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
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.
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.
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 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.
What is an example of a tax-exempt account? ›
Two of the most commonly-used tax-exempt accounts in the U.S. are the Roth IRA and Roth 401(k). Contribution limits for Roth IRAs and Roth 401(k)s are the same as for traditional IRAs and 401(k)s. In Canada, the equivalent of these accounts is a tax-free savings account (TFSA).
How do I know if 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.
Are you tax-exempt yes or no? ›
To be exempt from withholding, both of the following must be true: You owed no federal income tax in the prior tax year, and. You expect to owe no federal income tax in the current tax year.
How long can you go tax-exempt without owing? ›
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.
What is tax-exempt income examples? ›
Exempt income is a type of income that isn't subject to taxation. This includes certain types of investment income, such as interest from municipal bonds. Also included are certain government benefits, such as Social Security retirement benefits.
Is tax-exempt a good thing? ›
Federal, state, and local governments create tax exemptions to benefit people, businesses, and other entities in special situations. Those who are entitled save on taxes by reducing their top-line income.
to free from an obligation or liability to which others are subject; release: A grade above B+ is required in order to exempt a student from an examination. Synonyms: except, relieve, excuse.
What is an example of a tax-exempt entity? ›
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).
Why are some people tax-exempt? ›
Who Does Not Have to Pay Taxes? 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.
What is an example of tax free benefit? ›
Tax-free employee fringe benefits include: Health benefits. Health benefits are by far the single most important tax qualified employee fringe benefit. Health benefits include providing employees with health, dental, and vision insurance, and paying for uninsured health-related expenses.
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.
What question is tax-exempt interest income on fafsa? ›
This is question 41d on the Free Application for Federal Student Aid (FAFSA®) PDF. The answer to this question may be prefilled with "Transferred from the IRS." If the answer to this question isn't prefilled, enter the total amount of tax-exempt interest income you reported in 2021.
What is an example of a tax-exempt bond? ›
Examples of Exempt Facility Revenue Bonds
Typical examples are terminals, hangars, aircraft repair facilities, freight forwarding/warehousing facilities, etc. If tax-exempt bonds are to be used to finance such facilities, certain limitations and conditions exist.
