What are tax-free investments?

State and local governments around the country issue a large quantity of debt securities to raise needed capital. The majority of these securities—often referred to as municipal bonds or simply munis—provide investors with interest that is exempt from federal income taxes. This income may also be exempt from state and local taxes for investors who reside in the issuing state or locality. A New York City bond, for example, would be triple-tax-free (i.e. exempt from federal, state, and local taxes) for an investor living in New York City. Because of this tax exemption, the terms tax-free investments and municipal investments are often used interchangeably.

What different types of municipal securities are available to investors?

General obligation bonds (GOs) and revenue bonds are two major classes of municipal securities differentiated by the source of funding for their interest payments. GOs are issued to finance various government operations and are backed by the issuer’s power to raise taxes, if necessary, to make scheduled interest and principal payments. Revenue bonds, meanwhile, finance specific projects, such as transportation and utilities, and are backed by the revenue generated from the projects. Due to their potentially variable cash flows, revenue bonds are often considered riskier than GOs.

In addition, municipalities sometimes issue securities to help finance private development considered beneficial to local economies. The income from these private activity bonds is exempt from federal income tax but may be subject to the alternative minimum tax.

Municipal securities are issued for a wide variety of purposes and, as such, have varying maturities and yields. Many munis are short-term notes issued in anticipation of pending tax receipts or other revenues. These money market securities generally offer low yields due to their short maturities. Major projects, on the other hand, tend to be funded by longer-term bonds offering higher yields. In either case, coupon payments may be fixed or tied to a floating interest rate that resets periodically.

What factors should investors consider when choosing between taxable and tax-exempt securities?

Due to the potential tax advantage, investors typically accept lower yields from munis than they would from similar taxable securities. Because of this yield differential, one’s tax status plays a major factor in the attractiveness of tax-free investments. While municipal securities could benefit investors in any tax bracket, they tend to appeal the most to those who are in the highest tax brackets or live in high-tax jurisdictions.

A simple way to gauge whether investing in a given municipal security would be more attractive than investing in a comparable taxable security is to calculate its equivalent taxable yield. This can be done in three steps: