Goods and financial securities that aren’t taxed, like municipal bonds, are called “tax-free.” It also refers to earnings that are tax-exempt as well. Due to the fact that these goods, investments, and income are not taxed, people and businesses may spend more or invest more. Tax free may also be referred to as tax-exempt. How Does Tax Free Work?
Tax Free Concepts
Tax-free investments and purchases do not have the usual tax consequences that come with other investments and purchases. Many states, for example, offer tax-free weekends where store purchases aren’t taxed, lowering the consumer’s overall cost. As a way of motivating students to purchase school supplies, clothes, computers, calculators, etc., these sales tax holidays occur before school starts in the fall.
A government will often offer investors a tax break on government bonds in order to ensure that enough money is available to fund expenditures. In addition to earning interest income tax free, investors can earn interest on tax-exempt municipal bonds. If, for instance, a California resident purchases a New York municipal bond, interest is tax free at the federal level. Each state, however, has its own tax laws. Some states, like Wisconsin and Illinois, tax state-issued municipal bonds, with a few exceptions. On the other hand, California and Arizona tax their own Muni bonds.
Let’s say that a local government in California issues a municipal bond to pay for a recreation center. John Smith, a resident of the state of issuance, purchases a $5,000 bond with a par value of $5,000 and a coupon rate of 3%. After two years, the investor receives $150 in interest income based on the amount of $5,000. This income is not taxable to the federal or state governments. A local government will return John Smith’s original principal investment after the bond matures.
There is no state income tax in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming, so interest on Muni bonds is exempt. At the state and local levels, interest on Treasury Savings Bonds and Treasury Inflation Protected Securities (TIPSs) is tax-free, but at the federal level, it isn’t.
If a state or local government obligation isn’t a bond, interest on it may be tax-free, according to the Internal Revenue Service (IRS). For example, interest may not be taxed on a debt evidenced only by a written purchase and sale agreement. Moreover, an insurer may be exempt from tax if the state or political subdivision defaults and incurs a default. According to federal income tax guidelines, the portion of earnings generated by municipal bonds will be tax-exempt for mutual funds that hold a mix of stocks and bonds, and may also be exempt from state taxes, depending on where the bonds originate and/or where the taxpayer resides.
AGI is not calculated for taxation purposes using tax free interest, since tax free interest is not subject to income taxes. Form 1099-INT must be filed by both the issuer and the lender if they pay tax free interest exceeding $10. Taxpayers and borrowers must report tax-exempt interest on Form 1040. The amount of a taxpayer’s tax-free interest is used by the IRS to figure out how much of their Social Security benefits are taxable.
The Tax-Equivalent Yield and the Tax-Free Yield
Investing in tax free securities is more valuable and beneficial to an investor when his or her marginal tax bracket is higher. Tax-equivalent yields for tax-free investments are often higher than the current yield, as a result of the investor’s tax situation. The taxable interest rate needed to get the same tax-equivalent yield as the after-tax interest rate is equal to the after-tax interest rate.