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What Does Tax-Exempt Mean?

What Does Tax-Exempt Mean?


Tax-exempt debt is a special type of security issued by states, cities, communities, political subdivisions, agencies and authorities, and non-profit organizations (collectively known as public issuers), where interest payments received by the investor may be exempt from federal, state, and local income taxes. 

Public Issuers are allowed to issue tax-exempt securities with the most common being municipal bonds. If the securities meet certain criteria set by the Treasury, including how the bond proceeds are to be used, interest received by investors is federally tax-free.

Additionally, investors that live in the same state as the issuing organization may have their interest earnings exempt from state income taxes, which would make the earnings double tax-exempt. And, if those investors live in the same city or community as the issuing organization, their interest earnings may also be exempt from local income taxes, making the bonds triple tax-exempt.

Debt issued by Puerto Rico, Guam, Northern Mariana Islands, American Samoa, and the Virgin Islands are triple tax-exempt for all US investors. 

However, some interest from tax-exempt debt is subject to the alternative minimum tax (AMT). This includes private-activity bonds that raise funds not used solely for government functions, such as sports stadiums. The AMT recalculates an individual’s income tax after adding back certain tax-free income items, such as interest from private-activity bonds. 

The advantage of tax-exempt debt to investors is that they receive a greater after tax return than they would with a taxable security. For example, a 4.00% yielding tax-exempt bond is approximately equal to a 6.15% yielding taxable security if the investor is in the 35% tax bracket.


What’s important here?

Tax-exempt debt allows investors to collect interest payments free from federal income taxes. Double tax-exempt debt is free from federal and state taxes, while triple tax-exemption includes federal, state, and local taxes. However, some tax-exempt debt issued by state and local governments used for private projects is subject to the alternative minimum tax.