Table of Contents
- What Is Tax-Exempt Interest?
- Understanding Tax-Exempt Interest
- Important Note on Triple-Tax-Exempt
- State and Local Taxation of Interest
- Does Adjusted Gross Income (AGI) Include Tax-Exempt Interest?
- Reporting Tax-Exempt Interest
- Is Tax-Exempt Interest Included in Social Security Calculations?
- What Does Tax-Exempt Interest Income Mean for FAFSA?
- How Do I Know My Tax-Exempt Interest?
- The Bottom Line
What Is Tax-Exempt Interest?
Let me explain tax-exempt interest directly: it's interest income that you don't have to pay federal, state, or local income taxes on. You'll most commonly see this from municipal bonds.
Key Takeaways
- Tax-exempt interest means interest income free from taxes at the federal, state, or local level.
- Certain municipal bonds are triple-exempt, meaning no taxes at federal, state, or local levels.
- You can also earn tax-exempt interest in Roth retirement accounts and similar tax-advantaged setups.
- Earning tax-exempt interest might limit your eligibility for other tax benefits in some cases.
Understanding Tax-Exempt Interest
You need to know that tax-exempt interest might be free from taxes at one level but not others. For instance, it could be exempt federally but taxed at state or local levels, or vice versa—like with Treasury bills, notes, and bonds, which are taxed federally but exempt at state and local.
Remember, this interest could still face the alternative minimum tax (AMT). Also, any capital gains from these investments are taxable; only the interest itself is exempt.
To get interest exempt at all levels—federal, state, and local—buy a municipal bond issued in your own state or municipality. But watch out: if you're a California resident buying a New York municipal bond, you'll pay California tax on that interest. Rules differ by state—Wisconsin taxes most municipal bond interest, even its own, while California and Arizona exempt it for in-state residents. Utah exempts out-of-state bonds if that state doesn't tax Utah bonds.
As I mentioned, U.S. Treasury securities give you interest exempt at state and local levels, but you pay federal tax on it.
Important Note on Triple-Tax-Exempt
Triple-tax-exempt describes investments, typically municipal bonds, where interest payments escape taxes at local, state, and federal levels. That's a key feature you should consider.
State and Local Taxation of Interest
Per the IRS, interest from state or local government obligations can be tax-exempt even if it's not a bond—for example, from a simple written purchase agreement or insurer payments on defaults by the state or subdivision.
If you invest in mutual funds mixing stocks and municipal bonds, the bond-derived earnings are tax-exempt federally and possibly at the state level, based on bond origins and your residence.
Does Adjusted Gross Income (AGI) Include Tax-Exempt Interest?
No, tax-exempt interest isn't included in your AGI calculation since it's not taxable.
Reporting Tax-Exempt Interest
Issuers paying over $10 in tax-exempt interest report it to you and the IRS on Form 1099-INT. You must report it on your Form 1040, even though it's tax-free.
Is Tax-Exempt Interest Included in Social Security Calculations?
Yes, the IRS uses your tax-exempt interest to figure out how much of your Social Security benefits are taxable.
What Does Tax-Exempt Interest Income Mean for FAFSA?
You have to include tax-exempt interest on your FAFSA, as per the instructions: enter any interest you earned without paying taxes on it.
How Do I Know My Tax-Exempt Interest?
If you received it, expect a Form 1099-INT or 1099-OID. Check box 8 on 1099-INT for tax-exempt interest, or box 2 on 1099-OID for tax-exempt OID bonds.
The Bottom Line
Tax-exempt interest is income free from taxes at specific levels: federal, state, or local. Some, like certain municipal bonds, are exempt federally but taxed at state/local depending on your location. Treasury securities are exempt at state/local but not federal. And in-state municipal bonds can be exempt at all three levels.
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