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).
How do I know if my interest is tax-exempt? ›
However, some interest you receive may be tax-exempt. You should receive Copy B of Form 1099-INT or Form 1099-OID reporting payments of interest and/or tax-exempt interest of $10 or more. You may receive these forms as part of a composite statement from a broker.
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 interest income from the IRS? ›
Most interest income is taxable-that is, it is subject to income tax. 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.
Is interest on an IRA considered tax-exempt interest? ›
A traditional IRA is a way to save for retirement that gives you tax advantages. Generally, amounts in your traditional IRA (including earnings and gains) are not taxed until you take a distribution (withdrawal) from your IRA.
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 income does not pay taxes? ›
In most cases, if your only income is from Social Security benefits, then you don't need to file a tax return. The IRS typically doesn't consider Social Security as taxable income.
Although tax-exempt interest is not itself taxable, it can cause the taxation of additional social security benefits because the interest is added to adjusted gross income to form a larger modified adjusted gross income.
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.
How to avoid paying taxes on interest income? ›
Strategies to avoid paying taxes on your savings
- Leverage tax-advantaged accounts. Tax-advantaged accounts like the Roth IRA can provide an avenue for tax-free growth on qualified withdrawals. ...
- Optimize tax deductions. ...
- Focus on strategic timing of withdrawals. ...
- Consider diversifying with tax-efficient investments.
Exemption Rules and Limits under the Income Tax Act
According to the Finance Act of 2014, taxable income eligible for complete tax exemption has been increased in its limits, from the earlier Rs. 200000 to Rs. 250000. It should be kept in mind that these exemptions are allowed for salaried individuals only.
Does Amazon take tax-exempt? ›
Our Amazon Tax Exemption Program (ATEP) supports tax-exempt purchases for sales sold by Amazon, its affiliates, and participating independent third-party sellers.
How many times can you go exempt without owing taxes? ›
The Frequency of Going Exempt:
According to the IRS, you can go exempt from tax withholdings as long as you meet specific criteria and don't exceed one year. However, it's important to exercise caution when considering this option repeatedly or for extended periods.
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.
What are tax-exempt obligations? ›
(B) Tax-exempt obligation The term “tax-exempt obligation” means any obligation the interest on which is wholly exempt from taxes imposed by this subtitle. Such term includes shares of stock of a regulated investment company which during the taxable year of the holder thereof distributes exempt-interest dividends.
What is tax-exempt financing? ›
"Tax-exempt" means that the interest component of bond debt service payments is exempt from federal and sometimes state and local income taxes for the bond holder.
