Tax-Exempt Income

Tax-exempt income is income that a tax law excludes from the tax base, so the recipient owes no income tax on it even though it is real income. Governments use exemptions to encourage particular behaviour, such as lending to local governments or saving for retirement, or to avoid taxing what has already been taxed. For investors, the best-known example is interest on US municipal bonds, which is generally free of federal income tax.

Tax-exempt is different from tax-deferred. Deferred income, such as growth in a traditional individual retirement account (IRA), is taxed later; exempt income is never taxed under that particular tax. An exemption is also usually partial: income may be exempt from federal tax but not state tax, or the reverse, and it may still count in other calculations such as the alternative minimum tax (AMT).

Picture a toll road where most cars pay at every booth, but some vehicles carry a pass that waves them through certain booths. A city bus might skip the national toll but still pay the local one. Tax-exempt income works the same way: some money passes one or more tax booths without paying, depending on which pass it carries.

Because skipping a toll is valuable, investments with a pass usually pay a lower headline return. The sensible comparison is not the headline number but what you keep after every booth.

US states, cities, school districts and public authorities borrow by issuing municipal bonds. Under Section 103 of the Internal Revenue Code, interest on most of these bonds is excluded from federal gross income. The exclusion has existed since the first modern income tax in 1913, though the Supreme Court ruled in South Carolina v. Baker (1988) that it rests on statute, not the Constitution, so Congress could change it.

State treatment varies. Most states exempt interest on their own bonds for residents but tax interest on other states' bonds, so a "double tax-free" bond is an in-state issue held by an in-state resident. The reverse applies to Treasury securities: their interest is federally taxable but exempt from state and local income tax. Interest on corporate bonds is taxable at both levels.

Three details catch investors. Interest on certain "private activity" bonds is a preference item for the AMT. Any capital gain from selling a municipal bond above its purchase price is taxable. And tax-exempt interest must still be reported on the federal return and counts in the formula that decides how much of a person's Social Security benefit is taxed. Municipal bond funds pass the exemption on as "exempt-interest dividends", shown in box 12 of Form 1099-DIV.

To compare a tax-free yield with a taxable one, investors convert it into a tax-equivalent yield. The standard calculation is:

• $\text{TEY}$ is the yield a taxable bond must pay to leave the same amount after tax.
• $y_{\text{exempt}}$ is the tax-exempt yield, such as a municipal bond's yield to maturity.
• $t$ is the investor's marginal tax rate, written as a decimal.

Worked example: a municipal bond yields 3.5% and the investor is in the 32% federal bracket. The tax-equivalent yield is $3.5\% \div (1 - 0.32) = 3.5\% \div 0.68 \approx 5.15\%$. A taxable bond of similar credit risk and interest rate risk would need to yield more than about 5.15% to be better. For an investor in the 12% bracket the same bond is worth only $3.5\% \div 0.88 \approx 3.98\%$, which is why municipal bonds are usually held by people with higher incomes. If the bond is also exempt from a 5% state tax, the combined rate is often approximated as $t = 0.32 + 0.05 \times (1 - 0.32) = 0.354$, giving about 5.42%.

• Qualified Roth withdrawals. Withdrawals from a Roth IRA or Roth 401(k) are tax-free once the five-year and age conditions are met.
• Gifts, inheritances and life insurance proceeds. In the US these are generally not income to the person who receives them, though estate or gift tax may apply to the giver.
• Savings wrappers abroad. Interest, dividends and gains inside a UK Individual Savings Account (ISA) are free of UK income and capital gains tax, and many countries exempt interest on chosen government savings schemes.
• Exempt organisations. Charities and pension trusts may be exempt on most investment income; this is a status of the entity, not of the income itself.

Cross-border investors face a different picture. A source country may still levy a withholding tax on income that the investor's home country treats as exempt, and relief depends on tax residency and double taxation treaties.

Exemptions are a cost to government, often called tax expenditures, and are periodically debated when Congress looks for revenue. For investors the main trade-off is that tax-exempt instruments yield less, so they make sense only above a certain bracket and are wasted inside an account that is already sheltered. Higher-yielding municipal bonds can carry real default risk, and the market is less liquid than the Treasury market. Most adviser guidance treats exemptions as one input into asset allocation rather than a reason to buy on its own, and all exempt income should still be shown correctly when tax filing.

• Investor.gov (SEC): Municipal bonds
• MSRB: Electronic Municipal Market Access (EMMA)
• IRS: Topic no. 403, Interest received