What is the Mutual Exclusion Doctrine?

The Mutual Exclusion Doctrine refers to an agreement prevailing among federal, state and local taxing bodies inducing mutual exclusion while taxing the interest on government bonds. Hence, an individual doesn't have to pay any state or local tax on the interest expenses incurred on the securities issued by the federal government authorities. Also, if state or local government bodies issue any debt, it is exempted from federal taxation too. Therefore, investors who rely on stable earnings and follow a conservative approach find it tempting to invest in government issues as the interest thereon is free from any local and state taxes.

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How Does the Mutual Exclusion Doctrine Work?

It has been many decades that the mutual exclusion doctrine is in existence. Investors with high income levels who aim for getting relaxation from federal tax preferred investing in municipal bonds, and this is how they become popular. As compared to local or state taxes, federal tax is more, and sometimes, the rates of local and state tax are ascertained on the basis of federal tax. Therefore, affluent investors whose income fall in high tax brackets prefer receiving returns that are free from federal taxes. Federal Alternative Minimum Tax, that affected high-income individuals badly, exempted interest on municipal bonds long-ago. There are different state policies for how municipal bond income will be taxed. Usually, most of the states provide an exemption on income earned on any municipal bonds in the state. For instance, if a person living in San Diego purchases a Los Angeles municipal bond, he will receive a tax exemption for the income on the Los Angeles bond by the state of California. In case, he had bought the Philadelphia municipal bonds, the government of California would have taxed him for them.

Cities that Exclude Bond Tax

Cities such as New York provide tax exemption to the eligible municipal bonds. This point holds significant value for the people working in New York but living somewhere outside. New York collects taxes on all earnings made within the city irrespective of the location of the earner.

Investors must follow Taxable Equivalent Yield

As there are obvious tax exemptions associated with the mutual exclusion doctrine, the bond issuing authorities make adjustments in the price and yield in an according manner. Taxable equivalent yield is a strategy used by investors for ascertaining if its more beneficial to invest either in a tax-free bond or a non-taxable bond. For instance, a tax-free municipal bond offers 2.5% return as compared to the certificate of deposit (issued by a bank) with 3% per annum. As per the calculations, the investor will receive $250 as annual interest on its tax-free bond, and $300 on its certificate of deposit. However, the yield on CD will be reduced automatically if he/she falls in the 39.6% tax bracket. The yields will decrease to $181 post-tax, thereby, offering the municipal bonds a more effective taxable equivalent yield.