Tax-Exempt Interest: Comprehensive Guide and Real-Life Examples

Julia Kagan is a seasoned financial journalist and former senior editor specializing in personal finance at Investopedia.

What Is Tax-Exempt Interest?

Tax-exempt interest represents income earned from interest that is not subject to taxation at the federal, state, or local levels. The primary source of this income typically comes from municipal bonds.

Key Insights

• Tax-exempt interest is income free from federal, state, and local taxes.
• Some municipal bonds offer 'triple-exempt' status, meaning their interest is exempt from taxes at all three levels.
• Tax-exempt interest can also be generated within Roth IRAs and other tax-advantaged accounts.
• Earning tax-exempt interest may influence eligibility for other tax benefits.

Understanding the Nuances of Tax-Exempt Interest

While tax-exempt interest can be free from taxation at one level, such as federal, it might still be taxable at state or local levels, or vice versa. For example, U.S. Treasury securities are exempt from state and local taxes but taxable federally.

Additionally, interest income might be subject to the alternative minimum tax (AMT), and capital gains from tax-exempt investments remain taxable. The tax benefits apply solely to the interest portion.

Purchasing municipal bonds issued by your own state or municipality often grants tax exemption on interest at all levels.

However, tax rules vary by state. For instance, California residents pay state tax on interest from out-of-state municipal bonds, while states like California and Arizona exempt interest on bonds from within their borders. Utah exempts interest on out-of-state bonds if reciprocal tax exemptions exist.

U.S. Treasury securities pay interest exempt from state and local taxes, but not from federal taxes.

Important Consideration

'Triple-tax-exempt' describes investments—usually municipal bonds—whose interest payments are exempt from federal, state, and local taxes.

State and Local Tax Implications

According to the IRS, interest on state or local government obligations may be tax-exempt even if the obligation is not a bond. For example, interest from a written purchase and sale agreement or insurer-paid interest on state defaults can be exempt.

Mutual funds holding stocks and municipal bonds distribute tax-exempt interest based on the bonds' origins and the investor's residency, potentially exempt from federal and state taxes.

Does Adjusted Gross Income (AGI) Account for Tax-Exempt Interest?

No. Since tax-exempt interest is not taxable income, it is excluded from the calculation of adjusted gross income (AGI).

Entities paying more than $10 in tax-exempt interest report this income on Form 1099-INT to both taxpayers and the IRS. Taxpayers must report it on Form 1040.

Tax-Exempt Interest and Social Security Benefits

The IRS includes tax-exempt interest when determining the taxable portion of Social Security benefits.

Impact on FAFSA Applications

Tax-exempt interest must be reported on the Free Application for Federal Student Aid (FAFSA). Instructions specify including any interest earned on which no taxes were paid.

How to Identify Your Tax-Exempt Interest

Recipients of tax-exempt interest typically receive Form 1099-INT or Form 1099-OID. Tax-exempt interest is found in box 8 of Form 1099-INT or box 2 of Form 1099-OID for original issue discount bonds.

Summary

Tax-exempt interest is income free from taxation at one or more government levels—federal, state, or local. Certain municipal bonds offer exemptions at all levels, while Treasury securities are exempt only at state and local levels. Understanding these distinctions helps maximize tax benefits and informs financial planning in today's economic environment.

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