Certain investments, such as municipal bonds, can generate interest that is exempt from federal, and sometimes even state and local, income taxes. This makes them especially appealing to high-income earners, retirees and those looking to build a more tax-efficient portfolio. However, not all interest income qualifies. Knowing which sources are truly tax-exempt can help you make smarter financial decisions.
A financial advisor can help you identify which types of tax-exempt investments align with your income needs, risk tolerance and long-term goals.
What Is Tax-Exempt Interest Income?
Tax-exempt interest income is income earned from investments that are not subject to federal income taxes. In some cases, it’s also exempt from state or local taxes.
Most often, this type of income comes from certain types of municipal bonds or other government-issued securities designed to promote public projects like schools, hospitals or transportation infrastructure. The interest is exempt from taxation to encourage investment in public initiatives.
While tax-exempt interest income is excluded from federal income tax calculations, it may still be subject to state and local taxation. Whether or not it is depends on the type of investment and where you live. For instance, a municipal bond issued by a city or county in your home state is typically exempt from both federal and state taxes. However, say you purchase a bond from a different state. In that case, you may owe state income tax on the interest, even if it remains federally tax-exempt.
It’s also important to note that you still must report tax-exempt interest income on your federal tax return. The IRS requires disclosure of this income, usually via Form 1099-INT. While this income doesn’t affect your taxable income, it may factor into other financial calculations, such as eligibility for certain credits or the taxation of Social Security benefits.
5 Examples of Tax-Exempt Interest Income
As we mentioned above, tax-exempt interest income is often associated with government or municipal entities that use the funds for public works and community development. For investors, these investments offer a way to earn passive income while limiting or avoiding the impact of federal taxes. Here are five common examples of tax-exempt interest income.
One of the most well-known sources of tax-exempt interest income is municipal bonds, often referred to as “munis.” These bonds are issued by states, cities, counties and other local government entities to finance public projects. When you purchase a municipal bond, you’re essentially lending money to the issuer in exchange for periodic interest payments. And in many cases, that interest is exempt from federal income tax.
If the bond is issued by your home state or a municipality within it, the interest may also be exempt from state and local taxes. This triple tax advantage (federal, state and local) makes municipal bonds especially attractive to investors in higher tax brackets. However, not all municipal bonds are tax-exempt. Some, known as “private activity bonds,” may be subject to the alternative minimum tax (AMT).
2. Qualified 501(c)(3) Bonds
These is a type of private activity bond issued to fund projects for nonprofit organizations, such as hospitals, universities and charitable institutions. When properly structured, the interest earned from these bonds can be exempt from federal income tax. In some cases, it’s also exempt from state taxes.
501(c)(3) bonds must meet strict requirements to maintain their tax-exempt status. This includes ensuring that proceeds are used exclusively for charitable or public purposes. Because they’re often used to fund large-scale public health or education projects, they provide a socially responsible way to invest while receiving tax-free interest income.
3. U.S. Territory Bonds (e.g., Puerto Rico, Guam)
Bonds issued by U.S. territories including Puerto Rico, Guam, the U.S. Virgin Islands and American Samoa offer a unique tax advantage. Interest from these bonds is typically exempt from federal, state and local income taxes, regardless of the investor’s residency.
This triple exemption makes them appealing to investors nationwide. However, U.S. territory bonds may carry different levels of risk depending on the financial health of the issuing territory. Before investing in these bonds, it’s a good idea to evaluate the creditworthiness of the issuer. You might also want to consult with a financial advisor to determine if the potential tax benefits outweigh any associated risks.
4. Build America Bonds (Tax Credit Variant)
Build America Bonds (BABs) are generally taxable. However, a special variant of these bonds issued in 2009–2010 under the American Recovery and Reinvestment Act offered tax credits to bondholders instead of tax-exempt interest. Depending on the structure of the bond, the income might be excluded from taxation or partially offset by a federal tax credit.
There are no new BABs are being issued today. But some remain in circulation and may still offer tax advantages depending on how they were originally structured. If you’re holding older BABs, you might consider reviewing their specific tax treatment with a financial professional.
5. State-Specific Tax-Exempt Savings Programs
Certain state-sponsored savings programs, such as prepaid tuition plans or education-related bond programs, may offer tax-exempt interest income at the state level. While the federal government may still tax these earnings in some cases, the state tax exemption can be valuable for residents investing in their own state’s education or infrastructure initiatives.
To qualify for these benefits, you typically need to invest in a program offered by your state of residence. You’ll also want to review the program’s guidelines and tax treatment to ensure the income you earn qualifies as tax-exempt.
Frequently Asked Questions
How do I know my tax-exempt interest?
You’ll typically find your tax-exempt interest income listed on Form 1099-INT. This form is typically issued by the financial institution or brokerage where the investment is held. Box 8 of the form specifically reports tax-exempt interest. Box 9 may show private activity bond interest subject to AMT. You can also determine whether an investment will generate tax-exempt interest by reviewing the bond’s prospectus or asking your broker.
What does tax-exempt interest income mean for FAFSA?
On the FAFSA (Free Application for Federal Student Aid), tax-exempt interest income is still counted as part of a family’s adjusted gross income (AGI). As such, it can influence financial aid eligibility. It’s necessary to report this income in FAFSA’s financial information section, even though it’s excluded from federal income tax. The reasoning is that tax-exempt income still contributes to a household’s financial resources and thus can affect how much need-based aid a student receives.
Is tax-exempt interest included in Social Security calculations?
Yes, the IRS includes tax-exempt interest income when determining if your Social Security benefits are subject to federal tax. The IRS uses a formula known as “combined income” to determine this, which includes:
If your combined income exceeds certain thresholds ($25,000 for individuals or $32,000 for married couples filing jointly), a portion of your Social Security benefits may become taxable. That’s even if you technically earned tax-exempt interest.
Bottom Line
Investors can leverage tax-exempt interest income to reduce their tax burden while maintaining a steady stream of investment income. Whether you’re investing in municipal bonds, U.S. territory bonds or nonprofit-backed securities, these options offer opportunities to grow your wealth in a tax-efficient manner. However, tax-exempt doesn’t mean tax-ignored. You still need to report this income and understand how it interacts with other parts of your financial life, from college aid to Social Security.
Tax Planning Tips
- A financial advisor can help manage your tax liability. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Mandatory distributions from a tax-deferred retirement account can complicate your post-retirement tax planning. Use SmartAsset’s RMD calculator to see how much your required minimum distributions will be.
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