Mutual funds that offer exempt-interest dividends are typically invested, in whole or in part, in municipal bonds. These bonds are not subject to federal taxation. In some cases, they aren’t subject to state taxation, either. Some not-for-profit entities may also issue tax-exempt bonds. State and local bonds have been exempt from taxation since the inception of the income tax in 1913. The federal government created the exemption in order to encourage state and local investment in infrastructure projects. Municipal bonds are generally rated higher and are considered safer than corporate bonds. As a result, mutual funds composed of municipal bonds are a popular investment for high-net-worth individuals looking to minimize their federal tax burden, even though state and local bonds tend to generate low rates of return. Mutual funds that issue dividends send shareholders Form 1099-INT, which details the amount of interest income, the payer’s and shareholder’s identifying information, and tax information. Shareholders are then obligated to report their earnings as income on their Form 1040. Municipal bonds cannot be used to avoid paying taxes entirely. In 1969, Congress enacted the individual Alternative Minimum Tax (AMT). The AMT was designed to prevent high-income individuals from using loopholes to avoid paying taxes entirely. The AMT was designed to ensure that everyone remits a baseline of taxes to the federal government. Thus, investors who earn income via exempt-interest dividends may still be liable for taxes under the AMT.
Example of Exempt-Interest Dividends
Some examples of funds that may pay out tax-exempt interest include Vanguard Massachusetts Tax-Exempt Fund (VMATX), which seeks to invest in securities exempt from federal and Massachusetts personal income taxes. Another example is Fidelity Conservative Income Municipal Bond Fund (FCRDX), which aims to invest at least 80% of its assets into municipal debt securities not subject to federal income taxes.
Pros and Cons of Exempt-Interest Dividends
Pros Explained
Useful in tax planning: High-net-worth individuals can use exempt-interest dividends to minimize their tax burden.Reliable: Exempt-interest dividends are usually reliable and the underlying bonds are considered to carry a low risk of default compared to other types such as corporate bonds.
Cons Explained
Need to report on tax return: Even though exempt-interest dividends are not taxable, investors still need to report them to the IRS on their tax return.Smaller returns than other investments: Because exempt-interest dividends come from mutual funds made up of low-risk bonds, the returns you get may be smaller over time than investments in stocks.
What Exempt-Interest Dividends Mean For Individual Investors?
The benefit of exempt-interest dividends is that they are typically not subject to federal income taxes. However, mutual funds that pay out such dividends invest in securities that may yield a low rate of return.
Also bear in mind that these dividends may be subject to state taxes or, in the case of high-income earners, AMT. If you’re interested in preserving your wealth rather than growing it and AMT is not an issue for you, you’ll likely appreciate the low risk presented by mutual funds that offer exempt-interest dividends.
