What Is Tax Free?
Tax-free refers to certain types of goods and financial securities, such as municipal bonds, that are not subject to taxation. It also includes earnings that aren’t taxed. The tax-free status of these products and income sources can incentivize individuals and businesses to increase spending and investing, stimulating economic growth. Tax-free and tax-exempt are often used interchangeably.
The Inspiring Benefits of Tax-Free Investments
Tax-free purchases and investments do not incur the usual tax liabilities associated with other transactions. For example, many states sponsor tax-free weekends where store purchases aren’t taxed, lowering the overall cost to consumers—often in preparation for the school season to boost spending on school supplies, clothing, electronics, and more.
Governments might offer a tax break to investors purchasing government bonds to ensure sufficient funds for public projects. Tax-free investments, like tax-exempt municipal bonds (munis), allow investors to earn interest income free of federal taxation. However, these exemptions can vary by state. For instance, states like Wisconsin and Illinois generally tax interest on all municipal bonds, whereas states like California and Arizona exempt interest only if the investor resides in the state issuing the bond.
A Real-Life Example of Tax-Free Income:
Consider a local government in California issuing a municipal bond to finance a recreational park. John Smith, a California resident, purchases a $5,000 bond with a 3% annual coupon rate, which matures in two years. Each year, John receives $150 in interest, which is not taxed at either the federal or state level. After two years, John gets back his original $5,000 investment from the local government.
Some states, including Alaska, Florida, and Texas, do not have a state-level income tax, so they naturally exempt interest on all municipal bonds. Meanwhile, U.S. Treasury securities like U.S. Savings Bonds and Treasury Inflation Protected Securities (TIPS) pay interest that is tax-free at the state and local levels, though federally taxed.
According to the Internal Revenue Service (IRS), interest on certain state or local government obligations may be tax-free even if not in bond form, such as interest from an ordinary written purchase and sale agreement. Mutual funds holding stocks and municipal bonds also provide tax-exempt earnings depending on federal and state tax laws.
Tax-Free Income and Adjusted Gross Income (AGI)
Tax-free interest is not included in the calculation of adjusted gross income (AGI) for taxation purposes. Lenders or issuers that pay over $10 in tax-free interest must report it to both taxpayers and the IRS via Form 1099-INT. Taxpayers, in turn, must report this interest on Form 1040. This amount is used by the IRS to determine the taxable portion of the taxpayer’s Social Security benefits.
Maximizing Benefits with Tax-Equivalent Yield
The higher the investor’s marginal tax bracket, the more valuable tax-free securities become. These investments carry a tax-equivalent yield that often exceeds the current yield, adjusted for the investor’s tax rate.
The tax-equivalent yield formula is:
Tax-Equivalent Yield = Tax-Exempt Yield / (1 - Marginal Tax Rate)
For example, for John Smith in the 35% tax bracket, the 3% muni yield is equivalent to a taxable bond yield of:
0.03 / (1 - 0.35) = 0.03 / 0.65 = 0.046, or 4.6%
In the 22% tax bracket, the tax-equivalent yield would be:
0.03 / 0.78 = 0.038, or 3.8%
Higher tax rates yield higher tax-equivalent returns, demonstrating that tax-free securities are particularly advantageous for investors in higher tax brackets.
Related Terms: tax-exempt, municipal bonds, adjusted gross income, mutual funds, U.S. Savings Bond.
References
- U.S. Securities and Exchange Commission. “Municipal Bonds”.
- Illinois Department of Revenue. “Publication 101: Income Exempt from Tax”, Page 4.
- State of Wisconsin Department of Revenue. “Individual Income Tax and Municipal Bond Interest”.
- Arizona Department of Revenue. “Identifying Other Taxable Income”.
- Tax Foundation. “State Income Tax Rates for 2021.”
- Internal Revenue Service. “Publication 550, Investment Income and Expenses”, Page 5.
- Internal Revenue Service. “Publication 550, Investment Income and Expenses”, Page 11.
- Internal Revenue Service. “2020 Instructions for Forms 1099-INT and 1099-OID”, Page 1.
- Internal Revenue Service. “Form 1040: U.S. Individual Income Tax Return”, Page 1.
- Internal Revenue Service. “Income – Wages, Interest, Etc.”, Page 8.
