How Tax-Exempt Interest Works
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. But when certain conditions are met, the interest you earn isn’t subject to various kinds of taxes. 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.
Example of Tax-Exempt Interest
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.
What Tax-Exempt Interest Means for You
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.
