One big lure of tax-exempt securities is their ability to generate income that is not subject to income taxes. In most cases when an investment pro talks about tax-exempt securities, she's referring to municipal bonds. But not all municipal bonds are tax-exempt securities, and there are tax-exempt securities that are not municipal bonds. Just to muddy the waters even further, some income produced by tax-exempt securities might be taxable.
A tax-exempt security is an investment product that produces income that is exempt from some level of taxation. Some securities are exempt from federal income taxes, but not state and local taxes, while others might be exempt from state and local taxation, but not from federal income taxes. Still others might be exempt from taxation in some states, but not in other states. Before you invest in a so-called tax-exempt security, it pays to know exactly which taxes it is exempt from.
The interest paid by municipal bonds is typically free from federal income taxes, and might be exempt from state and local taxes if you live in the state of issue. If you buy a municipal bond issued by a state that you are not a resident of, and your state has a state income tax, the interest from that bond might be exempt from federal taxes, but taxable on your state return. Municipalities sometimes issue bonds to support projects that are good for the region, but that don't benefit the general public. Commonly referred to as taxable municipal bonds, the interest on these securities doesn't qualify for tax-exempt status. The taxable nature of these bonds is identified in the bond's indenture.
Situational Tax Exemption
Some securities might be free from taxation depending on how they are used. For example, the interest on U.S. savings bonds is exempt from income taxes at the state and local level, but is typically taxable on your federal income tax return. If you use your savings bonds to pay for qualified higher education expenses, the interest on those bonds is also free from federal income taxes.
The tax exemption offered by tax-exempt securities only applies to the interest paid by those securities. The exemption does not extend to capital gains. For example, the market price of municipal bonds fluctuates in the secondary market, typically in the opposite direction of prevailing interest rates. If interest rates fall, the market price of your bond will likely rise. If you sell your bond for a profit, any interest payments you've received will be tax-exempt, but the profit on the sale is taxed as a capital gain.
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