What Is an Exempt-Interest Dividend?
An exempt-interest dividend is a distribution from a mutual fund that is not subject to federal income tax. These dividends are usually derived from mutual funds investing in municipal bonds.
While exempt-interest dividends escape federal tax, they may still be subjected to state income tax or the alternative minimum tax (AMT). It’s crucial, therefore, to report this dividend income on your tax return, typically noted by the mutual fund on Form 1099-INT.
Key Points to Remember
- Exempt-interest dividends come from mutual funds and bypass federal income tax.
- High-net-worth individuals often favor municipal bonds to benefit from tax exemptions.
- While federally exempt, these dividends might not be exempt from state taxes.
- Exempt-interest dividends can fall under the AMT, nullifying some tax benefits.
- Such dividends are reported on Form 1099-DIV in box 12.
Delving Into Exempt-Interest Dividends
A dividend is essentially a company’s profit distribution to its shareholders, detached from obligatory costs like debt. Provided out of net earnings, dividends aren’t expenses but rewards to shareholders, typically delivered quarterly.
For example, Apple’s dividend as of February 2, 2023, stood at $0.23 per share, disbursed four times annually, creating taxable income for its shareholders.
In contrast, an exempt-interest dividend is a mutual fund payout, not subject to federal income tax, primarily derived from municipal bonds.
Prospective Buyers of Tax-Exempt Bonds
Wealthy individuals inclined to save on taxes might invest in municipal bonds to offset their hefty tax obligations with lower-yield, tax-exempt investments. These bonds usually fund community-benefitting projects.
It’s important to note, the tax breaks from such investments are redundant within an IRA because all earnings inside IRAs are essentially tax-exempt.
State Income Tax Implications
The federally exempt status might not extend to state taxes. This depends on where the municipal bonds were issued and where you pay state tax.
For example, if your total dividend interest is $100, with $60 from your state and $40 from another, and your state tax laws exempt in-state bonds, you owe state tax only on the out-of-state $40 portion.
Alternative Minimum Tax (AMT) Considerations
AMT requires a minimal tax level regardless of the deductions claimed via returns. As of 2022, single filers have an AMT exemption of $75,900 and married filers $118,100. For 2023, these are raised to $81,300 and $126,500, respectively.
Exempt-interest dividends might still face AMT to ensure a baseline tax contribution, moderating high earners’ tax elimination strategies.
Forms like IRS Form 6251 ascertain any AMT obligations, with tax software assisting in calculations.
Strategies to Sidestep Investment Income Tax
Investments eliciting tax-free returns, such as municipal bonds representing state or public-approved projects, can yield interest free from federal taxes and potentially state taxes, making attractive options for high-net-worth individuals.
Are Mutual Fund Distributions Subject to Tax?
Generally, yes. Exempt-interest dividends from municipal bond-centric funds are exceptions.
Form 1099-DIV delineates your taxable and tax-exempt dividends post the calendar year-end.
Why AMT Regards Tax-Exempt Interest as Taxable
Designed to ensure high earners pay a justified tax share, AMT consolidates municipal bonds into taxable income, fortifying this objective against tax avoidance tactics.
Related Terms: alternative minimum tax, municipal bonds , dividend, shareholders, IRA, Form 1099-INT, Form 6251, tax-exempt bonds.
References
- Internal Revenue Service. “Topic No. 403 Interest Received”.
- Internal Revenue Service. “Topic No. 556 Alternative Minimum Tax”.
- Internal Revenue Service. “Form 1099-DIV (Rev. January 2022)”.
- Apple. “Dividend History”.
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2022”.
- IRS. “IRS Provides Tax Inflation Adjustments for Tax Year 2023”.
- Internal Revenue Service. “About Form 6251, Alternative Minimum Tax - Individuals”.
