Tax-Exempt Interest: Definition & Example

KEY TAKEAWAYS

• Tax-exempt interest is an amount of interest income that isn’t subject to regular federal income tax. However, certain tax-exempt interests can be taxed at the local or state levels.
• Certain tax-exempt municipal bonds are triple-exempt. This means that you will not have to pay taxes at the local, state, or federal levels.
• Roth retirement accounts are an effective way of earning tax-exempt interest.

What Is Tax-Exempt Interest?

Tax-exempt interest is an amount of interest that isn’t subject to the regular federal income tax. Even though you might have to still report it on your return, it doesn’t mean you have to include it in your taxable income.

And since it’s exempt from the taxable income you earn, it isn’t subject to federal tax. As well, there can be times when you may not qualify for certain tax breaks since you can be limited by the amount of tax-exempt interest you earn.

How Tax-Exempt Interest Works

Tax-exempt interest isn’t subject to federal income tax. In most cases, there are three distinct types of tax-exempt interest. It can be interesting that it’s redeemed from a Series EE or Series I bond or interest earned on various Veteran Affairs (VA) insurance dividends. The final type of tax-exempt interest is interest earned on certain bonds that are used to help finance government projects.

Let’s take a closer look at how each of them works.

• Interest from a Series EE or Series I bond — These are types of savings bonds issued by the U.S. government. Interest earned on bonds issued after 1989 can be excluded from your income. However, you can only exclude the interest if you paid cash for higher-education expenses. The Educational Savings Bond Program also has a few requirements you will need to meet.
• Interest from VA insurance dividends — Some people choose to leave interest earned on insurance dividends on deposit. The interest is considered to be tax exempt.
• Interest from government projects — Depending on the type of bond purchased, it might not be taxable at the federal level. However, you will still have to report the income on your tax return. These are often considered municipal bonds and can be purchased through a mutual fund.

Essentially, tax-exempt interest isn’t always going to be exempt from certain taxes. For example, if you qualify for the alternative minimum tax (AMT) you might need to include any interest earned on bonds purchased. You do this when you are calculating how much is owed.

How Do I Claim Tax-Exempt Interest Income?

When you receive tax-exempt interest from various bonds, you should also receive Form 1099-INT or Form 1099-OID from the payer. Once you are able to calculate your total tax-exempt interest, you will fill in box 8 of Form 1099-INT. For any tax-exempt OID bonds, you will use box 2 of Form 1088-OID. From here, you will then include your tax-exempt OID in box 11 of Form-1099-OID.

For a deeper breakdown of everything you need to know for tax-exempt interest income, refer to the Instructions for Schedule on the Internal Revenue Service (IRS) website.

Examples of Tax-Exempt Interest

You often have to pay taxes on additional income you receive when you receive interest. This could be the yield on money in a savings account or the interest given to bondholders, for example. However, some interest types are exempt from taxes. This may imply that you are not required to pay specific taxes like federal income taxes or state income taxes.

For instance, tax-exempt interest is frequently generated by municipal bonds. These are issued by governments and they can be at the local, state, or federal levels. The interest on these bonds is often not subject to federal taxes. But, if you live in a state other than the one where the municipal bond was issued, you might not be able to escape state or local taxes.

In some unique circumstances, such as the alternative minimum tax, interest from municipal bonds is subject to other taxes. Treasury bills, notes, and bonds issued by the federal government offer tax-exempt interest in terms of state and local taxes. However, the interest earned on these Treasury securities may still be subject to federal income tax.

Summary

Interest income that is exempt from federal income tax is referred to as tax-exempt interest. In rare circumstances, a taxpayer’s eligibility for certain other tax advantages may be restricted. This often comes from the amount of tax-exempt interest the person earns.

Municipal bonds and income-producing investments held within Roth retirement accounts are the most frequent sources of tax-exempt interest. The IRS website — Instructions for Schedule B — breaks down exactly how to claim tax-exempt interest as well as instructions for Form 1099 and Form 1088. You can always speak to your mutual fund manager if you have additional questions.