Quick Answer
Corporate bond interest and bank or money-market interest are fully taxable as ordinary income. Treasury interest is taxable federally but exempt from state and local income tax. Municipal bond interest is excluded from federal gross income, with narrow exceptions. A tax-exempt security only beats a taxable alternative once the customer's bracket is high enough.
How a security is taxed changes what it is actually worth to a given customer, which is why this topic sits inside a unit about portfolio cost and risk rather than inside a product-mechanics unit.
How Are Portfolio Securities Taxed at the Federal Level?
| Security | Federal tax treatment |
|---|---|
| Corporate bond interest | Fully taxable as ordinary income |
| Bank and money-market interest | Fully taxable as ordinary income |
| U.S. Treasury security interest | Taxable federally; exempt from state and local income tax |
| Municipal bond interest | Excluded from gross income for federal tax, with narrow exceptions |
- Most states also exempt interest on their own bonds from state and local tax, but that half of the picture comes from each state's own law, not from the federal exclusion.
Why Does the Customer's Tax Bracket Change Which Security Wins?
- A tax-exempt security is worth more, after tax, to a customer in a higher tax bracket, because that customer would keep a smaller share of a fully taxable alternative's yield than a customer in a lower bracket would. The higher the bracket, the more of a taxable yield the tax takes, and the more the exemption is worth.
- A customer in a lower tax bracket has less to gain from tax-exempt income and can come out ahead, after tax, holding a fully taxable security with a higher stated yield instead.
- The standard tool for this comparison is the tax-equivalent yield: the taxable yield a security would need to match a given tax-exempt yield, for a customer in a specific bracket.
Exam Tip: Gotchas
- A municipal bond is not automatically the better portfolio holding. Its tax exemption outweighs a taxable alternative's higher stated yield only once the customer's bracket is high enough. A low-bracket customer can net more after-tax income from the taxable security instead.
What Should You Check on Exam Day?
- Match each security to its federal tax treatment before comparing yields: corporate and bank interest is fully taxable, Treasury interest is federally taxable only, municipal interest is federally excluded.
- Keep the state-exemption half separate: it comes from the issuing state's own law, not from the federal exclusion for municipal interest.
- Confirm the customer's bracket before crediting a municipal bond as the better choice; a low-bracket customer can net more after tax from a taxable security.