Tax-Exempt Interest Income: Your Path to Tax-Free Earnings

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• Tax-exempt interest comes mainly from municipal bonds and U.S. Treasury bonds.
• Interest from Treasury bonds, bills, and notes is federally taxed.
• Muni bond interest is not federally taxed and may be exempt from state and local taxes.

There are plenty of reasons to buy bonds. Many investors are attracted to municipal bonds and U.S. Treasury bonds, in particular, for their tax-exempt status.

"Individuals are always looking for a return on principal, and so tax-exempt interest is a very appealing item to individuals, especially those who live in zero-income-tax states," says Danny Moore, a certified public accountant and managing partner of tax at Galway Family Office.

Tax-exempt interest refers to interest that's excluded from your gross income calculation at the federal level, the state/local level, or both. Here's how it works.

Tax-exempt interest from municipal bonds

What are municipal bonds?

Municipal bonds, or muni bonds, are typically issued by state and local governments and U.S. territories. They finance government operations and projects, such as building schools or restoring roads.

The two main types of muni bonds are revenue and general obligation. Revenue bonds can be slightly riskier because repayment relies on revenue from a specific project or source. Repayment of general obligation bonds comes from the issuing state or local government, which can raise taxes to pay off the bonds if needed.

Tax advantages

Usually, bondholders receive two interest, or coupon, payments a year, which are not subject to federal income tax. After a set period of time, bondholders receive their original investment back.

Investors can buy muni bonds from the state or locality in which they reside, or from another state or locality. Typically interest income from muni bonds — or muni bond funds — issued by your home state is not taxable there.

Risks and considerations

Your muni bond interest income may not be fully tax-exempt at home if you buy an out-of-state bond, says Derrick Doerr, a CPA and vice president at financial-services firm Nepsis in Minneapolis.

State rules vary, but generally, the interest you earn from an out-of-state bond can trigger taxes in your home state. Exceptions include Washington D.C. and some states with no income tax, such as Florida.

Also, Doerr notes, "Municipal bonds are generally low risk, but not risk-free." One risk is that muni bonds can be called early by the issuer. This often happens when interest rates fall, and can leave an investor choosing from lower-paying alternatives.

If you're a high earner, there's something else to consider: Interest from private activity bonds, a type of muni bond issued by a private business and not a government entity, may not be tax-exempt if you pay the Alternative Minimum Tax (AMT). AMT may apply to individuals with incomes over $609,350 or married couples filing jointly with incomes above about $1.2 million.

Note: The U.S. Securities and Exchange Commission recommends reading official statements and disclosures from bond issuers and reviewing trade prices of municipal bonds you are considering buying.

Tax-exempt interest from U.S. Treasury Securities

What Are U.S. Treasury Securities?

Tax-exempt interest income can also come from U.S. Treasury Securities. Interest is paid semiannually and subject to federal taxation, but exempt from state and local taxes.

Treasurys are backed by the federal government and are categorized by their maturities, or how long it takes to return your original investment (principal). Bills mature within a year, notes mature within 10 years, and bonds mature in 20 or 30 years.

Treasury Inflation Protected Securities (TIPS) are a type of Treasury bond that protects your investment from inflation. They're available in terms of five, 10, or 30 years. The interest rate is fixed, and semiannual payments are only federally taxable, but your principal can fluctuate.

Interest earned from Series EE and Series I Savings Bonds are also exempt from state and local taxes. Interest, which is collected at maturity or whenever you cash the bond, could be exempt from federal taxation if you use the proceeds for qualified higher education expenses, though several rules apply.

Tax advantages

Treasurys produce fixed interest that's not subject to state or local taxes, offering predictable income for bondholders.

For T-bonds, bills, and notes, you have to include the interest in your federal gross income each year that you collect it. For savings bonds, interest isn't paid until the bond is redeemed, so you have the choice to pay federal taxes on it in the year you collect or spread it out over the life of the bond.

Risks and considerations

Treasurys are the closest thing to a risk-free investment since they're backed by the full faith and credit of the federal government. But you still owe federal taxes on the interest income.

Much of the risk associated with Treasurys is in how long they take to mature. Interest rates are fixed for the life of the bond, which can be as high as 20 or 30 years for bonds or up to 10 years for bills. If interest rates rise on newly issued Treasurys, the value of existing bonds drops. This is referred to as interest rate risk.

If rates go up and you decide to sell a bond before its maturity date, you may experience a significant loss because there's less demand for lower-yield bonds. If you hold on to the bond, you may be losing out on a higher-return investment.

Tax-exempt interest from other investments

Other types of investments may produce a kind of tax-exempt interest or return. For example, investment gains in a 529 college savings plan are not taxable at the federal or state levels if the funds are used for education.

Similarly, some might consider Roth IRAs a tax-exempt investment, since the accounts are funded with posttax dollars, which grow tax-free and can be withdrawn penalty- and tax-free under certain circumstances, such as reaching age 59 and a half.

Taxable interest vs. tax-exempt interest

Many corporate bonds have higher advertised interest rates than tax-exempt bonds, but the interest is fully taxable. It can seem like a no-brainer, then, to opt for a bond that gives you a tax break over one that doesn't.

But, Moore says, "It's not just a federal tax-free amount" with municipal bonds. "You have to look at the states and you have to look at somebody's complete tax picture to see if it makes sense."

When comparing bonds, investors need to find the tax-equivalent yield of their bond options to see which produces a higher after-tax return, says Doerr. A specialized calculator, like this one from Fidelity, can help crunch the numbers.

And although the IRS (and many state governments) exempt certain interest income from the computation of income tax, those amounts may later be added back in other situations.

For federal income tax calculation purposes, tax-exempt interest is added back to figure your modified adjusted gross income, which is a crucial figure that determines deductible contributions to traditional IRAs, eligibility for a Roth IRA, and qualification for education credits, healthcare credits, and the Child Tax Credit. It's also used to figure out how much of your Social Security benefits are taxable.

Estimate your taxes

FAQs about tax-exempt interest income

Is interest from my savings account tax-exempt?

No, interest from savings accounts isn't tax-exempt. You'll get a 1099-INT from your bank with the amount of interest earned during the year, which should be included in your gross income.

Are dividends from stocks tax-exempt?

Dividends from stocks and generally not tax-exempt. Qualified dividends are taxed at capital gains rates (0%, 15%, 20%), while nonqualified dividends are taxed at ordinary rates (10%, 12%, 22%, 24%, 32%, 35%, 37%).

How do I report tax-exempt interest on my tax return?

Tax-exempt interest is reported on Line 2a of your Form 1040. You'll find the amount of tax-exempt interest you earned in Box 8 of your 1099-INT. Reporting the interest is required, but doesn't make it taxable.