Tax-Free Definition

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Tax-Free Definition

What Is Tax Free?

Tax-free commodities and financial securities (such as municipal bonds) are those that are not taxed. It also refers to non-taxable profits. The tax-free status of these commodities, investments, and income may encourage people and businesses to boost their spending or investing, resulting in economic stimulation. Tax-free is another term for tax-exempt.

Understanding Tax Free

Tax-free purchases and investments may not have the same tax implications as conventional purchases and investments. For example, tax-free weekends are held in many states once or twice a year, when retail purchases are not taxed, lowering the total cost to the customer. These sales tax holidays are often held before the start of the school year in order to encourage spending on school supplies, clothing, computers, calculators, and other items.

Governments often provide tax breaks to investors who purchase government bonds in order to guarantee that enough cash is available for spending initiatives. Tax-free investments, such as tax-exempt municipal bonds (or munis), enable investors to receive tax-free interest income. If, for example, a California person purchases a New York municipal bond, the interest may be tax-free at the federal level. These tax regulations, however, differ from state to state. Some states, such as Wisconsin and Illinois, tax interest on all muni bonds, including their own, with a few exceptions. Meanwhile, jurisdictions such as California and Arizona exclude interest from taxation only if the investor lives in the state where the interest is issued.

Assume a California city 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. Both the federal and state governments will not tax this income. The local government will repay John Smith’s initial primary investment when the bond matures.

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Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming do not have a state income tax, hence interest on all muni bonds is automatically free. Treasury securities issued by the United States government, namely the United States Savings Bond and Treasury Inflation Protected Securities (TIPSs), pay tax-free interest at the state and municipal levels but not at the federal level.

Interest on a state or local government obligation may be tax-free, even if the obligation is not a bond, according to the Internal Revenue Service (IRS). For example, interest on a debt proven only by an ordinary written purchase and sale agreement may be tax exempt. In addition, interest paid by an insurer on the failure of a state or political subdivision may be tax-free. Mutual funds that invest in a combination of stocks and municipal bonds will have the share of profits from the bonds tax-free under federal income tax standards and perhaps tax-free under state tax guidelines, depending on where the bonds originated and/or the taxpayer’s place of residency.

Because tax-free interest is not taxable, it is not included in the computation of adjusted gross income (AGI) for tax purposes. Issuers or lenders who pay more than $10 in tax-free interest must declare the interest revenue on Form 1099-INT to both taxpayers and the IRS. In turn, taxpayers or borrowers must declare this tax-free interest on Form 1040. The IRS uses the amount received as tax-exempt interest to calculate how much of the taxpayer’s Social Security payments are taxable.

Tax Free and the Tax-Equivalent Yield

The higher an investor’s marginal tax rate, the more valuable and advantageous tax-free securities are. A tax-free investment will typically have a tax-equivalent return that is 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:

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Tax-Equivalent Yield = Tax-Exempt 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 larger the tax-equivalent yield—this demonstrates how tax-free assets benefit individuals in higher tax brackets.

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