What is Tax-Exempt Security?

Generally, tax-exempt securities are those whose interest, dividends or gains are free from federal income taxation.

How Does Tax-Exempt Security Work?

For example, let's assume that John purchases $1,000 of municipal bonds. The bonds pay 7% interest per year, or $70. Because municipal bonds are typically tax-exempt securities, John does not have to pay federal income tax on the $70 worth of interest income. He may also not have to pay state or local taxes on that income, depending on whether he lives in the municipality issuing the bonds.

Municipal bonds are the most common tax-exempt security, but mutual funds that invest in municipal bonds, U.S. savings bonds, or other tax-exempt securities can also receive tax-exempt status.

Why Does Tax-Exempt Security Matter?

Tax-exempt securities save investors money on taxes. Accordingly, tax-exempt securities can be very attractive, particularly to investors in high tax brackets.

Tax-exempt securities also provide local governments and nonprofits (the most common issuers of tax-exempt securities) with lower borrowing rates. This in turn encourages governments and nonprofits to undertake new projects.

Considerable controversy exists regarding what sorts of securities should be tax exempt. Most of the time, an organization has to be registered under section 501(c)(3) of the Internal Revenue Code before it can issue tax-exempt securities.

It is also important to note that even though a tax-exempt security may provide income or gains that are exempt from federal income taxes, the taxpayer or organization might still have to pay state, local, or other types of taxes (such as payroll taxes, sales taxes, or excise taxes).