Tax-Exempt Security

Definition

Tax-Exempt Security refers to a financial obligation whose interest income is exempt from federal, state, and/or local taxation. These securities are typically issued by governmental entities, including state governments, counties, and other political subdivisions. They are also referred to as Municipal Bonds. Despite this common term, issuers can be broader than just cities or towns.

Examples

Municipal Bonds: A bond issued by a local government to finance public projects such as roads, schools, and water systems. The interest from these bonds is typically exempt from federal income tax and, in many cases, state and local taxes as well.
State-Issued Bonds: Bonds issued by state-level entities where the interest is federally tax-exempt. Some states may also exempt these from state income tax for residents.
School District Bonds: These bonds are issued by school districts to finance educational facilities and infrastructure. They often carry tax-exempt interest for public-spirited enterprises.

Frequently Asked Questions

What is a municipal bond?

A municipal bond is a type of tax-exempt security issued by local or state governments to finance public works or other projects. The interest earned on these bonds is typically exempt from federal income tax.

Are municipal bonds completely tax-exempt?

While municipal bonds are usually exempt from federal income tax, they may also be exempt from state and local taxes if the investor resides in the issuing state. However, capital gains from selling a municipal bond are subject to taxation.

How do municipal bonds benefit investors?

Municipal bonds offer tax advantages, providing tax-free interest income, which can be particularly attractive for investors in higher tax brackets. They also contribute to conservative income strategies.

Can non-residents purchase tax-exempt securities?

Yes, non-residents can purchase tax-exempt securities, but they generally won’t receive state tax exemptions unless the issuer’s state extends such benefits to out-of-state investors.

Are there any risks associated with tax-exempt securities?

Tax-exempt securities are subject to credit risk, interest rate risk, and liquidity risk. Additionally, changes in tax laws could affect their tax-exempt status.

What is the difference between a general obligation bond and a revenue bond?

A general obligation bond is backed by the full faith and credit of the issuing government entity, whereas a revenue bond is secured by the specific revenue generated by the project it finances.

How do tax-exempt securities affect tax planning?

They play a significant role in tax planning by allowing investors to receive interest income without incurring additional tax liabilities, thus optimizing their overall tax strategy.

Is interest from tax-exempt securities reportable on tax returns?

Even though the interest is tax-exempt, it must still be reported on federal tax returns, primarily for informational purposes.

Do tax-exempt securities offer higher yields than taxable bonds?

Typically, tax-exempt securities offer lower yields than taxable bonds. However, the tax savings can make their effective yield higher for investors in high tax brackets.

Can tax-exempt securities be part of a retirement portfolio?

Yes, they can be included in retirement portfolios as part of a diversified fixed-income strategy, especially for conservative income-focused retirement planning.

Municipal Bond: A debt security issued by a city or local government offering tax-exempt interest.
Credit Risk: The risk that an issuer of a bond may default and fail to repay the principal and interest.
General Obligation Bond: A municipal bond backed by the issuer’s full faith and credit, often including the power to tax residents.
Revenue Bond: A municipal bond secured by specified revenue sources, such as tolls or utilities.
Tax-Equivalent Yield: The pretax yield a taxable bond needs to provide to match the after-tax yield of a tax-exempt bond.

Online Resources

Suggested Books

“The Handbook of Municipal Bonds” by Sylvan G. Feldstein and Frank J. Fabozzi
“Municipal Bond Market: The Advisor’s Guide” by Peter Schurtz
“Investing in Municipal Bonds: How to Balance Risk and Reward for Success in Today’s Bond Market” by Philip Fischer

Fundamentals of Tax-Exempt Security: Finance Basics Quiz

### What is the primary benefit of investing in a tax-exempt security? - [x] Interests earned are exempt from federal income tax. - [ ] Higher yields compared to other securities. - [ ] Guaranteed returns. - [ ] Exempt from all forms of risk. > **Explanation:** The primary benefit of tax-exempt securities is that the interest earned is exempt from federal income tax, providing tax savings for investors. ### Where are most tax-exempt securities typically issued from? - [ ] Federal government - [x] State and local governments - [ ] Private corporations - [ ] Non-profit organizations > **Explanation:** Tax-exempt securities are typically issued by state and local governments to fund public projects. ### Can tax-exempt securities also be free from state taxes? - [x] Yes, if the investor resides in the issuing state. - [ ] No, they are only free from federal taxes. - [ ] Depending on federal laws. - [ ] Only when specific conditions are met. > **Explanation:** Tax-exempt securities can also be free from state taxes if the investor resides in the issuing state. ### What type of bond is typically backed by the full faith and credit of the issuing government entity? - [x] General Obligation Bond - [ ] Revenue Bond - [ ] Corporate Bond - [ ] Treasury Bond > **Explanation:** A general obligation bond is backed by the full faith and credit of the issuing government entity. ### What additional form of financial risk do revenue bonds hold compared to general obligation bonds? - [x] Revenue-specific risk - [ ] Exempt from financial risk considerations - [ ] Guaranteed returns by federal entities - [ ] Risk-free due to government backing > **Explanation:** Revenue bonds hold revenue-specific risks as they are secured by the revenue generated from a specific project. ### What is the term for the yields required on a taxable bond to match the after-tax yield of a tax-exempt bond? - [ ] Revenue Yield - [x] Tax-Equivalent Yield - [ ] Federal Yield Benefit - [ ] Fixed Yield Calculation > **Explanation:** Tax-Equivalent Yield is the pretax yield that a taxable bond needs to offer to match the after-tax yield of a tax-exempt bond. ### How should interest from tax-exempt securities be reported on tax returns? - [ ] Only for taxable income calculations - [x] For informational purposes - [ ] It should not be reported at all - [ ] Exclusively during audits > **Explanation:** Interest from tax-exempt securities must be reported on federal tax returns primarily for informational purposes. ### In what tax bracket are tax-exempt securities particularly attractive? - [ ] Low tax brackets - [ ] Any tax bracket - [ ] Irrelevant of tax bracket - [x] High tax brackets > **Explanation:** Tax-exempt securities are particularly attractive for investors in high tax brackets as the tax savings can significantly enhance effective yield. ### Are capital gains from selling a tax-exempt security subject to taxation? - [x] Yes - [ ] No - [ ] It depends on the original issue of the security. - [ ] Only for state taxes. > **Explanation:** The capital gains earned from selling a tax-exempt security are subject to taxation. ### Who benefits most from including tax-exempt securities in their investment portfolio? - [ ] Young investors looking for growth. - [ ] Investors with no tax concerns. - [x] Investors seeking conservative income strategies and tax savings. - [ ] Individuals with low annual incomes seeking equities. > **Explanation:** Tax-exempt securities benefit those seeking conservative income strategies and tax savings, often appealing to investors in higher tax brackets.

Thank you for learning about Tax-Exempt Security. This resource should provide you with a solid foundation for integrating these securities into your financial strategy, as well as handling them effectively within your fiscal planning.