Tax-exempt interest is money that you receive in the form of interest that is not subject to certain taxes. Not all interest is tax-exempt, but sometimes you can earn a yield on some assets without incurring additional taxes. Let’s take a closer look at what tax-exempt interest entails.
Definition and Examples of Tax-Exempt Interest
Typically, when you receive interest, such as the yield on money sitting in a savings account or interest paid to bondholders, you have to pay taxes on those additional earnings. However, some types of interest are tax-exempt, which could mean that you don’t have to pay certain taxes, such as federal income or state income taxes.
Just because something counts as tax-exempt interest doesn’t mean that it is exempt from all types of taxes.
For example, municipal bonds, which are issued by governments (such as at the state or city level), often generate tax-exempt interest. But while the interest on these bonds tends to be federally tax-exempt, you might not be able to avoid state or local taxes, for instance, if you reside in a state outside of where the municipal bond was issued. Interest from municipal bonds also could trigger other types of taxes in some specialized situations, such as the alternative minimum tax.
Meanwhile, federal government debt in the form of Treasury bills, notes, or bonds provides tax-exempt interest in terms of state and local taxes but you still could have to pay federal income tax on interest from these Treasury securities.
Sometimes tax-exempt interest can be a bit more nuanced. For example, some or all of the interest from Series EE or I U.S. savings bonds issued after 1989 could be tax-exempt if the interest is used for qualified higher education expenses, among other requirements.
How Tax-Exempt Interest Works
Tax-exempt interest means some assets generate interest that then does not count as taxable income, such as for federal or state income tax purposes. However, the specifics about what types of taxes the interest is exempt from can vary, based on the assets and taxpayer circumstances.
Also keep in mind that you may need to meet certain tax reporting requirements, even if something counts as tax-exempt interest. Doing so would be for informational purposes only, but don’t assume that you can ignore tax-exempt interest when it comes to tax filing.
The amount you receive in tax-exempt interest for a given tax year would often be provided to you by the interest payer via Form 1099-INT or Form 1099-OID.
In addition to certain types of assets being tax-exempt, you also can generate tax-exempt interest within certain types of accounts. For example, if you have a retirement account like a Roth IRA, you might have some assets like bond funds that pay interest within that account. Yet that interest would be tax-exempt, assuming you meet the Roth requirements to be able to take tax-free distributions.
Non-Roth retirement accounts, like traditional IRAs, also could receive interest that wouldn’t necessarily be reportable or taxable in the year the interest is received. Instead, the interest would accrue on a tax-deferred basis, and you would then start to pay taxes once you take distributions from the account.
What Tax-Exempt Interest Means for Individuals
Understanding tax-exempt interest can help individuals properly file their taxes and potentially save money. Knowing what types of assets generate tax-free interest could also affect investment decisions, such as if you choose to invest more in municipal bonds that generate tax-exempt interest, as opposed to, say, corporate bonds.
However, the risk/return benefits associated with various assets may differ, so you might not want to base your decision entirely around taxes. Consider consulting with a professional to see how you can take advantage of tax-exempt interest based on your circumstances.
- Tax-exempt interest involves earnings from interest payments that are not subject to certain taxes, such as federal or state income taxes.
- Many types of interest are taxable; tax-exempt interest generally applies to more nuanced or niche situations.
- Tax-exempt interest still might need to be reported on a tax return, even if the interest does not incur a tax liability in terms of payment.