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In general, the IRS wants to know about — and tax — all your sources of income, including interest you’ve earned on a bank account balance or other investment and financial accounts.
But certain types of earned interest can be considered tax-exempt. If you think you’ve earned tax-exempt interest during the year, it’s important to understand what qualifies and what to do about it.
What is tax-exempt interest?
Tax-exempt interest is interest income that’s not subject to federal income tax, so while you may still need to report it on your return, you aren’t required to include it in your taxable income. Because it’s excluded from your taxable income, it’s not subject to federal tax.
In general, there are three types of tax-exempt interest.
- Interest redeemed from Series EE and Series I bonds: Series EE and Series I bonds are U.S. savings bonds issued by the federal government. If the bonds were issued after 1989, the interest you earned from them may be excludable from income. But it’s only excludable if you used the cash to pay for qualified higher-education expenses and meet other requirements for the Educational Savings Bond Program.
- Interest on some bonds used to finance government projects: If you’ve purchased bonds issued by a state, the District of Columbia or a U.S. possession, the interest you may earn likely isn’t taxable at the federal level, although you will still have to report the income. These types of bonds are often called municipal bonds or “munis.” They’re often available through mutual funds.
- Interest on VA insurance dividends: If you leave interest earned on insurance dividends on deposit with the U.S. Department of Veterans Affairs, it’s considered tax exempt.
“Tax-exempt interest is not always exempt from taxes, despite the name,” says Eric Nisall, a Florida-based accountant and owner of AccountLancer. For example, if you’re subject to the alternative minimum tax, or AMT, you may need to include interest earned on certain bonds when calculating how much you owe.
Do I need to report tax-exempt interest?
In general, the IRS requires you to report all the interest you earned during the year, both taxable and tax-exempt. That’s because even if you’re not including it in your taxable income, the IRS uses it to calculate your modified adjusted gross income, or MAGI.
“[MAGI] is used to determine eligibility for certain tax deductions, credits or retirement contribution amounts,” Nisall says.
With tax-exempt interest earned from Series EE and Series I bonds, you’ll fill out Form 8815 to determine how much may be excludable from your income, then report the number on Schedule B of your 1040 form.
With interest earned on municipal bonds, you’ll need to include it in the total amount you report on Line 2a of your 1040 income tax return, but it won’t be included when totaling your gross income.
Interest earned on insurance dividends and left on deposit with the VA is an exception to the reporting requirement.
Will my state tax my federally tax-exempt interest?
Depending on the type of tax-exempt interest, you may need to pay state taxes on the amount you earned. Interest earned from a Series EE or Series I savings bond, for instance, is not taxable at the state level. Municipal-bond interest, however, may be partially or fully taxable, depending on where you live.
“States have their own rules for dealing with tax-exempt interest,” says Nisall. “For the most part, only bonds issued within your state may be exempt from state taxes. If you receive interest from bonds issued by other states, you may have to pay state taxes on that portion of the interest.”
Some states have reciprocity agreements, however, choosing not to impose an income tax on interest earned on municipal bonds issued by states that have the agreement.
Unless you purchased Series EE or Series I savings bonds or certain municipal bonds, or left interest you’ve earned on insurance dividends on deposit with the VA, you likely won’t have any tax-exempt interest to claim on your tax return. Be sure to review all forms you receive to help determine what interest income you must report on your tax return.
If you do earn what the IRS considers tax-exempt interest, make sure you know the reporting requirements. Also, check with your state’s tax department to understand how you might be taxed on the state level.
Earning tax-exempt interest may complicate your tax situation a little, but it can be a way to take advantage of investment opportunities while minimizing your tax burden.