Tax-exempt Security

A tax-exempt security is an investment instrument that produces income free from local, state, and federal taxes. Bonds issues by cities, states, and territories – often called municipal bonds despite their diverse origins – are the most common tax-exempt security. In some instances, interest from U.S. savings bonds may be exempt from federal income taxes, but otherwise, these don’t qualify as a tax-exempt security at the local and state level. The exact degree of tax-exemption provided by a tax-exempt security often depends on where an investor lives; residents of a U.S. state who purchase a tax-exempt security issued by their state will not have to pay state taxes on them, but unless a reciprocity agreement is in place residents of a different state who purchase the security may have to. Some mutual funds are exclusively dedicated to tax-exempt security investments. Like U.S. savings bonds, these funds count as a tax-exempt security at the federal level. However, their status as a tax-exempt security at the state level will depend on the state where an investor lives, the size of the fund’s investment in that state’s bonds, and state-to-state reciprocity laws. Although the yield from a tax-exempt security is lower than a pre-tax yield of a taxable bond with similar risk, the equivalent taxable yield may be higher, especially if an investor is in a high tax bracket, potentially making a tax-exempt security more attractive.

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