Business Glossary

security whose interest is not subject to federal or local tax in the state of the issuer. Though often called a municipal bond, it may also be issued by a county, state, or state agency. For example, a New York City resident does not pay federal, state, or city tax on the interest received from a New York City obligation. It is triple tax-free, though this is not necessarily true of other states. An investor in a mutual fund that invests solely in tax-exempt bonds often pays no tax on interest earned. However, some states tax fund dividends. The return on a tax-exempt bond is equivalent to a higher return on a taxable corporate bond because of the tax savings. The dollar advantage of a tax-exempt security increases as the tax rate rises. Assume a taxpayer in the 35% tax bracket receives 6% on a taxexempt bond. The equivalent taxable yield on a corporate bond is 9.23% (6%/.65). It should be noted, however, that the holder of a taxexempt security does have to pay tax on the gain at the time of sale representing the difference between the cost and the selling price. For example: An investor buys a $1000, 5% tax-exempt bond for 90%. The cost is therefore $900. The taxpayer will be taxed on the gain of $100 in the year the bond is redeemed.

municipal bond that is not taxed by the federal government and is free from state and local taxes in most states if purchased by an in-state resident. Most general obligation municipal bonds are exempt from state and local taxes in the states where they are originated, and certain bonds are triple tax exempt, regardless of where they originate. Five states (Texas, Nevada, Alaska, South Dakota, and Wyoming) do not tax municipal bonds issued by other states. If the yield differential is high enough, a taxable bond issued out of state actually may pay a better return to the investor.