The mutual exclusion doctrine is an agreement between federal, state, and local taxing authorities mandating mutual exclusion in taxation of government bond interest. Thus the interest paid on any security issued by the federal government is not taxable at the state or local level.
Conversely, any debt issued by state or local municipalities is free from federal taxation as well. The freedom from state and local taxes also makes interest from governmental issues more palatable for conservative investors living on fixed incomes.
This rule applies mainly to holders of municipal bonds, and largely helps higher-income taxpayers.
Holders of such securities need to consider the taxable equivalent yield in order to correctly assess their net return potential.
The mutual exclusion doctrine has been in place for decades and is a major reason for the popularity of municipal bonds with high-income investors seeking federal tax relief. Federal income tax is usually much higher than state or local taxes, and in many cases determines state and local tax rates. Thus any investment income that is free of federal taxation is most appealing to wealthy individuals in high tax brackets. Moreover, municipal bond interest is exempt from the federal alternative minimum tax (AMT), which hit high earners severely prior to the Tax Cuts and Jobs Act of 2017 (TCJA).
State rules vary on taxation of municipal bond income. Generally, however, most states exempt municipal bond income that is earned on any bonds issued within the state. For example, if a resident of San Diego buys a Los Angeles municipal bond, the state of California would exempt the San Diego owner from tax on the Los Angeles bond income. However, if the same investor bought Philadelphia municipal bonds, they would be taxed by California.
Many cities that have an income tax, including New York City, also exempt qualifying municipal bonds from taxation under this arrangement. This can be important to people who work in New York City but live outside the city, since New York taxes all income earned with the city limits, regardless of the earner’s residence.
One downside to mutual exclusion is that bond issuers are well aware of the tax savings inherent in their offerings, so the price and yield are adjusted accordingly. To determine if a tax-free bond is a better investment than a taxable bond, investors calculate the “taxable equivalent yield.”
For example, say a tax-free municipal bond issued in your own state yields 2.5 percent, and a bank certificate of deposit (CD) is paying 3 percent annually. Investing $10,000 in the CD yields $300 in annual interest, while the bond only pays $250. But let’s say you’re in the 39.6 percent tax bracket. After taxes, your income on the CD is reduced to $181, giving the municipal bond a better taxable equivalent yield.