By computing whether the return net of taxes is greater than tax-free versus tax or vice versa. How do you do this? There is a formula for computing the tax equivalent. Take your tax-free return percentage-wise, divide it by one minus your income tax bracket. That will give you the tax equivalent. Let’s assume somebody has a six percent tax-free investment and is in the forty percent tax bracket. Put 6% in the numerator and then (1 - 40) in the denominator (so you have .06/.60). The answer is .10 or 10%. So, the 6% tax free bond would be the equivalent of 10% before taxes (if an investor is in the 40% bracket).
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