What Are Examples of Tax-Exempt Interest?

Tax-exempt interest is income generated from specific investments that is not subject to federal income tax. This tax advantage is a feature designed to make certain types of investments, particularly those issued by government entities, more appealing to the public. By forgoing tax revenue on the interest paid, the federal government lowers the borrowing costs for these entities, which helps finance public projects and encourages private investment in infrastructure.

Common Sources of Federally Tax-Exempt Interest

The most prevalent source of federally tax-exempt interest comes from municipal bonds, often called “munis.” These are debt securities issued by states, cities, counties, and other governmental bodies to fund public projects like building schools, highways, or sewer systems. An investor who buys a municipal bond is lending money to that government entity, and in return, the entity pays the investor periodic interest payments that are not taxed by the federal government. This makes them attractive to individuals in higher tax brackets.

Municipal bonds fall into two main categories. General Obligation (GO) bonds are backed by the full faith and credit of the issuing government, meaning it can use its taxing power to pay back the bondholders. Revenue bonds are not backed by taxing power; instead, they are financed by the income generated from a specific project, such as tolls from a bridge.

Interest earned from bonds issued by U.S. territories is also exempt from federal income tax. This includes bonds from Puerto Rico, Guam, the U.S. Virgin Islands, and American Samoa. The interest from these territorial bonds is “triple-exempt,” meaning it is free from federal, state, and local income taxes for any U.S. investor, regardless of their state of residence.

A more conditional source of tax-exempt interest comes from certain U.S. savings bonds. Interest from Series EE and Series I bonds issued after 1989 can be excluded from federal income tax, but only if the bond proceeds are used to pay for qualified higher education expenses. This includes tuition and fees for the taxpayer, their spouse, or a dependent at an eligible postsecondary institution. This exemption is subject to income limitations and other rules to qualify.

State and Local Tax Considerations

The term “tax-exempt” refers to an exemption from federal income tax, but it does not automatically extend to state and local taxes. Whether the interest income is also free from state-level taxation depends on the source of the bond and the residency of the investor.

The general rule is that interest from municipal bonds issued by the taxpayer’s home state is exempt from that state’s income tax. This creates a “double exemption”—the interest is exempt from both federal and state taxes. For instance, a resident of a state with an income tax who buys a municipal bond issued within that state will not owe federal or state tax on the interest.

Conversely, interest earned from out-of-state municipal bonds is taxable by the investor’s home state. If that same resident were to purchase a bond issued by a different state, the interest would still be exempt from federal income tax but would be subject to their own state’s income tax. This can negate some of the tax benefits, making in-state bonds a more tax-efficient choice for investors in states with an income tax.

Reporting and Tax Return Implications

Even though tax-exempt interest is not subject to federal income tax, the Internal Revenue Service (IRS) requires that it be reported on your tax return. Taxpayers report the total amount of tax-exempt interest received on Form 1040. This information is provided to the investor by the bond issuer or brokerage firm on Form 1099-INT.

This income is reported because it has indirect consequences. The figure for tax-exempt interest is added back into a taxpayer’s income to calculate their modified adjusted gross income (MAGI) for several tax provisions, which can alter the overall tax liability.

One of the most common impacts is on the taxability of Social Security benefits. To determine if Social Security benefits are taxable, the IRS looks at a taxpayer’s “combined income,” which includes adjusted gross income, nontaxable interest, and half of the Social Security benefits received. By adding tax-exempt interest back into this calculation, a taxpayer may find that a larger portion of their Social Security benefits becomes subject to income tax.

A high amount of tax-exempt interest from certain private activity bonds can trigger the Alternative Minimum Tax (AMT). The AMT is a separate tax system designed to ensure that high-income individuals pay a minimum amount of tax. Interest from these specific bonds, which are often issued to finance projects like airports or sports stadiums, is considered a “tax preference item.” This interest must be added back when calculating income for AMT purposes.