Tax-Exempt Interest Definition

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Tax-Exempt Interest Definition

What Is Tax-Exempt Interest?

Tax-exempt interest is interest income that is not taxed by the federal government. In certain situations, the amount of tax-free interest earned by a taxpayer may restrict the individual’s eligibility for certain additional tax advantages. Municipal bonds and income-producing assets held in Roth retirement accounts are the most prevalent sources of tax-exempt interest.

Key Takeaways

  • Tax-exempt interest is interest income that is not taxed, most notably at the federal level.
  • Some municipal bonds may also be “triple-exempt,” meaning they are tax-free at the federal, state, and local levels.
  • Roth retirement funds, as well as various other tax-advantaged products and accounts, may receive tax-free interest.

Tax-Exempt Interest Explained

Tax-exempt interest might be misleading since it may still be taxed at the state or municipal levels. It may be subject to the alternative minimum tax as well (AMT).Furthermore, capital gains on tax-free assets are remain taxable; only interest on these investments is excluded from taxation. An investor’s most frequent approach to earn tax-free interest at the state and local levels, in addition to the federal level, is to acquire a municipal bond issued in his or her state or town of residence.

Municipal bonds are one of the most frequent forms of tax-exempt investments, but although interest is tax-free at the federal level, it may still be taxed at the state level. A California person, for example, who purchases a New York municipal bond must pay California income tax on the interest. These tax regulations, however, differ from state to state. For example, Wisconsin and Illinois tax income paid on most muni bonds, including their own, but California and Arizona exclude interest from taxation if the investor lives in their states. Utah is an example of a state that exempts interest on out-of-state bonds as long as the issuing state does not levy a tax on Utah bonds. Treasury securities issued by the United States government pay tax-free interest at the state and municipal levels, but not at the federal level.

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A triple-tax-exempt investment, generally a municipal bond, has interest payments that are tax-free at the local, state, and federal levels.

State and Local Taxation of Interest

Interest on a state or local government obligation may be tax-exempt, even though the obligation is not a bond, according to the Internal Revenue Service (IRS). Interest on a debt, for example, that is shown merely by an ordinary written agreement of purchase and sale may be tax-exempt. In addition, interest paid by an insurer on the failure of a state or political subdivision may be tax-free.

Mutual funds that contain a combination of stocks and municipal bonds will have the share of profits produced from the bonds tax-free under federal income tax standards and perhaps tax-free under state tax guidelines depending on where the bonds originated and/or the taxpayer’s place of residence.

Other Considerations

Because tax-exempt interest is not taxable, it is not included in the computation of adjusted gross income (AGI) for tax purposes. Issuers or lenders who pay more than $10 in tax-exempt interest must disclose the interest revenue on Form 1099-INT to both taxpayers and the IRS. In turn, taxpayers or borrowers must declare this tax-free interest on Form 1040. The IRS uses the amount received as tax-exempt interest to calculate how much of the taxpayer’s Social Security payments are taxable.

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