Tax-exempt interest is a form of interest income that is not subject to federal income tax. In some scenarios, earning tax-exempt interest can affect eligibility for other tax benefits. The primary sources of tax-exempt interest are municipal bonds and certain assets within Roth retirement accounts.
Key Takeaways
-
Tax-Exempt Nature: Tax-exempt interest refers to income that isn’t taxed at the federal level, making it a valuable component of a tax-efficient investment strategy.
-
Varied Tax Scope: Some municipal bonds may be “triple-exempt,” where the interest is free from federal, state, and local taxes.
-
Retirement Accounts: Beyond municipal bonds, Roth retirement accounts also offer tax-exempt interest along with some other tax-advantaged investment vehicles.
Clarifying Tax-Exempt Interest
While the term ’tax-exempt interest’ suggests freedom from taxes, this interest can still be taxed at state or local levels. It could also be subject to the alternative minimum tax (AMT). Moreover, capital gains on these investments are still taxable; only the interest itself is exempt. An investor can achieve tax-exempt status at state and local levels by purchasing municipal bonds issued by the state or locality in which they reside.
Examples with Practical Implications
-
State and Local Variations: While municipal bonds are a prevalent example of tax-exempt interest, their tax status can vary. For instance, a resident of California who buys a New York municipal bond would still owe California state taxes on that interest. Ohio and Illinois impose state tax on most municipal bond interest, even within their bonds. On the other hand, states like California and Arizona offer exemptions for in-state municipal bond interest.
-
Treasury Securities: US Treasury securities provide interest that is exempt from state and local taxes but is taxed federally. Similarly, investments like triple-tax-exempt municipal bonds offer federal, state, and local tax relief, enhancing their attractiveness.
State and Local Taxation Nuances
The IRS notes that even if an obligation is not bonded, the interest can still be tax-exempt. Examples include interest from debts documented via ordinary purchase agreements or insurance agreements covering defaults by states or political subdivisions.
Mutual Funds and Tax Implications
Mutual funds that diversify portfolios with a mix of stocks and municipal bonds offer a portion of income that is tax-exempt under specific conditions. The exemption status can depend on the origination and investment state’s tax regulations.
Effect on Adjusted Gross Income (AGI)
Since tax-exempt interest isn’t subjected to income taxes, it’s excluded from the adjusted gross income (AGI) calculation for tax purposes. However, issuers of such interest, paying more than $10 annually, are required to report this to the IRS through Form 1099-INT. Taxpayers then must document this amount in their own filings using Form 1040—the IRS scrutinizes tax-exempt interest to determine taxable amounts of Social Security benefits.
Dive deeper into tax-exempt interest strategies and explore specific bonds or Roth IRAs to integrate these optimizations in your financial planning.
Related Terms: income tax, alternative minimum tax, adjusted gross income, capital gains, Roth IRA.
References
- Internal Revenue Service. “Instructions for Form 6251: Alternative Minimum Tax”, Page 1.
- Internal Revenue Service. “Publication 550: Investment Income and Expenses,” Page 11.
- Internal Revenue Service. “Publication 550: Investment Income and Expenses”, Page 11.
- State of California, Franchise Tax Board. “2018 Supplemental Guidelines to California Adjustments”, Page 5.
- State of Wisconsin, Department of Revenue. “Individual Income Tax State and Municipal Bond Interest”.
- Illinois Department of Revenue. “Publication 101: Income Exempt from Tax”, Page 4.
- Arizona Department of Revenue. “Identifying Other Taxable Income”.
- California Constitution. “Article XIII: Taxation (Sec. 26)”.
- Utah State Tax Commission. “Municipal Bond Interest (Code 57)”.
- Internal Revenue Service. “Topic No. 403: Interest Received.”
- Internal Revenue Service. “Instructions for Form 1099-DIV”, Page 4.
- Internal Revenue Service. “Form 1040 (2019)”, Page 1.
- Internal Revenue Service. “About Form 1099-INT, Interest Income”.
- Internal Revenue Service. “Income, Wages, Interest, Etc.”, Page 8.
