What Is Tax-Exempt Interest?

Tax-exempt interest is interest income that is not subject to federal income tax. In some cases, the amount of tax-exempt interest a taxpayer earns can limit the taxpayer's qualification for certain other tax breaks.

Tax-Exempt Interest Explained

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 (AMT). Furthermore, capital gains on tax-exempt investments are still taxable; only the interest on these investments is tax-exempt.

The most common way to earn interest that is 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 be tax-exempt at the federal level only in a situation where, for example, a California resident buys a New York municipal bond. These tax laws, however, vary by state. For instance, some states such as Wisconsin and Illinois tax interest earned on all muni bonds, including their own, while states such as California and Arizona exempt interest from taxes if the investor resides in their states. Indiana and Florida are examples of states that exempt interest on all muni bonds regardless of the issuing state and origin. 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.

According to the Internal Revenue Service (IRS), interest on a state or local government obligation may be tax-exempt even if the obligation is not a bond. For example, interest on a debt evidenced only by an ordinary written agreement of purchase and sale may be tax-exempt. Also, interest paid by an insurer on default by the state or political subdivision may be tax-exempt. Mutual funds that hold a mix of stocks and municipal bonds will have the portion of earnings derived from the bonds tax-exempt under federal income tax guidelines and possibly exempt from state taxes depending on the location from which the bonds originated and/or the taxpayer's state of residence.

Since tax-exempt interest is not subject to income taxes, it is not included in the calculation of adjusted gross income (AGI) for taxation purposes. Issuers or lenders that pay more than $10 in tax-exempt interest must report the interest income to both taxpayers and the IRS on Form 1099-INT. Taxpayers or borrowers, in turn, must report this tax-exempt interest on Form 1040 or Form 1040A. The amount received as tax-exempt interest is used by the IRS to determine what amount of the taxpayer’s Social Security benefits is taxable.