Tax-Exempt Interest
Candlefocus EditorAt the federal level, the most common form of tax-exempt interest is generated through the purchase of municipal bonds. Municipal bonds are generally issued by state and local governments, cities, towns and other public financing entities. These bonds generally carry a lower interest rate than traditional bonds issued by corporations and individuals as the issuer is a “tax-exempt” entity. Investors in municipal bonds have the additional benefit of not having to pay federal taxes on the interest income generated from the bonds.
In addition to municipal bonds, there are other investment vehicles that generate tax-exempt interest. For example, Roth IRAs are an increasingly popular retirement account option where contributions are made with after-tax dollars, but the account grows tax-free while the money remains in the account. Similarly, some life insurance policies can offer tax-exempt growth, either through the cash value component or the proceeds that are paid out on death.
Tax-exempt interest can be an attractive option for those investors looking to optimize their portfolio and reduce their overall tax burden. However, it is important to note that tax-exempt interest is not the same as tax deferred. Tax-exempt interest means that the interest earned is not subject to taxation while tax-deferred investments mean the taxation is delayed into a later period. Investors should carefully consider the opportunity cost of a tax-exempt investment, especially when compared to a risky investment like stocks, which can potentially generate more income on a year-by-year basis. Additionally, the investor should consider any federal, state and local tax implications associated with these investments.
Therefore, investors should assess the pros and cons of a tax-exempt investment, taking into account the additional costs associated with taxation, as well as the opportunity cost of not reporting taxable income. By taking the time to do an analysis, one can make well-informed decisions that will provide benefits both now and in the future.