What it means
When a government borrows for roads, schools or water systems, it can issue bonds whose interest is exempt from federal income tax. The saving is shared: the issuer pays a lower rate, and the investor receives income that is not reduced by tax.
There are several types. General obligation bonds are backed by the issuer's power to tax, while revenue bonds are repaid from the income of a specific project such as a toll road.
Some bonds that fund private projects are taxable or fall under the alternative minimum tax (a parallel tax calculation aimed at high earners), so the label on the bond matters. Comparing a tax-exempt security with a taxable one requires an after-tax view.
A 3.5% exempt yield can be worth more than a 5% taxable yield for someone in a high bracket, but less for someone in a low bracket. The break-even depends entirely on the investor's marginal tax rate.
Risk still applies. Municipal issuers can run into financial trouble, interest rates can move against the holder, and thinly traded bonds can be hard to sell at a fair price.
Credit ratings help, but they are opinions and not guarantees. Many people hold these securities through funds or managed accounts, which spread the risk across many issuers.
Fees, however, reduce the yield, so it is worth comparing the fund's after-fee return with the benefit of the exemption. Liquidity and timing are the last things to weigh.
Some tax-exempt bonds can be called, meaning the issuer repays them early, which can leave an investor reinvesting at lower rates. Reading the call terms and the maturity date is therefore as important as reading the yield.
In practice
Real-world examples.
Example
A couple saving for a house in five years buy $150,000 of high-quality municipal bonds. Their income puts them in a high bracket, so the exempt interest leaves them with more spendable cash than an equivalent corporate bond would. They plan to use the money for the deposit, so they choose bonds that mature just before they expect to buy.
Example
A manufacturing firm with excess cash looks at tax-exempt notes. Its treasurer concludes that the company's tax rate is too low for the exemption to beat a taxable money-market fund. It keeps the cash in the taxable fund, where the after-tax return is higher for a company in its position.
Example
A hospital authority issues $40,000,000 of revenue bonds to build a car park. Investors buy the bonds because repayments come from parking fees, and the interest is exempt from federal income tax. The issuer's lawyers and a rating agency review the project before the bonds are sold to the public.
Formula
Calculation
After-tax yield of a taxable security = Taxable yield x (1 - marginal tax rate)
An investor in a 30% bracket compares a tax-exempt bond yielding 3.5% with a taxable bond yielding 5%. The taxable bond's after-tax yield is 5% x (1 - 0.30) = 5% x 0.70 = 3.5%. The two are exactly equal, so the investor is indifferent on return and would choose based on risk, liquidity and state tax. On $200,000 invested, each pays $7,000 a year after tax. This shows why the break-even tax rate is the key number: any investor above 30% would prefer the exempt bond and any investor below it would prefer the taxable one.Case study
Seen in the real world.
Riverbend Wealth Partners is an illustrative, fictional advisory firm. A client, Daniel, asks whether he should move $500,000 from a taxable bond fund yielding 5% into a municipal fund yielding 3.6%.
The adviser calculates Daniel's after-tax return on the taxable fund as 5% x (1 - 0.32) = 3.4%. The municipal fund's 3.6% is higher, so the switch adds 0.2 percentage points, or about $1,000 a year on $500,000.
The adviser also points out the fund charges slightly higher fees and that some of its bonds could trigger the alternative minimum tax. In this fictional example Daniel goes ahead with a smaller switch and keeps part of his money in the taxable fund for easier access.
Watch out
Common mistakes.
- Ignoring the investor's tax bracket and simply picking whichever security shows the higher stated yield.
- Assuming every municipal bond is tax-exempt, when some are taxable and some are subject to the alternative minimum tax.
- Believing tax-exempt securities carry no risk, when issuers can default and prices can fall.
Questions
People also ask.
Are tax-exempt securities always exempt from state tax too?
No, many states tax interest on bonds issued by other states, so residents often prefer bonds from their own state.
Should I hold tax-exempt securities in a retirement account?
Usually not, because a retirement account already shelters the income and you would give up yield for a benefit you cannot use.
How do I compare an exempt and a taxable security?
Convert both to an after-tax yield using your marginal tax rate, then compare the results alongside risk and liquidity.
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