DEFINITION of Nontaxable Dividends

Nontaxable dividends are dividends from a mutual fund or some other regulated investment company that are not subject to taxes. These funds are often not taxed because they invest in municipal or other tax-exempt securities.

BREAKING DOWN Nontaxable Dividends

A mutual fund is an investment vehicle made up of a pool of money collected from many investors. Mutual funds invest in securities such as stocks, bonds, money market instruments, and other assets. Investors receive two types of earnings from mutual fund shares: dividends and interest from the securities held in the fund portfolio, or investment income; and capital gains that result from the for-profit sale of portfolio securities.

Investment income can be reinvested in the fund or paid in cash to the investor. Either way, it is taxable as ordinary income, depending on the investor's marginal tax bracket.

Nontaxable Dividends

Not all dividends are subject to taxation, however. One common type of tax-exempt income is interest earned on municipal bonds, which are bonds issued by states and cities to raise funds for general operations or a specific project. When a taxpayer makes interest income on municipal bonds issued in their state of residence, the profit is exempt from both federal and state taxes.

A mutual fund must primarily invest its capital into tax-exempt investments for its dividends to be classified as nontaxable.

Municipal Bonds

Municipal bonds (or “munis” for short) are debt securities issued by states, cities, counties, and other government entities to fund day-to-day obligations and to finance capital projects such as building schools, highways, or sewer systems. By purchasing municipal bonds, you are in effect lending money to the bond issuer in exchange for a promise of regular interest payments, usually semi-annually, and the return of the original investment, or “principal.” A municipal bond’s maturity date (the date when the issuer of the bond repays the principal) may be years in the future. Short-term bonds mature in one to three years, while long-term bonds won’t mature for more than a decade.

Generally, the interest on municipal bonds is exempt from federal income tax. The interest may also be exempt from state and local taxes if you reside in the state where the bond is issued. Bond investors typically seek a steady stream of income payments and, compared with stock investors, may be more risk-averse and more focused on preserving, rather than increasing, wealth. Given the tax benefits, the interest rate for municipal bonds is usually lower than on taxable fixed-income securities such as corporate bonds.