What Is Tax-Exempt Interest?
Tax-exempt interest is interest income that is not subject to federal income tax. In some cases, the amount of tax-exempt interest a taxpayer earns can limit the taxpayer's qualification for certain other tax breaks. The most common sources of tax-exempt interest come from municipal bonds or income-producing assets inside of Roth retirement accounts.
Key Takeaways
- Tax-exempt interest refers to interest income that is not subject to taxation, most notably at the federal level.
- Some municipal bonds may also be "triple-exempt", where tax is not paid at the federal, state, nor local level.
- Tax-exempt interest may also be earned in Roth retirement accounts as well as some other tax-advantaged products and accounts.
Tax-Exempt Interest Explained
Tax-exempt interest can be somewhat of a misnomer as it may still be taxed at the state or local levels. It may also be subject to the alternative minimum tax (AMT). Furthermore, capital gains on tax-exempt investments are still taxable; only the interest on these investments is tax-exempt. The most common way to earn interest that is tax-exempt at the state and local levels in addition to the federal level is for an investor to purchase a municipal bond issued in his or her state or locality of residence.
Municipal bonds are one of the most common types of investments that pay tax-exempt interest, but while interest may be tax-exempt at the federal level it may still be taxed at the state level. For example, a California resident who buys a New York municipal bond would pay California income tax on that interest. These tax laws, however, vary by state. For instance, some states such as Wisconsin and Illinois tax interest earned on most muni bonds, including their own, while states such as California and Arizona exempt interest from taxes if the investor resides in their states. Utah is an example of a state that exempts interest on out-of-state bonds, as long as that state does not impose a tax on bonds issued by Utah. Treasury securities issued by the U.S. government pay interest that is tax exempt at the state and local levels, but not the federal level.
Triple-tax-exempt is a way of describing an investment, usually a municipal bond, which features interest payments exempt from taxes at the municipal, state and federal levels.
State and Local Taxation of Interest
According to the Internal Revenue Service (IRS), interest on a state or local government obligation may be tax-exempt even if the obligation is not a bond. For example, interest on a debt evidenced only by an ordinary written agreement of purchase and sale may be tax-exempt. Also, interest paid by an insurer on default by the state or political subdivision may be tax-exempt.
Mutual funds that hold a mix of stocks and municipal bonds will have the portion of earnings derived from the bonds tax-exempt under federal income tax guidelines and possibly exempt from state taxes depending on the location from which the bonds originated and/or the taxpayer's state of residence.
Impact on Adjusted Gross Income (AGI)
Since tax-exempt interest is not subject to income taxes, it is not included in the calculation of adjusted gross income (AGI) for taxation purposes. Issuers or lenders that pay more than $10 in tax-exempt interest must report the interest income to both taxpayers and the IRS on Form 1099-INT. Taxpayers or borrowers, in turn, must report this tax-exempt interest on Form 1040. The amount received as tax-exempt interest is used by the IRS to determine what amount of the taxpayer’s Social Security benefits is taxable.
FAQs
Examples of Tax-Exempt Interest
This may imply that you are not required to pay specific taxes like federal income taxes or state income taxes. For instance, tax-exempt interest is frequently generated by municipal bonds. These are issued by governments and they can be at the local, state, or federal levels.
Should you file if you have tax-exempt interest? ›
You must report all taxable and tax-exempt interest on your federal income tax return, even if you don't receive a Form 1099-INT or Form 1099-OID.
What is tax-exempt in simple terms? ›
A tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax.
What is tax-exempt interest income on a 1040 line? ›
If the answer to this question isn't prefilled, enter the total amount of tax-exempt interest income you reported in 2021. Tax exempt interest income can be found on IRS Form 1040-line 2a. If married, and you and your spouse filed separate tax returns, enter the total amount of your combined tax-exempt interest income.
How do I find my tax-exempt interest? ›
Tax-exempt interest.
In general, your tax-exempt stated interest should be shown in box 8 of Form 1099-INT or, for a tax-exempt OID bond, in box 2 of Form 1099-OID, and your tax-exempt OID should be shown in box 11 of Form 1099-OID. Enter the total on line 2a of your Form 1040 or 1040-SR.
What is an example of a tax-exempt benefit? ›
Certain Social Security Benefits: A portion of Social Security benefits may be tax-exempt, depending on the recipient's total income and filing status. Generally, if Social Security benefits are the only source of income, they are likely to be tax-exempt as the taxpayer may not meet a taxable threshold.
Does tax-exempt interest affect social security? ›
For a quick computation, add one-half of your Social Security benefits to all your other income, including tax-exempt interest. If this amount is greater than the base amount for your filing status, a part of your benefits will be taxable.
Is tax-exempt interest deductible? ›
Taxpayers cannot deduct expenses that are allocable to income that is wholly tax-exempt, or expenses incurred in the production of income that are allocable to interest that is wholly tax-exempt (IRC § 265). See Explanation: §265, Tax-Exempt Income.
Is tax-exempt interest a permanent difference? ›
The permanent difference arises when the unevenness between taxable and accounting income will never reverse. Example: fine, penalties, Tax-exempt interest, etc.
How do you answer are you tax-exempt? ›
To claim exempt, write EXEMPT under line 4c. You may claim EXEMPT from withholding if: o Last year you had a right to a full refund of All federal tax income and o This year you expect a full refund of ALL federal income tax.
Tax exemptions are important for individuals because they lower the total amount of taxes paid, resulting in taxpayers having more money to spend. Governments use tax exemptions to stimulate the economy by increasing the disposable income for individuals or businesses.
What does it mean when someone says they are tax-exempt? ›
Being tax-exempt means that some or all of a person's or business's income is free from federal, state or local tax. Tax-exempt organizations are typically charities or religious organizations recognized by the IRS. Internal Revenue Service. Exempt Organization Types. Accessed Mar 26, 2024.
What is an example of tax-exempt interest? ›
In some cases, the amount of tax-exempt interest a taxpayer earns can limit the taxpayer's qualification for certain other tax breaks. The most common sources of tax-exempt interest come from municipal bonds or income-producing assets inside of Roth retirement accounts.
Does tax-exempt interest need to be reported? ›
You'll need to show the amount of any tax-exempt interest you received during the tax year. This doesn't convert tax-exempt interest to taxable interest.
How to avoid paying taxes on interest income? ›
You can make a number of moves to ease the tax burden from savings account interest, which include:
- Investing in a tax-deferred account such as a traditional individual retirement account or a 401(k).
- Stashing money in a tax-exempt account such as a Roth 401(k) or a Roth IRA.
Exempt income is any income that can't be taxed. Government pensions and retirement plans such as IRAs are examples of exempt income, as are gifts and inheritances. You may also qualify for an exemption if you receive disability payments or alimony.
What is an example of a tax-exempt account? ›
Tax-exempt account withdrawals are tax-free, meaning you'll pay taxes up front. Common tax-deferred retirement accounts are traditional IRAs and 401(k)s. Popular tax-exempt retirement accounts are Roth IRAs and Roth 401(k)s. An ideal tax-optimization strategy may be to maximize contributions to both types of accounts.
What generates tax-free interest? ›
Municipal Bonds
Like Treasury bonds, investors receive interest payments in the form of coupons, and their capital will be returned at maturity. Unlike Treasury bonds, however, interest earnings from municipal bonds are tax-free at the federal level.
What is tax-exempt interest in box 8? ›
Box 8 reports tax-exempt interest and relates to interest-bearing investments you hold with state and local governments, such as municipal bonds.
