What is 'Tax-Exempt Interest'

Tax-exempt interest is interest income that is not subject to federal income tax. 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. Furthermore, capital gains on tax-exempt investments are still taxable; only the interest on these investments is tax-exempt. Tax-exempt interest is reported to both taxpayers and the IRS on form 1099-INT. Taxpayers, in turn, must report this tax-exempt interest on form 1040.

BREAKING DOWN 'Tax-Exempt Interest'

The most common way for interest to be 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 interest may only be tax-exempt at the federal level if, for example, a California resident buys a New York municipal bond. These tax laws, however, vary by state. 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.

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