Tax-Exempt Interest

Tax-Exempt Interest

Definition

Tax-exempt interest is interest income that is not subject to income tax at one or more levels: federal, state, and/or local. The most common source is interest from municipal bonds, but tax-exempt interest can also arise in certain tax-advantaged accounts.

Key points

• Tax-exempt interest may be exempt at the federal level, the state/local level, or all three (“triple-exempt”).
• Capital gains from tax-exempt investments remain taxable — only the interest itself may be exempt.
• Tax-exempt interest can affect eligibility for other tax breaks and the amount of taxable Social Security benefits.
• Treatment often depends on the investor’s state of residence and the origin of the bond.

How it works

• Municipal bonds: Interest on many municipal bonds is exempt from federal income tax; bonds issued by a state or locality are often also exempt from that state’s and municipality’s income tax for residents. Some municipal bonds are exempt from federal, state, and local tax for residents of the issuing jurisdiction (triple-exempt).
• U.S. Treasury securities: Interest on Treasury bills, notes, and bonds is taxable at the federal level but exempt from state and local income taxes.
• Mutual funds: If a mutual fund holds municipal bonds, the portion of the fund’s income derived from those bonds is generally tax-exempt for federal tax purposes and may be exempt at the state level depending on the bond source and your residence.
• Alternative Minimum Tax (AMT): Certain tax-exempt interest may be included for AMT purposes, so exemption from regular income tax does not always mean exemption from AMT.

State and local variations

Tax treatment varies by state:
* Some states exempt interest on in-state municipal bonds for their residents.
* Other states may tax interest on municipal bonds, including in-state issues.
* A few states have rules that exempt out-of-state bond interest under specific conditions.

Always check your state tax rules for bonds issued outside your state or for special state provisions.

Reporting and tax forms

• Payers who report more than $10 in tax-exempt interest issue Form 1099-INT. Tax-exempt interest is typically shown in box 8 of Form 1099-INT.
• For tax-exempt Original Issue Discount (OID) bonds, the amount appears on Form 1099-OID (box 2).
• Tax-exempt interest is reported on Form 1040, even though it is not taxed at the federal level.
• Tax-exempt interest is not included in adjusted gross income (AGI) for federal income tax calculations.

Other implications

• Social Security: Tax-exempt interest is included when determining whether a portion of Social Security benefits is taxable.
• FAFSA: Tax-exempt interest must be reported on the Free Application for Federal Student Aid (FAFSA) as interest you earned on which you paid no taxes.
• Capital gains from selling tax-exempt investments are taxable and reported separately.

How to tell if your interest is tax-exempt

• Look for tax-exempt amounts on Form 1099-INT (box 8) or Form 1099-OID (box 2).
• Review the bond’s offering documents or ask the issuer/broker whether interest is federal tax-exempt and whether it’s exempt for residents of your state.

FAQs

Q: Is tax-exempt interest included in AGI?
A: No — tax-exempt interest is not included in AGI for federal income tax purposes.

Q: Does tax-exempt interest affect Social Security taxation?
A: Yes — tax-exempt interest is counted when calculating whether a portion of Social Security benefits is taxable.

Q: What does “triple-exempt” mean?
A: It refers to interest that is exempt from federal, state, and local income taxes (typically municipal bonds issued by the taxpayer’s state/municipality).

Q: Are capital gains on tax-exempt bonds tax-free?
A: No — capital gains from selling tax-exempt bonds are taxable.

Bottom line

Tax-exempt interest can reduce your federal and sometimes state/local tax burden, but treatment varies by instrument and jurisdiction. Understand where a bond is issued, review state rules, and check reporting forms (1099-INT/1099-OID) to determine how interest should be reported and whether it affects other tax calculations.