What Are Exempt-Interest Dividends and How Are They Taxed?
Understand the tax implications of exempt-interest dividends beyond their federal-free status, including state rules and how they affect your total tax picture.
Exempt-interest dividends are distributions paid to shareholders of mutual funds or exchange-traded funds (ETFs). These funds invest in securities that generate tax-exempt income, most commonly municipal bonds issued by state and local governments. The primary benefit for investors is that this dividend income is not subject to federal income tax. This allows investors to receive a regular income stream with a tax advantage, as the fund passes the tax benefits from its underlying bonds to its shareholders.
Federal and State Tax Treatment
The federal tax exemption on this income is a feature of the U.S. tax code designed to make it more attractive for investors to fund public projects like schools and highways. By purchasing municipal bonds, investors provide this funding. The mutual funds that hold these bonds can then pass the federally tax-free income to their shareholders.
State tax rules are more complex. For the dividend income to be exempt from state income tax, it must come from municipal bonds issued within your state of residence. If a fund holds bonds from multiple states, only the portion of the dividend from in-state bonds is exempt from your state’s tax. Dividends from out-of-state municipal bonds are taxable at the state level. However, if you live in a state with no personal income tax, these dividends are tax-free at the state level.
Reporting on Your Tax Return
The total amount of exempt-interest dividends you received for the year is reported in Box 12 of Form 1099-DIV, “Dividends and Distributions.” This form is sent by the financial institution that holds your fund shares. Although this income is not federally taxed, the Internal Revenue Service (IRS) requires you to report it for informational purposes.
You must report the total from Box 12 on Line 2a of Form 1040. This line is designated for tax-exempt interest. While the amount is used for other calculations on your return, it is not added to your total taxable income.
For state taxes, you must determine the taxable portion of your dividends. Your brokerage firm provides a year-end statement that breaks down the income between in-state and out-of-state sources. You will add the portion from out-of-state bonds to your income on your state tax return.
Special Tax Considerations
Exempt-interest dividends can have other tax implications, such as with the Alternative Minimum Tax (AMT), a parallel tax system designed to ensure high-income individuals pay a minimum amount of tax. Dividends from “private activity bonds” are considered a tax preference item for AMT purposes. These bonds are issued by municipalities to finance projects for private entities, such as sports stadiums or airports.
If your dividends come from these bonds, that amount must be added to your income when calculating the AMT. Your fund company reports the portion of your dividend subject to AMT in Box 13 of Form 1099-DIV. This income could subject you to the AMT, which is calculated on Form 6251.
Exempt-interest dividends can also affect the taxation of your Social Security benefits. While not federally taxed, this income is included when calculating your “provisional income.” This figure determines what portion, if any, of your Social Security benefits is taxable. Provisional income is calculated by adding your adjusted gross income, one-half of your Social Security benefits, and all of your tax-exempt interest. If your provisional income exceeds certain thresholds ($25,000 for single filers and $32,000 for married couples filing jointly), up to 85% of your benefits will become taxable.