What Is a 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.
How a Tax-Exempt Security Works
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.
Key Takeaways
- In a tax-exempt security, income is produced free from any tax burden.
- Municipal bonds, which represent obligations of a state, territory or municipality, are a typical example of a tax-exempt security.
- Tax-exempt securities are more valuable and beneficial the more tax a person must pay.
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:
= 0.03/0.78
= 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.
Most of the time, an organization has to be registered under section 501(c)(3) of the Internal Revenue Code (IRC) before it can issue tax-exempt securities.
FAQs
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.
How do you answer if you are tax-exempt? ›
To claim exempt, write EXEMPT under line 4c. You may claim EXEMPT from withholding if: o Last year you had a right to a full refund of All federal tax income and o This year you expect a full refund of ALL federal income tax. NOTE: if you claim EXEMPT you must complete a new W-4 annually in February.
How do you explain tax-exempt? ›
A tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax.
How to calculate a tax-exempt interest rate? ›
Tax-equivalent yield is determined by taking the yield of a tax-exempt bond and dividing it by one minus an investor's federal income tax bracket. Here's how to figure it: tax-free rate/1 - federal tax bracket = taxable-equivalent yield. (Note: The following example does not include the impact of state income taxes.)
What is an example of a tax-exempt benefit? ›
Certain types of income, such as portions of retirement income and some academic scholarships, are tax exempt, meaning that they are not included as part of a filer's taxable income.
What is an example of an exempt transaction? ›
Transactions with financial institutions, fiduciaries, and insurance underwriters may be considered exempt. Unsolicited orders, which are those executed through a broker at the request of his or her client, are also considered exempt.
What does tax-exempt mean for dummies? ›
What does tax-exempt mean? Being tax-exempt means that some or all of a person's or business's income is free from federal, state or local tax. Tax-exempt organizations are typically charities or religious organizations recognized by the IRS. Internal Revenue Service.
What is the tax-exempt income? ›
Tax-exempt income is income from any source which the Federal, state, or local government does not include when implementing its income tax. Individuals and organizations may have to report this income on a tax return, but the income will not be considered when determining their tax liability.
What is the importance of tax-exempt? ›
Fewer state and federal taxes
The most important benefit of tax-exempt status comes at tax time — your organization pays less in both federal and state taxes. In many cases, you won't need to pay the federal corporate income tax or unemployment tax.
What is the difference between taxable and tax-exempt? ›
Generally, an amount included in your income is taxable unless it is specifically exempted by law. Income that is taxable must be reported on your return and is subject to tax. Income that is nontaxable may have to be shown on your tax return but is not taxable.
Filing for exemption from withholding won't cause you to pay any less in taxes. If you owe taxes but file as exempt, you'll have to pay the full tax bill when you file your taxes next year. Not only that, but the IRS can charge you additional penalties for failing to withhold.
Does tax-exempt interest have to be reported? ›
You must report all taxable and tax-exempt interest on your federal income tax return, even if you don't receive a Form 1099-INT or Form 1099-OID. You must give the payer of interest income your correct taxpayer identification number; otherwise, you may be subject to a penalty and backup withholding.
Are treasury bills tax-exempt? ›
The interest income that you may receive from investing in a treasury bill is exempt from any state or local income taxes, regardless of the state where you file your taxes. However, you will need to report interest income from these investments on your federal tax return.
What is tax-exempt accrued interest? ›
Form 1099-INT - Accrued Interest. If you state that all your tax-exempt interest is accrued tax-exempt interest, you are essentially saying that none of the interest is attributable to you. When you buy a bond between interest payment dates, there is interest that has accrued since the last interest payment date.
What is the difference between exempt and non exempt securities? ›
We'll now discuss exempt transactions, which allow non-exempt securities to be offered without registration in a specific type of transaction. A non-exempt security is one that does not have an exemption based solely upon what it is. Most securities, including the vast majority of stocks, are non-exempt.
How do I know if my Social Security is tax-exempt? ›
You report the taxable portion of your social security benefits on line 6b of Form 1040 or Form 1040-SR. Your benefits may be taxable if the total of (1) one-half of your benefits, plus (2) all of your other income, including tax-exempt interest, is greater than the base amount for your filing status.
How much of Social Security is tax-exempt? ›
Generally, your Social Security benefits are taxed when your income is more than $25,000 per year, including income from investments held in retirement accounts like traditional 401(k)s and IRAs. If Social Security is your only source of income, you likely won't pay any tax on those payments.
