Tax Free Bonds

Reviewed: November 14, 2014
By FinanceWeb

Tax-Free Federal Bonds

Interest income from investments are taxed at ordinary income rates. The tax brackets determine the exact percentage payable as taxes. Tax-free investing is a powerful incentive for investors; tax free bonds are a major form of investment in the United States. Some federal bonds incomes are not taxed when used in specific ways. One example is a Series EE Treasury Bond, which offers tax exemption for interest income used for educational purposes. Most federal tax-exempt bonds are state and local bonds.

Tax-free Municipal Bonds

Cities and local units of state government can have bond authority to raise funds for public activities. These government bonds have traditionally involved infrastructure projects such as roads, highways, bridges, and public facilities. Building schools and hospitals are excellent examples of uses of bond revenues. Tax-free municipal bonds are exempt from state taxes when purchased by an in-state resident or organization. Tax-free bonds can be medium or long-term securities. Short-term bonds, usually issued as notes, can be for one year or less. Medium-term bonds frequently have terms of one to three years. Long-term bonds can be for terms of 20 to 30 years or longer. The issuers offer high-interest rates to attract investors, and one can often purchase them for amounts far below face value.

Interest and Zero Coupon Bonds

Municipal bonds have low default rates. These investments can protect principal and ensure a stream of income from tax-free interest payments. Some municipal tax-free bonds have no coupons or periodic interest payments. Called zero coupon bonds, they repay principal and pay interest only at maturity. For this type of investment, issuers pay high yields to attract investors.

The Secondary Bond Market

Fitch, Moody’s and Standard & Poor’s are the leading rating services for municipal bonds. A rating grade of A or better is marketable on the secondary market. This is an important feature, for it converts bonds back into cash.

Taxable Municipal Bonds

Under long-standing court decisions and federal statutes, the general rule is that municipal bonds are exempt from federal taxes. The exceptions are few but significant, and one important exception is for private activity. As stated above, the policy for tax-exempt bonds is to promote the public good. The idea is to reward investments that carry out public purposes. However, some bonds have a private benefit or are in effect a private activity. One example might be building a football stadium for a privately owned sports franchise. It involves public benefits, but the main idea is a private activity; it is an enhancement of private business. Interest payments on bonds that fund private activity are not federally tax-exempt.

Impact of Federal Taxes

A tax-free bond has an investment advantage over higher yielding corporate or other taxable bonds. Depending on the individual’s tax bracket, the yield on a tax-free bond equals the yield on a taxed bond that may be two to three points higher. The federal government taxes interest income from bonds as ordinary income rather than the lower capital gains rate.

State and Local Taxes

Federal tax exemption does not include state and local taxes. Investors must also determine if their investments will be free of state assessments. One should note that estate taxes are a particular point for research. The overall impact of municipal tax-free bonds is a windfall for the investor. They get a tremendous return, safe investments, and neither the state nor the federal government gets full advantage of lower interest payments.