What Are Tax-Exempt Securities? Types and Tax Rules
Understand the tax implications of government securities. This guide clarifies the crucial distinction between tax-free interest and taxable capital gains.
A tax-exempt security is an investment, typically a bond, where the interest income generated is not subject to taxation at a specific level—federal, state, or local. These instruments are issued by government entities, such as states, cities, or counties, to raise capital for public purposes. Projects like building schools or repairing highways are often funded through these securities. By offering a tax benefit on the interest earned, governmental issuers can provide a lower interest rate compared to corporate bonds, which reduces their borrowing costs.
Types of Federally Tax-Exempt Securities
The most prominent securities offering federally tax-exempt interest are municipal bonds, often called “munis.” These are categorized into two main types based on the source of repayment funds: general obligation bonds and revenue bonds. Each type carries different features and levels of risk, which are tied to how the issuing entity guarantees the repayment of the principal and interest.
General Obligation (GO) Bonds
General Obligation (GO) bonds are backed by the “full faith and credit” of the issuing government entity. This means the issuer pledges its full taxing power to ensure that debt obligations are met. If the government’s revenues fall short, it has the authority to raise taxes to cover the bond payments. This strong backing makes GO bonds one of the safer types of municipal bonds, often resulting in higher credit ratings.
Revenue Bonds
Revenue bonds are not backed by the general taxing power of the government. Instead, they are secured by the income generated from a specific project or a dedicated revenue source. Examples include tolls from a bridge, fees from a public water system, or revenue from a university dormitory. The financial success of the underlying project is directly linked to the bond’s ability to make payments, making the credit quality of revenue bonds more variable than that of GO bonds.
Securities Exempt from State and Local Taxes
While municipal bonds offer federal tax exemption, another class of securities provides an exemption from state and local income taxes, though the interest is subject to federal income tax. This category is dominated by debt instruments issued by the U.S. federal government. The exemption from state and local taxation is based on the principle that states cannot tax the federal government.
The most common examples are U.S. Treasury securities, which are backed by the full faith and credit of the U.S. government and are considered one of the safest investments. These are issued in several forms with different maturities. Treasury Bills (T-Bills) are short-term with maturities of one year or less, Treasury Notes (T-Notes) have maturities from two to ten years, and Treasury Bonds (T-Bonds) are long-term, with 20-year and 30-year maturities.
Another type of federally issued debt with state and local tax exemptions are U.S. Savings Bonds, specifically Series EE and Series I bonds. A unique feature of these savings bonds is a potential federal tax exemption if the bond proceeds are used to pay for qualified higher education expenses. This educational exclusion is subject to certain income limitations and other rules outlined by the IRS.
Tax Reporting and Special Considerations
Even when interest income from a security is tax-exempt, it often must be reported to the Internal Revenue Service (IRS). For municipal bonds, tax-exempt interest is reported to the investor on Form 1099-INT in Box 8. The investor then reports this amount on their federal income tax return on Form 1040. While this interest is not added to taxable income, the IRS uses this information for various calculations.
A consideration for some investors is the Alternative Minimum Tax (AMT), a parallel tax system that ensures high-income individuals pay a minimum amount of tax. Interest from certain “private activity bonds,” which are issued by a government to finance projects for a private entity, is a tax preference item. This interest, reported in Box 9 of Form 1099-INT, must be added back to income when calculating the AMT, potentially making some tax-exempt interest taxable.
It is important to distinguish between tax-exempt interest and capital gains. While interest payments from a municipal bond may be tax-free, any profit from selling the bond is a taxable capital gain. This occurs if an investor sells a bond for a higher price than their purchase price and must be reported on Schedule D of Form 1040.
The applicable tax rate depends on how long the bond was held. Short-term gains for assets held one year or less are taxed at ordinary income rates. Long-term gains for assets held longer than one year are taxed at lower capital gains rates.