What Is Tax-Exempt Interest?

Interest income exempt from federal income tax is known as tax-exempt interest. The tax-exempt interest a taxpayer receives may sometimes restrict their eligibility for other tax benefits. Income-producing investments in Roth retirement accounts or municipal bonds are the most popular places to find tax-exempt interest.

Explanation

The term may be misleading since tax-exempt interest may still be subject to state or municipal taxes. The alternative minimum tax (AMT) can also apply. Moreover, only the interest on tax-free assets is excluded from capital gains taxes; the capital gains on these investments are still subject to taxes. Buying a municipal bond issued in one’s state or area is the most popular method for investors to earn income that is tax-exempt both federally and at the state and local levels.

One of the most popular investment options that pays tax-free interest is municipal bonds; however, even if the interest is exempt from federal taxes, state taxes may still apply. For instance, California income tax is applicable to the interest on a New York municipal bond that a Californian person purchased. States do, however, have different tax rules. While states like California and Arizona exclude interest from taxes if the investor lives in their states, others like Wisconsin and Illinois tax interest earned on most municipal bonds, including their own. As long as the recipient state does not tax bonds issued by Utah, Utah is one example of a state that exempts interest on bonds issued outside of the state. The interest paid on U.S. government-issued Treasury securities is free from federal taxes but not at the state or municipal levels.

An investment, often a municipal bond with interest payments free from local, state, and federal taxes, is triple-tax-exempt.

Local and State Interest Taxes

The Internal Revenue Service (IRS) states that even if an obligation isn’t a bond, interest on state or local government obligations may be excluded from federal taxes. For instance, interest on a debt that can only be verified in writing by a standard purchase and sale agreement could not be subject to taxes. Additionally, interest that an insurer pays after a state or political subdivision defaults may be excluded from taxes.

The percentage of profits from bonds in mutual funds that contain a combination of stocks and municipal bonds is tax-free under federal income tax regulations. Depending on the origin of the bonds and the taxpayer’s place of residency, the amount may also be exempt from state taxes. Effect on AGI (Adjusted Gross Income)

Tax-exempt interest is not included in the adjusted gross income (AGI) computation for taxation purposes since it is not liable to income taxes. When an issuer or lender pays more than $10 in tax-exempt interest, they must declare that interest revenue to the IRS on Form 1099-INT and to taxpayers. Taxpayers or borrowers must report this tax-exempt interest on Form 1040. The IRS uses the amount received as tax-exempt interest to calculate the portion of the taxpayer’s Social Security payments subject to taxation.

Conclusion

• Interest income exempt from taxes, particularly federal taxes, is tax-exempt interest.
• Certain municipal bonds may also be “triple-exempt,” meaning no local or state taxes are due.
• Roth retirement accounts and some other tax-advantaged products and accounts also allow earning tax-exempt interest.