What it means
Governments often let their own borrowing costs fall by making the interest on their bonds exempt from federal income tax. Because buyers keep more after tax, they are willing to lend at a lower rate than they would demand from a company, and the issuer saves money on every bond.
Whether tax-exempt interest is worth having depends on your tax bracket. A higher earner gains more from the exemption than a lower earner, so a bond that looks poor on its stated yield can beat a taxable bond once taxes are taken into account.
The usual way to compare the two is the taxable equivalent yield, which converts the exempt rate into the taxable rate you would need to match it. Exempt does not always mean exempt from everything.
Interest may still be taxed by your home state if the bond was issued elsewhere, and some bonds that fund private projects can be caught by the alternative minimum tax (a parallel tax calculation designed to stop high earners paying too little). Rules also change over time, so confirm the current treatment with a tax adviser.
Tax-exempt interest can still affect other calculations. In the US it is normally reported on your tax return even though it is not taxed, and it can be counted when working out how much of your Social Security benefits are taxable.
Lenders and means-tested programmes may also look at it when they assess your income. For businesses and treasurers, the idea matters when parking surplus cash or building an investment portfolio.
A company that pays tax at a high rate may find exempt securities attractive, though many corporate treasurers prefer more liquid taxable instruments for short-term needs. The choice comes down to after-tax return, not headline rate.
In practice
Real-world examples.
Example
A dentist in a high tax bracket has $200,000 to invest for ten years. She compares a municipal bond yielding 3.2% with a corporate bond yielding 4.4% and finds that after tax the municipal bond leaves her better off.
Example
A retired teacher lives on a modest pension and sits in a low bracket. For him a tax-exempt bond adds little because he pays little tax, so he chooses a higher-yielding taxable bond instead.
Example
A software company with spare cash of $5,000,000 asks its finance team to compare exempt and taxable options. The team works out the after-tax return of each and also weighs how quickly the cash can be withdrawn.
Formula
Calculation
Taxable equivalent yield = Tax-exempt yield / (1 - marginal tax rate)
Suppose an investor in a 25% marginal tax bracket is offered a municipal bond paying 3% tax-exempt interest. The taxable equivalent yield is 3% / (1 - 0.25) = 3% / 0.75 = 4%. A fully taxable bond must therefore pay more than 4% before the investor would prefer it. On a $100,000 holding the exempt bond pays $3,000 a year, and a taxable bond paying 4% would pay $4,000, of which 25% or $1,000 goes in tax, leaving the same $3,000.Case study
Seen in the real world.
Harbourline Logistics is an illustrative, fictional freight company with $3,000,000 of cash that it will not need for about two years. Its finance manager, Priya, is torn between a taxable bond paying 4.5% and an exempt bond paying 3.4%.
She applies the company's marginal tax rate of 25% and finds the taxable bond pays 4.5% x (1 - 0.25) = 3.375% after tax. The exempt bond's 3.4% is slightly higher, but the difference is only 0.025 percentage points, about $750 a year on $3,000,000.
Priya decides the tiny gain does not justify the lower liquidity of the exempt bond, and she buys the taxable one. In this fictional story the lesson is that the exemption is only worth chasing when the after-tax gap is large enough to matter.
Watch out
Common mistakes.
- Assuming tax-exempt interest is free of every tax, when state taxes, the alternative minimum tax or reporting rules may still apply.
- Comparing a 3% exempt yield with a 4% taxable yield without adjusting for the investor's tax bracket.
- Buying exempt bonds inside a retirement account that is already tax-sheltered, which wastes the benefit of the lower yield.
Questions
People also ask.
Is tax-exempt interest the same as tax-free income?
Not quite, because exempt interest is often still reported on a return and may count towards other thresholds even though no tax is charged on it.
Who benefits most from tax-exempt interest?
Investors in high marginal tax brackets, since the exemption saves them more per dollar of interest than it saves someone in a low bracket.
Do all government bonds pay tax-exempt interest?
No, the treatment depends on the issuer, the purpose of the bond and the tax rules of the country and state involved.
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