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
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.
What is an example of a tax-exempt interest? ›
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. The interest on these bonds is often not subject to federal taxes.
What are the examples of tax exemption? ›
Organizations organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, educational, or other specified purposes and that meet certain other requirements are tax exempt under Internal Revenue Code Section 501(c)(3).
What is an example of a tax-exempt benefit? ›
Certain types of income, such as portions of retirement income and some academic scholarships, are tax exempt, meaning that they are not included as part of a filer's taxable income.
What is tax-exempt income examples? ›
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.
How to report 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 tax-exempt interest income from the IRS? ›
Tax-exempt interest income is not subject to income tax and is earned on funds loaned to states, cities, counties, or the District of Columbia. In most cases, interest income is reported on Form 1099-INT. All taxable interest income is reported on the taxpayer's return, even if it is not reported on Form 1099-INT.
What are the two types of tax exemption? ›
There are two types of exemptions-personal and dependency. Each exemption reduces the income subject to tax.
What does being tax-exempt mean? ›
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.
What is the difference between a tax exemption and a tax deduction? ›
Tax deductions lower your taxable income based on specific investments or expenses, whereas tax exemptions directly exclude certain components of your income from being taxed. Understanding these options effectively can lead to substantial savings, making a noticeable difference in your annual tax outgo.
How Are Savings Accounts Taxed? The IRS treats interest earned on a savings account as earned income, meaning it can be taxed. So, if you received $125 in interest on a high-yield savings account in 2023, you're required to pay taxes on that interest when you file your federal tax return for the 2023 tax year.
Who is tax-exempt in the US? ›
Generally, you don't have to pay taxes if your income is less than the standard deduction, you have a certain number of dependents, working abroad and are below the required thresholds, or are a qualifying non-profit organization.
Where to find tax-exempt interest income on 1040? ›
Tax exempt interest income can be found on IRS Form 1040-line 2a.
What is a non exempt income? ›
“Non-exempt” is a term referring to employees who earn less than $684 per week. Non-exempt means that the employee is not exempt from the FLSA and must be paid overtime. The $684 weekly wage, resulting in an annual threshold of $35,568, was put into effect on Jan.
What is tax-exempt interest in box 8? ›
Some of this may be tax-exempt. Box 4 reports any federal tax withheld on your interest income by the payer. Box 8 reports tax-exempt interest and relates to interest-bearing investments you hold with state and local governments, such as municipal bonds.
Is interest on an IRA considered tax-exempt interest? ›
You do not need to report interest earned on tax-deferred accounts, such as Traditional IRAs or 401(k)s, until you withdraw the earnings.
What is tax-exempt interest on 1099-INT? ›
The next commonly used box on Form 1099-INT is Box 8, which reports the amount of tax-exempt interest. This type of interest is most often earned off of obligations issued by a state or other governmental entity. This amount is not taxable and is not to be included in the taxpayer's gross income.
Which of the following types of interest income is not taxed as it is earned? ›
C) Interest from Treasury bonds is exempt from federal taxation.
