Reporting tax-exempt interest on Form 1040 is required even though the interest is not taxed. This type of income often comes from municipal bonds and must be listed on your tax return to follow IRS rules. A financial advisor can help you track and report this income correctly as part of your overall tax strategy. Here’s what you need to know.
What Is Tax-Exempt Interest?
Tax-exempt interest refers to interest income earned from specific bonds and investments that the federal government does not tax. Most often, tax-exempt interest comes from municipal bonds that were issued by states, counties, cities or local government entities. Investors benefit from tax-exempt interest because it’s not included in taxable income for federal purposes, potentially lowering their overall tax liability.
The IRS considers tax-exempt interest separately from ordinary taxable income. Although tax rules exempt this type of interest from federal taxation, taxpayers must still report it to maintain accurate record-keeping and compliance.
Examples of Tax-Exempt Interest
Municipal bonds typically generate the majority of tax-exempt interest. These bonds may fund public projects, like infrastructure improvements, schools or hospitals, with their interest-free from federal taxation. Additionally, tax-exempt interest can also derive from some mutual funds or ETFs holding municipal bond investments.
Interest earned from U.S. savings bonds, like Series EE or Series I bonds, sometimes qualify as tax-exempt for federal purposes. The owner must redeem these bonds correctly, specifically for educational expenses, for this to apply though.
States, however, typically follow separate rules for the taxation of tax-exempt interest. Interest that is tax-exempt federally is often still taxed at the state level.
How to Report Tax-Exempt Interest
Taxpayers will refer to Form 1099-INT or Form 1099-DIV to find total tax-exempt interest received during a given year. Form 1099-INT lists tax-exempt interest income within Box 8, making it simple to locate when preparing tax returns. On Form 1099-DIV, taxpayers will refer to Box 12, labeled “Exempt-interest dividends.”
Additionally, on IRS Form 1040, taxpayers will need to report their tax-exempt interest directly in the income section, specifically on line 2a, labeled “Tax-exempt interest.” Even though the IRS does not tax this interest, disclosure remains necessary. It helps to both maintain transparency and monitor taxpayer eligibility for certain federal tax breaks and benefits.
For taxpayers using tax preparation software or an online tax filing service, inputting tax-exempt interest is usually straightforward. Most software or tax programs prompt users to enter amounts from Form 1099-INT or 1099-DIV and automatically place the appropriate totals in the right location on Form 1040.
Additional Considerations for Tax-Exempt Interest on Form 1040
Although tax-exempt interest isn’t subject to federal taxes, the amount factors into the calculation for modified adjusted gross income (MAGI). Federal programs use MAGI as a benchmark for determining eligibility for deductions, credits and government benefits. As a result, tax-exempt interest can indirectly influence available tax benefits despite itself remaining untaxed federally.
Also note that tax-exempt interest received from particular private activity bonds issued by state or local governments can trigger the alternative minimum tax (AMT). If bonds are subject to AMT, investors earning significant amounts of this type of tax-exempt interest might owe additional taxes under the AMT rules.
Another consideration is state taxation. Although federal rules exempt this type of interest from taxation, many states have their own rules on municipal bond income earned from out-of-state bonds. This may make some payments taxable at the state level—even if they’re federally exempt.
Bottom Line
Tax-exempt interest from bonds or funds is not included in federal taxable income. But while taxpayers don’t directly pay taxes on this interest federally, they still have to report it using Form 1040 and provide the necessary documentation. Tax-exempt interest may also affect calculations for MAGI, AMT, or be taxable at the state level, so these factors should be reviewed when reporting this income.
Tax Planning Tips
- A financial advisor can help you create a plan to optimize your portfolio for lower taxes. 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.
- SmartAsset’s tax return calculator has updated brackets and rates to help you estimate your next refund or balance.
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