DEFINITION of '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.

BREAKING DOWN '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, while 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 2 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.

Indiana and Florida are examples of states that exempt interest on all muni bonds regardless of the issuing jurisdiction. Treasury securities issued by the U.S. government, namely the U.S. Savings Bond and Treasury Inflation Protected Securities (TIPS), 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 or Form 1040A. 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.

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.

RELATED TERMS
  1. Tax-Exempt Interest

    Tax-exempt interest is interest income that is not subject to ...
  2. Tax Exempt

    Tax-exempt is to be free from, or not subject to, taxation by ...
  3. Taxable Municipal Bond

    A taxable municipal bond is a fixed-income security issued by ...
  4. Federal Income Tax

    A federal income tax is levied by the United States Internal ...
  5. Tax Rate

    A tax rate is the percentage at which an individual or corporation ...
  6. Special Tax Bond

    A special tax bond is a type of bond that is repaid with revenues ...
Related Articles
  1. Investing

    Do Municipal Bond Mutual Funds Offer a Tax Incentive?

    Learn about individual municipal securities and municipal bond funds, whose principal stability and tax-free yield appeal to high-income investors.
  2. Investing

    Taxation Rules for Bond Investors

    To sum-up there are three types of bonds: government bonds, municipal bonds, and corporate bonds. Find out how each of these bonds are taxed and what you can do as an investor.
  3. Investing

    How To Choose The Right Bond For You

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  4. Investing

    Foreign Investors Flock to U.S. Municipal Bonds

    Interest in U.S. municipal bonds by foreign investors is on the rise. Here's why.
  5. Investing

    A Look at the Pros and Cons of Muni Bonds

    Considering muni bonds? Here's a look at their pros and cons.
  6. Taxes

    3 Ways To Avoid The Dividend Tax Hike

    Find out how you can offset the potential tax hikes.
  7. Investing

    4 Tax-Free Muni Bond ETFs to Consider

    Tax free municipal bond ETFs are an excellent way to build wealth slowly. Here are 4 you should consider.
  8. Investing

    Trump's Tax Cuts Threaten Pillar of Muni Market

    The $3.8 trillion muni bond market could see plunging demand if Trump implements tax cuts
  9. Investing

    Municipal Bonds Vs. Money Market Funds

    Municipal bonds are a loan from you to a state or local government or authority; money market funds are a type of mutual fund.
RELATED FAQS
  1. What is the difference between a state income tax and a federal income tax?

    Learn the difference between state income tax and federal income tax based on tax rates, deductions, tax credits and taxable ... Read Answer >>
  2. Where can I buy government bonds?

    The type of bond dictates its purchase. Federal bonds are issued by the federal government, while municipal bonds are issued ... Read Answer >>
Hot Definitions
  1. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  2. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  3. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  4. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  5. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
  6. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained in a company’s financial statements.
Trading Center