Tax-Exempt Interest

What Is Tax-Exempt Interest?

Tax-Exempt Interest refers to interest income from municipal bonds or other income-producing securities that are not considered taxable for the federal income tax. However, such an exemption can deprive the taxpayer of other tax benefits up to the amount of interest income considered tax-free herein.

Although the government taxes any capital gain made from tax-exempt interest-bearing assets, such interest income may pose state or local income tax liabilities or may be subject to the alternative minimum tax (AMT). Alternatively, the interest income from triple-exempt municipal bonds is tax-free at all levels—local, state, and federal. 

• Tax-exempt interest is the regular interest income from municipal bonds or other income-generating securities, considered tax-free at the federal level.
• However, such interest income may not always be tax-free at the state and local levels, except for the interest income from the triple-exempt municipal bonds, which does not account for any income tax liability at all three levels, i.e., the local, state, and federal levels.
• Due to the exemption, taxpayers are subjected to the alternative municipal tax (AMT) instead of claiming other tax benefits.

Tax-Exempt Interest Explained

Tax-exempt interest is income from municipal bonds and other tax-free investments not subject to federal income tax. When local and state governments issue municipal bonds, holders are exempt from paying income tax. Certain tax-exempt bonds or assets may be subject to the alternative minimum tax (AMT) or local/state income tax. All interest income from the federal municipal bonds, or munis, is tax-free. It is mentioned in the bond or security advertisement on the respective websites.

However, investors cannot claim such an exemption on the capital gain from the same securities or assets. The IRS factors tax-exempt interest into AGI for social security benefit tax calculations, potentially leading to taxable benefits. Moreover, claiming such an exemption can disqualify individuals from the earned income credit and limit their other tax benefits. Also, any expense made for the tax-exempt investment is not deductible. 

How To Claim?

Tax-exempt interest from municipal bonds must be reported by the payer using either Form 1099-INT or Form 1099-OID. Taxpayers should locate this information in box 8 of Form 1099-INT or box 2 of Form 1099-OID for tax-exempt stated interest and tax-exempt OID, respectively. The taxpayer should record these figures on line 2a of Form 1040 or 1040-SR. 

Assume the taxpayer obtained a premium using a tax-exempt bond. The taxpayer should enter the net tax-exempt interest amount, which is the interest received in excess of the amortized bond premium, in line 2a of Form 1040 or 1040-SR. If a taxpayer purchased a tax-exempt OID bond and paid an acquisition premium, they should report the net tax-exempt OID amount on line 2a of Form 1040 or 1040-SR.

Additionally, taxpayers should include any exempt-interest dividends from a mutual fund or regulated investment company on line 2a of their Form 1040 or 1040-SR, as indicated in box 12 of Form 1099-DIV. The taxpayer should generally report amounts from box 9 of Form 1099-INT on line 2g of Form 6251. For specific guidelines, taxpayers should refer to the Instructions for Form 6251. Moreover, suppose taxpayers cashed series EE or I U.S. savings bonds issued after 1989 and paid qualified higher education expenses in 2023 for themselves, their spouses, or dependents. In that case, they might qualify to exclude part or all of the interest on those bonds. Further information can be found in Form 8815.

Examples

IRS tax-exempt interest is a preferable income source for investors belonging to the low-income group. Investing in local and state-level assets is more beneficial. Below are some examples:

Example #1

Suppose Alan holds an XYZ state municipal bond, which yields him 5.4% p.a. state tax-exempt interest. While his annual income is $9000, including $540 from the XYZ state municipal bond, Alan will not be liable to pay income tax on this $540 at both the federal and state levels.

Example #2

One example of tax-exempt interest-earning municipal bonds is the Nuveen Wisconsin municipal bond fund (FWIRX), which has a current NAV of $9.94 and a 30-day security yield of 3.35% as of March 1, 2024. The YTD NAV performance of the fund was 0.53%, and the distributed yield at NAV is 3.20%. This fund was incepted on February 25, 1997, and its current monthly dividend is $0.0265. Interest income is tax-exempt from state and federal income tax and, in some cases, from local income tax.

Tax-Exempt Interest vs Taxable Interest

Investors typically assess securities' tax implications before investing for effective tax planning. There can be two different forms of interest income, i.e., taxable and tax-exempt interests, differentiated as follows:

Basis	Tax-Exempt Interest	Taxable Interest
Definition	It is the interest income that is excluded from the taxable income at the federal level.	Such an income is chargeable for local, state, and federal income taxes.
Taxability at the Federal Level	Not liable for federal income tax.	Subject to federal income tax.
State- or Local-Level Taxation	Except for the triple-exempt municipal bonds, almost all the other tax-exempt interest-bearing securities are taxable at the state and local levels.	The interest income from all the taxable investments is considered taxable for local and state income taxes.
Returns	The rate of return from such securities is comparatively lower than the taxable ones.	The returns in the form of interest income are comparatively higher but subject to tax implications, including the new 3.8% surtax on net investment income for higher-income individuals.
Investment Instruments	Such income is the yield on local, state, or federal municipal bonds and other tax-advantaged products and income-producing investments like the Roth retirement accounts.	Such returns are derived from investments in corporate or government securities or accounts like savings accounts, fixed deposits, certificates of deposits (CDs), corporate bonds, etc.
Issuers	Local, state, or federal government.	Corporations or the federal government.

Frequently Asked Questions (FAQs)

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