What Is Tax Free?
Tax free refers to certain types of goods and financial securities (such as municipal bonds) that are not taxed. It also refers to earnings that are not taxed. The tax free status of these goods, investments, and income may incentivize individuals and business entities to increase spending or investing, resulting in economic stimulus. Tax free may also be known as tax-exempt.
Understanding Tax Free
Tax free purchases and investments do not incur the typical tax consequence of other purchases and investments. For instance, tax free weekends occur in many states where, once or twice a year, store purchases are not taxed, thereby, reducing the overall cost to the consumer. Frequently these sales tax holidays occur before school starts in the Fall to incentivize spending on school supplies, clothes, computers, calculators, etc.
Governments will often provide a tax break to investors purchasing government bonds to ensure that enough funding will be available for expenditure projects. Tax free investments such as tax-exempt municipal bonds (or munis) allow investors to earn interest income tax free. Interest may only be tax free at the federal level if, for example, a California resident buys a New York municipal bond. These tax laws, however, vary by state. For instance, some states such as Wisconsin and Illinois tax interest earned on all muni bonds, including their own, subject to a few exceptions. Meanwhile, states such as California and Arizona exempt interest from taxes only if the investor resides in the issuing state.
For example, assume a local government in California issues a municipal bond to finance a recreational park. An investor, John Smith, who resides in the state of issuance purchases the $5,000 par value bond which matures in two years and has a coupon rate of 3% to be paid annually. At the end of each of the two years, the investor receives interest income of 3% x $5,000 = $150. This income will not be taxed by both the federal and state government. After the bond matures, John Smith will receive his original principal investment back from the local government.
Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming don't have a state-level income tax, so they naturally exempt interest on all muni bonds. Treasury securities issued by the U.S. government, namely the U.S. Savings Bond and Treasury Inflation Protected Securities (TIPSs), pay interest that is tax free at the state and local levels, but not the federal level.
According to the Internal Revenue Service (IRS), interest on a state or local government obligation may be tax free even if the obligation is not a bond. For example, interest on a debt evidenced only by an ordinary written agreement of purchase and sale may be tax free. Also, interest paid by an insurer on default by the state or political subdivision may be exempted from tax. Mutual funds that hold a mix of stocks and municipal bonds will have the portion of earnings derived from the bonds tax-exempt under federal income tax guidelines and possibly free from state taxes depending on the location from which the bonds originated and/or the taxpayer's state of residence.
Since tax free interest is not subject to income taxes, it is not included in the calculation of adjusted gross income (AGI) for taxation purposes. Issuers or lenders that pay more than $10 in tax free interest must report the interest income to both taxpayers and the IRS on Form 1099-INT. Taxpayers or borrowers, in turn, must report this tax-exempt interest on Form 1040. The amount received as tax-exempt interest is used by the IRS to determine what amount of the taxpayer's Social Security benefits are taxable.
Tax Free and the Tax-Equivalent Yield
The higher an investor’s marginal tax bracket, the more valuable and beneficial tax free securities are for the investor. A tax free investment will carry a 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 calculated as:
Tax-Equivalent Yield = Tax-Exempt Yield/(1 – Marginal Tax Rate)
For example, if John Smith in the example 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—this shows how tax free securities are best suited to those in higher tax brackets.