- What are exempt interest dividends? Exempt-interest dividends are mutual fund distributions that are exempt from federal income tax.
- Such distributions are paid by mutual funds that invest in tax-exempt securities, which are most often municipal bonds issued by local government authorities.
- These tax advantages are particularly advantageous for individuals in higher tax brackets who want to invest in income-producing assets.
In this article, we will answer the following question: ‘What is exempt interest dividends?’ We will also discuss how to select qualified mutual funds that pay such dividends.
Table of Contents
What Are Exempt Interest Dividends: Understanding the Basics
Mutual funds are pooled investment vehicles that offer the benefit of instant diversification. The underlying assets of mutual funds can include stocks, bonds and other securities. Fund managers select a portfolio of securities that match the declared strategy and combine them into a single investment product.
The fund pays most of the money received from these assets out to shareholders as dividends, in proportion to their shareholding. For example, if the fund distributed an annual yield of $50 million, an investor with a 0.01% stake in the fund would receive $5,000.
In most cases, federal taxes and state taxes must be paid on this income. However, payments from funds investing in tax-exempt bonds are not subject to federal income tax.
Beginning investors often ask: ‘What are the tax-exempt dividends?’ These are distributions from funds that invest in the debt obligations of state governments, local governments, and nonprofit organizations.
What Are Exempt Interest Dividends: Types of Securities That Generate Them
When discussing municipal bonds, tax-exempt municipal bonds are primarily associated with exemption from federal income tax. In this case, however, the investor will still have to pay state income tax or other local taxes. However, there are also:
- double tax-exempt securities (at the federal level and at the state level);
- triple tax-exempt securities (municipal, state, and federally tax-exempt securities).
However, even if a person invests in tax-exempt bond funds, they may still have to pay the alternative minimum tax (AMT). This rule applies to both municipal bond funds and individual municipal bonds.
Tax Treatment and Reporting Requirements
A commonly referred question from beginner investors is: ‘Are exempt interest dividends taxable, and do they need to be included in federal returns?’ Although this type of income is not subject to federal income tax, it must be reported in your tax returns.
You can find the amount of payments received during the calendar year in box 12 of Form 1099-DIV.
Now let’s consider where to report exempt interest dividends on 1040. Exemption amounts are indicated on line 2a of Form 1040. This line is completed using data from box 12 of forms 1099-DIV, 1099-INT and 1099-OID, as well as possibly from schedule K-1.
Investment income from municipal bonds may be exempt from state income tax. In some states, such dividends are not taxed (an exempt interest dividends state). In others, however, only payments from bonds issued within the state are exempt.
It is not enough to know ‘where are exempt interest dividends reported on 1040’. It is also important to understand that there is another type of tax liability: the alternative minimum tax (AMT). Use Form 6251 to determine whether you need to pay it. For the 2025 tax year, the exemption amounts are:
- $88,100 for single filers;
- $68,500 for married filing separately;
- $137,000 for married filing jointly and qualifying widows/widowers.
The exempt interest dividends tax treatment is complex. Therefore, it is advisable either to use tax software that simplifies calculations or to consult a financial advisor to develop a plan that precisely matches your needs and interests.
Who Should Invest in Exempt-Interest Dividends
Investments in the interest dividends of municipal bond funds offer particular benefits to high-net-worth investors in higher tax brackets. They can benefit from tax savings of up to 37% of their taxable income (20% if the dividends are qualified rather than ordinary income).
However, the trade-off for stable yields and an absence of federal taxes is low returns from municipal bonds. Nevertheless, there are other tax planning options that can enhance overall investment returns.
Therefore, it is advisable to consult with a financial advisor before purchasing municipal bond funds. They can help you make the most of this asset class within your investment strategy. A tax professional may also be able to suggest an alternative tax strategy to help increase long-term yields and achieve your financial goals more quickly.
Municipal bonds, which are issued by state and local governments, are used to finance important societal projects. This is why people sometimes invest in them, not only for tax savings and reaching their financial goals, but also to support community development.
Investment Characteristics and Risk Profile
Bonds issued by states, municipalities or nonprofit organizations are considered to be among the most reliable assets. Unlike corporate bonds, municipal securities carry minimal credit risk. Many issuers are legally prohibited from declaring default.
However, higher-rated bonds tend to have low yields than lower-rated bonds. In other words, the price of stability and high credit quality is lower income.
Another characteristic is the long duration and maximum maturity of such bonds, which can be issued for decades.
It is important to pay attention to the expense ratio when choosing a fund, as this can have a significant impact on the investor’s overall yield.
How to Invest in Exempt-Interest Dividends
Municipal bond funds can be selected via brokerage platforms, mutual fund providers or financial advisors. The first step is to study the fund prospectus to ensure that the fund is a tax-exempt bond fund.
When choosing municipal bond funds, investors also consider:
- the credit quality and duration of the bonds that make up the fund’s assets;
- the expense ratio of the fund;
- the yield of the fund.
Investors need to strike a balance between the low credit risk of higher-rated bonds and the attractive yields of lower-rated bonds with lower credit ratings.
Limitations and Considerations
Interest income from tax-exempt bonds can sometimes result in tax liabilities. Firstly, it may be subject to state income tax. Secondly, there is a possible tax situation where the investor may have to pay the alternative minimum tax (AMT).
The AMT requirement means the investor loses certain tax benefits. However, this has a social justification. The AMT was introduced to ensure that everyone pays their fair share of taxes.
Another factor for investors to consider is the location of the assets. If securities are held in an individual retirement account (IRA) or other accounts with tax benefits, their own tax breaks become irrelevant. Income earned within IRAs and 401(k)s is not subject to federal or state income tax.
FAQ
Do I have to report exempt interest dividends?
This is not taxable income at the federal level. However, it must be reported to the Internal Revenue Service (IRS). It is also important to know the answer to the question: ‘Where do exempt interest dividends go on tax return?’ Tax-exempt interest dividends on 1040 are reported in line 2a of Form 1040.
How do I know which state exempt interest dividends from?
Mutual funds typically provide this information alongside Form 1099-DIV. These details may also be available on the fund’s website. However, investors can generally proceed without this information by selecting the ‘Multiple States’ option in tax software.
Who is exempt under dividend income?
Dividend income in the form of interest dividends from mutual funds is exempt from federal income tax if the fund’s underlying assets are bonds issued by state governments, local governments, or non-profit organizations. However, such interest and dividends may be subject to state income taxes.
What are box 12 exempt interest dividends?
Box 12 of Form 1099 shows the amount of dividends that are exempt from federal income tax. However, this income may be taxed by the state as exempt dividend income.
The Bottom Line
For investors wondering what are exempt interest dividends, these are dividends paid by qualifying mutual funds that are exempt from federal income tax. However, they are subject to state taxes and capital gains taxes realized upon sale.
Such dividends are particularly beneficial for taxpayers with high taxable incomes. However, before selecting tax-exempt investments, it is important to create a financial plan. This will help to ensure that your asset allocation and tax strategy align with your investment goals. Seeking advice from a personal finance expert can be helpful in this regard.
Article Sources
- Rumpf, D. (2011). “The dividends received deduction in the corporate income tax and cost of capital.” Working Papers 01/2011, German Council of Economic Experts / Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung. RePEc:zbw:svrwwp:012011
- Internal Revenue Service (2024). “Instructions for Form 1099-DIV.” U.S. Department of Treasury. Publication for tax year 2024, detailing exempt-interest dividend reporting requirements in Box 12.
- Sureth, C. & Langeleh, D. (2007). “The Degree of Integrating Corporate and Capital Gains Tax into Income Tax and its Impact on Investment Decisions.” Schmalenbach Business Review (sbr), LMU Munich School of Management, vol. 59(4), pages 310-339.
- Pennsylvania Department of Revenue (2024). “PA Personal Income Tax Guide – Dividends.” Commonwealth of Pennsylvania, official state guidance on exempt-interest dividend taxation for Pennsylvania residents.
