DEFINITION of 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 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
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 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, 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 Treasury Inflation 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 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 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 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.
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 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:
= 0.038, or 3.8%
The higher your tax rate, the higher the tax-equivalent yield – showing how tax-exempt securities are best suited to those in higher tax brackets.