What is Tax-Exempt Interest?

Tax-exempt interest is interest income that is exempt from federal and/or state taxes.

Tax-Exempt Interest Example

For example, let's assume that John Doe purchases a municipal bond. The bond pays 5% interest per year, or $50 for every $1,000 John Doe invests. That $50 is income to John, which is normally taxable. However, because municipal bonds are tax-free securities, John's interest is tax-exempt.

Taxpayers are required to report the amount of tax-exempt interest they receive on Form 1040 or Form 1040A. Borrowers that pay more than $10 of tax-exempt interest must report those payments to the IRS and the lenders via Form 1099-INT.

In some cases, the amount of tax-exempt interest a taxpayer earns can limit the taxpayer's qualification for certain other tax breaks.

Why Tax-Exempt Interest Matters

Municipal bonds are the most common instruments for paying tax-exempt interest. However, interest on insurance dividends left on deposit with the Department of Veterans Affairs and some interest from certain savings bonds is tax-exempt as well. Interest income from Treasuries is subject to federal tax but is exempt from state and local taxes.

A tax-exempt municipal bond often has a higher after-tax yield than a corporate bond with the same coupon rate. For this reason, municipal-bond yields are frequently articulated in terms of the taxable interest-rate equivalent to similar corporate-bond rates.

One of the largest advantages of investing in municipal bonds is that the interest is usually exempt from federal taxes and is also exempt from most state and local taxes if the investor lives in the state or municipality issuing the debt (capital gains on municipal bonds are taxable, however). Although investors subject to the alternative minimum tax may be required to pay taxes on municipal-bond interest, tax-exempt interest means that many investors in high federal-tax brackets particularly benefit from investing in municipal bonds.

The lower yields associated with bonds that pay tax-exempt interest also provide borrowers with borrowing rates that may be more attractive than what is available through other means. This in turn encourages the local governments to undertake new projects.