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.
Michael,
The fund probably purchases only tax-exempt securities.
Jim: Thanks for clarifying the tax treament. I’ve been swamped all day and didn’t see this until just now.
Robert, You don’t have to itemize to see savings for tax exempt interest. When you report your interest gains you report them on lines 8a for taxable interest or 8b for tax exempt interest. The value in 8b from tax exempt interest is not added to the gross income so its not considered taxable income.
I think you’re probably thinking of the deduction from home mortgages. Interest on homes is a deduction that you have to itemize to see a benefit from. So for that you DO have to itemize to see a tax benefit from it.
Jim
Tax-free yields soard due to flight to quality – yes even munis were hit. These yields should come back in line, maybe with Prime and maybe a little above. There are definitely new risks in munis – not widescale bankruptcy, but tighter and less borrowing – given fewer tax revenues and budget cuts among major issuers. Think CA, NY, NJ and MA.
Haven’t you forgotten a large piece of the puzzle with your yield formula? The only way tax exempt products yield any savings is if the person itemizes their deductions. Otherwise, their ‘savings’ will be useless. Now, 3.94 is great in its own right. Just wanting to clarify in case readers get excited about something that doesn’t apply to them.
Good explanation – you could write textbooks!
So, how does Vanguard get their products to be tax-exempt? I always thought that was a special privilege enjoyed by state and local government via “muni bonds”.