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
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 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 a tax-exempt interest example? ›
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.
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.
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.
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).
Is tax-exempt a good thing? ›
A tax exemption reduces or eliminates a portion of your income from taxation. 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.
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).
What is tax-exempt accrued interest? ›
Form 1099-INT - Accrued Interest. If you state that all your tax-exempt interest is accrued tax-exempt interest, you are essentially saying that none of the interest is attributable to you. When you buy a bond between interest payment dates, there is interest that has accrued since the last interest payment date.
Interest on bonds, mutual funds, CDs, and demand deposits of $10 or more is taxable. Taxable interest is taxed just like ordinary income. Payors must file Form 1099-INT and send a copy to the recipient by January 31 each year. Interest income must be documented on Schedule B of IRS Form 1040.
How do I know if I'm exempt from income tax? ›
You can claim exemption from withholding only if both the following situations apply: For the prior year, you had a right to a refund of all federal income tax withheld because you had no tax liability. For the current year, you expect a refund of all federal income tax withheld because you expect to have no liability.
What should I put for personal exemption? ›
The deduction for personal exemptions is suspended (reduced to $0) for tax years 2018 through 2025. If a taxpayer can be claimed as a dependent on a taxpayer's return, they must check the box on Form 1040 that indicates that they can be claimed as a dependent.
Is it better to claim 0 or exempt? ›
When you claim 0 on your taxes, you have the largest amount withheld from your paycheck for federal taxes. If your goal is to receive a larger tax refund, then it will be your best option to claim 0.
Am I exempt from withholding if I'm 16? ›
Generally, if a minor's income does not exceed the standard deduction he or she will not be required to file a tax return. If the above scenario is true, then the minor can check the box on Form W-4 that classifies he or she as exempt from withholding.
