What Is Tax Free?

Tax free refers to certain types of goods and financial securities (such as municipal bonds) that are not taxed. It also refers to earnings that are not taxed. The tax free status of these goods, investments, and income may incentivize individuals and business entities to increase spending or investing, resulting in economic stimulus. Tax free may also be known as tax-exempt.

Understanding Tax Free

Tax free purchases and investments do not incur the typical tax consequence of other purchases and investments. For instance, tax free weekends occur in many states where, once or twice a year, store purchases are not taxed, thereby, reducing the overall cost to the consumer. Frequently these sales tax holidays occur before school starts in the Fall to incentivize spending on school supplies, clothes, computers, calculators, etc.

Governments will often provide a tax break to investors purchasing government bonds to ensure that enough funding will be available for expenditure projects. Tax free investments such as tax-exempt municipal bonds (or munis) allow investors to earn interest income tax free.

Interest may only be tax free at the federal level if, for example, a California resident buys a New York municipal bond. These tax laws, however, vary by state. For instance, some states such as Wisconsin and Illinois tax interest earned on all muni bonds, including their own, subject to a few exceptions.

Meanwhile, states such as California and Arizona exempt interest from taxes only if the investor resides in the issuing state.

For example, assume a local government in California issues a municipal bond to finance a recreational park. An investor, John Smith, who resides in the state of issuance purchases the $5,000 par value bond which matures in two years and has a coupon rate of 3% to be paid annually. At the end of each of the two years, the investor receives interest income of 3% x $5,000 = $150. This income will not be taxed by both the federal and state government. After the bond matures, John Smith will receive his original principal investment back from the local government.