What Is a Tax-Exempt Security?

A tax-exempt security is an investment in which the income produced is free from federal, state, and/or local taxes. Most tax-exempt securities come in the form of municipal bonds, which repre🌳sent obligations of a state, territory or municipality. For some investors, U.S. Savings Bond interest may a🔥lso be free from federal income taxes.

How a Tax-Exempt Security Works

Income, such as dividends and interest, on tax-exempt securities does not have federal tax applied to it. Depending on where the investor lives, a tax-exempt security may be free from all taxes. An in-state resident will usually receive a state and federal tax exemption on 澳洲幸运5开奖号码历史查询:general obligation bonds from his or her home state. While municipal bonds are the most common references of tax-exempt securities, mutual funds that invest in municipal bonds, 澳洲幸运5开奖号码历史查询:U.S. Savings Bonds, or other tax-exempt securities can also receive tax-exempt status. Federal government bonds, namely the U.S. Savings Bond and 澳洲幸运5开奖号码历史查询:Treasury Inflati🌳on Protected Securities (TIPS), are taxed at the federal level, but exempt from state and local taxes.

For example, assume a local government issues a municipal bond to finance a recreational park. An investor, John Smith, who resides in the state of issuance purchases the $5,000 澳洲幸运5开奖号码历史查询:par value bond which matures in two years and has a 澳洲幸运5开奖号码历史查询:coupon rate of 3% to be paid annually. At the end ൲of each of the two years, the investor receives interest income of 3% x $5,000 = $150. This income will not be taxed by the federal or state government. After the bond matures, John Smith will receive his original principal investment back from the local government.

State and local governments and non-profit organizations are encouraged to undertake new projects given that tax-exempt bonds, used to finance these projects, carry low interest rates and, hence, low 澳洲幸运5开奖号码历史查询:cost of borrowing. Because municipal bonds have low interest rates, investors must determine whether their tax savings are significant enough to make up for this lower yield.

Tax Exempt and the Tax-Equivalent Yield

The higher an investor’s marginal tax bracket, the more valuable and beneficial tax-exempt securities are for the investor. A tax-exempt security will carry a 澳洲幸运5开奖号码历史查询:tax-equivalent yield that is often higher🍸 than the current yield, as determined by the investor's tax bracket. The tax-equivalent yield is the taxable interest rate that would be required to provide the same after-tax interest rate. The tax equivalent yield of a tax-exempt bond can be calc𓃲ulated as:

Tax-equivalent yield = Tax-exempt yield / (1 – Marginal tax rate)

For example, if John Smith in the exa๊mple above falls in the 35% tax bracket, the 3% muni yield is equivalent to a taxable bond with a yield of:

= 0.03/(1 – 0.35)

= 0.03 / 0.65

= 0.046, or 4.6%

What if John Smith 💟was in the 22% tax bracket? The tax-equivalent yield will be:

= 0.03/0.78

= 0.038, or 3.8%

The higher your tax rate, the higher the tax-equivalent yield – showing how tax-exempt securities are best suited to thos𓂃e in higher tax brackets.

Most of the time, an organization has to be registered under 澳洲幸运5开奖号码历史查询:section 501(c)(3) of the 澳洲幸运5开奖号码历史查询:Internal Revenue Code (IRC) before it can issue tax-exempt securities.

The Bottom Line

Tax-exempt securities may be free from federal, state, or local taxes, depending on the type. Examples include state and local municipal bonds, federal treasury securities, and certain mutual funds and ETFs. While these types of securities typically have lower yields than taxable securities, their low yield may be offset by their tax𒁏 treatment, especially for investors in higher tax brackets.