, but not the tax equivalent yield.
What I find interesting is the naive calculation of 3.62 / 5.93 yields a rate of ~39%. Which is probably derived from the 37% top marginal rate with some compounding thrown in. It is hardly surprising that Fidelity would choose the highest possible marginal rate since that most flatters the benefit of investing in munis.
As well, it is generally accepted that the bond market itself assumes the highest marginal tax rates as munis trade on the secondary market. With the result that anyone in less than the top marginal rate bracket is in effect overpaying for the tax relief they are getting.
I used to struggle with this with my late aged MIL. She had a bunch of assets, but negligble taxable income. But she lurved her the idea of buying munis “to save on income taxes”. I’d explain that she was giving up more interest income than she saved in reduced taxes. I’d show her examples with current bond prices. Did. Not. Sink. In.
In fact a bunch of the secondary market includes considerations about state-level income taxes. Which are most significant in the financially important states of NY & CA. IF one lives in a state with low or no income taxes one is further overpaying for tax relief because you’re competing with CA & NY entities who do get that tax relief and are happy to pay something for it.