DEFINITION of 'Tax-Exempt Security'
A security in which the income produced is free from federal, state and local taxes. Most tax-exempt securities come in the form of municipal bonds, which represent obligations of a state, territory or municipality. For some investors, U.S. savings bond interest may also be free from federal income taxes.
BREAKING DOWN 'Tax-Exempt Security'
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 general obligation bonds from his or her home state.
A tax-exempt security will carry a tax-equivalent yield that is often higher than the current yield, as determined by the investor's tax bracket. The higher the tax bracket, the more beneficial tax-exempt securities can become in a taxable investment account.