Tax-Exempt Interest

Tax-exempt interest is a wonderful phrase for any investor's ears. It refers to interest income that is not subject to federal income tax. In some cases, it can also be free from state and local taxes, making it a “triple threat” of tax savings. This special treatment is most famously associated with municipal bonds (often called “munis”), which are debt securities issued by states, cities, counties, and other government entities to fund public projects like schools, bridges, and water systems. The government essentially forgoes its tax revenue on the interest as a way to incentivize investors to lend them money, allowing these public works to be financed at a lower cost. For investors, particularly those in higher tax brackets, this creates a powerful opportunity to generate income while legally minimizing their tax bill. It’s a classic win-win scenario: communities get their projects built, and investors get to keep more of what they earn.

A core tenet of value investing is maximizing long-term, real returns. What matters isn't just the return you make, but the return you keep after inflation and taxes. This is where tax-exempt interest shines. It directly increases your after-tax return, which is the only return that truly counts. The key is learning to compare the tax-free apple of a municipal bond to the taxable orange of a corporate bonds or a high-yield savings account. You can't just look at the stated interest rate, or yield. You need to calculate the taxable equivalent yield (TEY).

The TEY tells you what yield a taxable investment would need to offer to equal the return of a tax-exempt investment after taxes are paid. The formula is simple: Taxable Equivalent Yield = Tax-Exempt Yield / (1 - Your Marginal Tax Rate) Let's say you're in the 32% federal tax bracket and are considering two bonds:

1. A tax-exempt municipal bond yielding 3.5%.
2. A taxable corporate bond yielding 4.5%.

At first glance, the corporate bond looks better. But let's run the numbers. The TEY of the municipal bond is: 3.5% / (1 - 0.32) = 3.5% / 0.68 = 5.15% To you, that 3.5% tax-free yield is equivalent to earning 5.15% from a taxable investment. Suddenly, the municipal bond is the clear winner. The higher your tax bracket, the more valuable tax-exempt interest becomes.

Not all municipal bonds are created equal. They generally fall into two main categories.

These are the gold standard of municipal debt. General Obligation (GO) Bonds are backed by the “full faith and credit” of the government entity that issues them. This means the issuer can use its general taxing power to raise the money needed to pay back bondholders. Because of this strong backing, they are considered very low-risk investments.

Revenue Bonds are not backed by general taxing power. Instead, they are funded by the revenue from a specific project or source, such as tolls from a new bridge, ticket sales from a stadium, or fees from a public utility. Because their repayment depends on the financial success of a single project, they carry slightly more risk than GO bonds and, as a result, often offer a slightly higher yield to compensate investors for that risk.

While tax-exempt interest is a fantastic tool, it’s not entirely without its complexities. Always be aware of the following:

• State and Local Taxes: The “tax-exempt” label usually refers to federal income tax. Your interest income is typically only exempt from state and local taxes if you buy municipal bonds issued within your own state of residence. If you live in New York and buy a bond from California, you'll still likely owe New York state income tax on the interest. Bonds that are exempt from federal, state, and local taxes are known as “triple-tax-exempt.”
• The Alternative Minimum Tax (AMT): Some revenue bonds, known as “private activity bonds” (used to finance projects like airports or sports stadiums), generate interest that may be subject to the Alternative Minimum Tax (AMT). This is a parallel tax system that affects some high-income earners, so it's a detail worth checking.
• Not Risk-Free: Tax-exempt doesn't mean risk-free. Like all bonds, munis are exposed to interest rate risk (if market rates rise, the value of your lower-yielding bond will fall) and credit risk (the small but real risk that the issuer could default on its payments). Always check the bond's credit ratings from agencies like Moody's or S&P Global Ratings to assess the issuer's financial health.