Tax-Exempt Security Definition

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Tax-Exempt Security Definition

What Is a Tax-Exempt Security?

A tax-exempt security is an investment that generates income that is exempt from federal, state, and/or municipal taxes. Municipal bonds, which reflect the liabilities of a state, territory, or municipality, are the most common tax-exempt securities. Interest on US Savings Bonds may be exempt from federal income taxes for certain investors.

How a Tax-Exempt Security Works

Income from tax-exempt securities, such as dividends and interest, is not subject to federal taxation. A tax-exempt security may be exempt from all taxes depending on where the investor resides. An in-state person will often be free from both state and federal taxes on general obligation bonds issued by his or her home state. While municipal bonds are the most frequent example of tax-exempt securities, mutual funds that invest in municipal bonds, U.S. Savings Bonds, or other tax-exempt securities may also qualify. Federal government bonds, such as the US Savings Bond and Treasury Inflation Protected Securities (TIPS), are taxed at the federal level but not at the state or municipal level.

Key Takeaways

  • Income is generated in a tax-exempt security that is tax-free.
  • Municipal bonds are a common example of a tax-exempt asset since they reflect the liabilities of a state, territory, or municipality.
  • The more tax a person has to pay, the more valuable and useful tax-exempt securities become.

Assume a municipal government issues a municipal bond to fund a recreational park. An investor named John Smith, who lives in the state of issue, acquires a $5,000 par value bond with a two-year maturity and a 3% annual coupon rate. The investor gets interest income of 3% x $5,000 = $150 at the conclusion of each of the two years. The federal or state governments will not tax this revenue. The local government will repay John Smith’s initial primary investment when the bond matures.

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State and local governments, as well as non-profit organizations, are encouraged to embark on new projects since the tax-exempt bonds used to fund these projects have low interest rates and hence a cheap cost of borrowing. Because municipal bonds offer low interest rates, investors must consider whether the tax savings are substantial enough to offset the lower return.

The higher an investor’s marginal tax rate, the more valuable and advantageous tax-exempt securities are. A tax-exempt asset will have a tax-equivalent yield that is often greater than the present yield, which is determined by the investor’s tax rate. The taxable interest rate that would be necessary to generate the same after-tax interest rate is referred to as the tax-equivalent yield. A tax-exempt bond’s tax equivalent yield may be computed as follows:

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

For example, if John Smith in the above example is taxed at 35%, the 3% muni yield is comparable to a taxable bond yielding:

= 0.03/(1 – 0.35)

= 0.03 / 0.65

= 0.046, or 4.6%

What if John Smith’s tax rate was 22%? The tax-equivalent yield will be as follows:

= 0.03/0.78

= 0.038, or 3.8%

The greater your tax rate, the greater your tax-equivalent return, demonstrating how tax-exempt assets are better suited to people in higher tax brackets.

Before issuing tax-exempt securities, an organization must usually be registered under section 501(c)(3) of the Internal Revenue Code (IRC).

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