Exempt-interest dividends are interest payments from a mutual fund exempted from federal tax. Mutual funds investing in municipal bonds issue tax exempt-interest dividends. Municipal bond investments can benefit high net-worth individuals because they are low risk and provide tax savings. However, these dividends may still be subject to state tax or the alternative minimum tax.
Exempt-interest dividends are investment payment distributions that are not federally taxed. These dividends come from a mutual fund invested in municipal bonds that are community project funds. These investments are a popular option to reduce tax bills for individuals with a higher income.
Keep reading to learn more about exempt-interest dividends and how to report them on your taxes.
What is an exempt-interest dividend?
Exempt-interest dividends are dividends not subject to federal income tax. Regulated investment companies distribute exempt-interest dividends. After the end of the tax year, investment companies provide written notice of these dividends.
To qualify for tax-exempt interest dividends, people can invest in a mutual fund that has investments in municipal bonds or other investment securities. Some nonprofit organizations may also issue tax-exempt bonds.
How exempt-interest dividends work
The IRS generally taxes investment dividends that corporations distribute to their shareholders. Similarly, a mutual fund also distributes dividends. Some mutual funds that have investments in municipal bonds distribute dividends that are not subject to federal income tax.
The exempt bonds have to be bonds used to fund communal projects, and not private causes. To foster state and local contributions to infrastructure projects, state and local bonds are exempt from federal taxation.
The IRS treats exempt-interest dividends in a similar manner to direct tax exemptions. The tax exempt-interest dividends have their own rules and regulations that individuals must follow when reporting taxes. Mutual funds provide shareholders with the IRS Form 1099-INT, including the interest income amount. Investors must detail their earnings as income on their annual income tax return.
Investors lose the tax benefits of exempt-interest dividends if the investments are in individual retirement accounts (IRAs). Dividends and interest in IRAs have an exemption from federal taxes.
State income tax and exempt-interest dividends
Interest that is federally exempt may not be exempt from state taxes. It may depend on where the investor purchased the bonds (typically printed with the face value) and where they reside.
Multiple states can allow the entire dividend to be tax-exempted or limit the tax-free portion of the dividends to bonds bought in that specific state. Retaining holdings from other states could subject people to local and state taxation.
Do your due diligence to research whether a portion or the entirety of your tax-exempt interest can be taxed.
Alternative minimum tax and exempt-interest dividends
Investors may pay an alternative minimum tax (AMT) on their exempt-interest dividends. The AMT creates a baseline on the percentage of taxes people must pay, no matter how many deductions or exemptions people can claim on their return. This AMT baseline prohibits high-income individuals from utilizing exempt-interest dividends to avoid income taxes.
People can use IRS Form 6251 or tax software to determine if they owe an AMT. Use the amount reported in box 13 of Form 1099-DIV, “Specified Private Activity Bond Interest Dividends,” to determine the AMT amount.
Calculating the AMT can be complex. Working with a tax professional or software can be beneficial for filing taxes with complicated elements like tax-exempt dividends.
How exempt-interest dividends affect individual investors
The primary benefit of exempt-interest dividends is that the federal government does not tax them. Exempt-interest dividends accumulate a reduced interest rate and a lower rate of return, making these bonds safer investments than corporate bonds.
It may be beneficial for individuals in high-income tax brackets to reduce their tax bills and utilize the tax breaks. The tax savings typically offset the lower returns. Hence, it is a popular option for high-income earners with higher taxes. However, it’s important to remember that investors may still have to pay the state income tax or the alternative minimum tax on these dividends.
How do I report exempt-interest dividends?
You report exempt-interest dividends on Form 1099-DIV on your tax form. You must declare whether or not you have to pay the AMT.
Do I have to report exempt-interest dividends?
While exempt-interest dividends aren’t taxable, you must report your dividend income, similar to any taxable interest income you have when you file your tax return.
How do I enter exempt-interest dividends in TurboTax?
You would enter the amount of your exempt-interest dividend on form 1099-DIV box 12 in TurboTax or another tax software system.
What kind of dividends are tax-exempt?
Dividends that come from mutual funds invested in municipal bonds are tax-exempt. The bonds must be funding projects that benefit the community.
- Exempt-interest dividends are payments issued by mutual funds that are not subject to federal income taxes.
- Mutual funds that invest in municipal bonds distribute exempt-interest dividends.
- An exempt-interest dividend can be beneficial to high-income individuals to minimize their tax burdens.
- Investors may need to pay taxes at the state level or the alternative minimum tax (AMT) on their exempt-interest dividends.
View Article Sources
- Letter Ruling 82-23: Dividends from Tax-Exempt Bonds Fund – Commonwealth of Massachusetts
- Taxability of Interest and Dividend Income – Nebraska Department of Revenue
- How to Guarantee You Will Get a Tax Refund Next Year – SuperMoney
- What Is Face Value? Definition and Examples – SuperMoney
- Tax Deductions and Credits List: Complete Guide for 2022 – SuperMoney
- Do I Have To Pay Taxes On My Checking Account? – SuperMoney