Triple-Tax-Free

What is Triple-Tax-Free?

Triple-tax-free, or "triple tax-exempt", is a way of describing an investment, usually a municipal bond, where the interest payments are exempt from taxes at the municipal, state and federal levels.

Understanding Triple-Tax-Free

A triple-tax-free municipal bond is a debt security issued by a state, municipality or county. Typically, municipal bonds are issued to generate capital for large infrastructure projects such as schools, bridges, hospitals or highways. Through offering tax incentives, localities encourage residents to invest in infrastructure improvements that benefit the community. Triple-tax-free municipal bonds may be general obligation bonds or revenue bonds.

Triple-tax-free municipal bonds function in the same way as other bond investments. The bond’s principal is paid back at the maturity date. In the interim, the bondholder receives interest payments. Triple-tax-free municipal bonds are typically considered a low-risk investment, as they are backed by the government that issues them.

Triple-tax-free municipal bonds offer tax-exempt interest payments to investors for several reasons, but the primary reason is the U.S. Constitution forbids the federal government from taxing interest earned on loans to municipalities and states.

Most, but not all, states have made interest income received from securities issued by the state or a state government entity exempt from state income tax. Finally, the remaining state or municipality offers tax-free status to the issuer at its particular level of government as a courtesy. These tax incentives encourage residents to invest in capital improvements in their local communities.

Limitations of Triple-Tax-Free

While there are definite tax benefits to owning triple-tax-free investments, tax-free status on earnings does come at a price. Because they are low-risk investments, tax-free municipal bonds usually offer lower returns than corporate bonds or other taxed investments. The low-interest rates of triple-tax-free municipal bonds may expose bondholders to inflation risk. Inflation risk happens if the rate of inflation outpaces the interest earned on the investment vehicle. The bondholder may ultimately end up with an investment that earns a negative rate of return.

Depending on an individual's tax obligation, this downside risk may not be recovered. Higher income earners gain more from tax-free investments than lower income earners. Triple-tax-free investments are also particularly appealing to investors who live in areas with high state or municipal tax rates, such as New York.