What Is an Exempt-Interest Dividend?

An exempt-interest dividend is a distribution from a mutual fund that is not subject to federal income tax. Exempt-interest dividends are often associated with mutual funds that invest in municipal bonds. While exempt-interest dividends are not subject to federal income tax, they may still be subject to state income tax or the alternative minimum tax (AMT). The dividend income must be reported on the income tax return and it is reported by mutual funds on Form 1099-INT.

Key Takeaways

  • An exempt-interest dividend is a distribution from a mutual fund that is not subject to federal income tax.
  • High-net-worth investors, due to their high-income tax brackets, often invest in municipal bonds to take advantage of the tax breaks.
  • Though exempt from federal income tax, interest dividends from municipal bonds may or may not be exempt from state taxes.
  • Interest-dividend may also be subject to the alternative minimum tax (AMT) even if it is exempt from federal or state income taxes.
  • Tax-exempt interest dividends are reported on Form 1099-DIV in box 11.

Understanding an Exempt-Interest Dividend

A dividend is a distribution of a company's profits to shareholders. Because it is not an incurred cost it is not classified as an expense, such as a non-operating interest expense. The most common form of dividends is found through corporate stocks, whereby shareholders receive dividend payments on a periodic basis throughout the year.

For example, Apple's most recent dividend as of Feb. 5, 2021, was $0.205 per share. Apple makes four dividend payments a year, all of which are taxable and paid by the shareholders.

An exempt-interest dividend is a payment from a mutual fund that is not subject to federal income tax and is mainly found in mutual funds on some municipal bond investments. Individuals with high-net-worths are more likely to use municipal bonds because the tax savings outweigh the lower returns provided by the investments. High-net-worth individuals are subject to higher taxes so a low-tax investment is often a popular choice.

The types of municipal bonds that are exempt from taxes have to be bonds whose funds are used for benefiting the community as opposed to funds used for private reasons.

The tax benefits provided by the investments, including exempt-interest dividends, are lost if the investments are held in an individual retirement account (IRA). This is because all dividends and interest within an IRA are tax-exempt.

State Income Tax

The dividend interest that is federally exempt may or may not be exempt from state taxes, depending on the state where the municipal bonds were issued and where you are filing your taxes.

Depending on the state, they may allow the entire portion of your dividend interest to be exempt or only the portion of the bonds that are issued in the state you are filing your taxes, while bonds from other states will be taxed.

For example, assume you have a total dividend interest of $100; $60 of which comes from the state you reside in and $40 from another state. The state you reside in only allows exemptions from its taxes on bonds within the state, so you do not have to pay state tax on the $60 but you will have to on the $40.

Alternative Minimum Tax (AMT)

The alternative minimum tax (AMT) places a floor on the percentage of taxes that an individual must pay, regardless of how many deductions or exemptions they may claim on their returns. In the U.S. the AMT exemption amount for 2020 is $72,900 for singles and $113,400 for married couples filing jointly. For 2021, the AMT is $73,600 for singles and $114,600 for married couples filing jointly.

The goal of the AMT is to ensure that individuals pay a certain level of taxes without escaping their obligation through various tax breaks. Therefore, exempt-interest dividends can be subject to the AMT to ensure individuals are not avoiding their fair share of tax payments.

IRS Form 6251 will help individuals determine if they owe an alternative minimum tax (AMT) or tax software will automatically calculate it for them. It is also always prudent to use a tax professional to help prepare your taxes if there are complex aspects to it, such as tax-exempt distributions.