What Is an Exempt-Interest Dividend?
An exempt-interest dividend is a distribution from a mutual fund that is not subject to federal income tax. Exempt-interest dividends most often are derived from mutual funds that invest in municipal bonds.
While exempt-interest dividends are not subject to federal income tax, they may still be subject to state income tax or the alternative minimum tax (AMT). The dividend income must be reported on the income tax return, and it is reported by mutual funds on Form 1099-INT.
Key Takeaways
- An exempt-interest dividend is a distribution from a mutual fund that is not subject to federal income tax.
- High-net-worth investors often invest in municipal bonds to take advantage of the tax breaks.
- Though exempt from federal income tax, interest dividends from municipal bonds may or may not be exempt from state taxes.
- Interest-dividend may also be subject to the alternative minimum tax (AMT) even if it is exempt from federal or state income taxes.
- Tax-exempt interest dividends are reported on Form 1099-DIV in box 12.
Understanding an Exempt-Interest Dividend
Adividendis a distribution of a company's profits toshareholders. It is not an incurred mandatory cost set by the receivers such as in the case of debt obligations. It is not classified as an expense and is deducted last after net earnings are determined and decisions are made to make distributions out of them.
Dividends are commonly paid to shareholders of corporate stocks. Shareholders receive dividend payments periodically throughout the year, commonly every quarter.
For example, Apple's dividend as of February 2, 2023, was $0.23 per share. Apple makes four dividend payments a year, all of which are taxable and paid by the shareholders.
An exempt-interest dividend is a payment from a mutual fund that is not subject to federal income tax and is mainly found in mutual funds that contain some municipal bond investments.
Who Buys Tax-Exempt Bonds?
People with high net worths are more likely to invest in municipal bonds because the tax savings outweigh the lower returns provided by the investments. High-net-worth individuals are subject to higher taxes, so a low-tax investment is a popular choice.
The types of municipal bonds that are exempt from taxes are those that are raising money for uses that benefit the community.
The tax benefits provided by the investments, including exempt-interest dividends, are lost if the investments are held in an individual retirement account (IRA). This is because all dividends and interest within an IRA are tax-exempt.
State Income Tax
The dividend interest that is federally exempt may or may not be exempt from state taxes, depending on the state where the municipal bonds were issued and the state in which you file your taxes.
Depending on the state, they may allow the entire portion of your dividend interest to be exempt or only the portion of the bonds that are issued in the state you are filing your taxes, while bonds from other states will be taxed.
For example, assume you have a total dividend interest of $100, $60 of which comes from the state you reside in and $40 from another state. The state you reside in only allows exemptions from its taxes on bonds within the state, so you do not have to pay state tax on the $60, but you will have to on the $40.
Alternative Minimum Tax (AMT)
The alternative minimum tax (AMT) places a floor on the percentage of taxes that an individual must pay, regardless of how many deductions or exemptions they may claim on their returns.
- For the 2022 tax year, the AMT exemption amount is $75,900 for single filers and $118,100 for married couples filing jointly.
- For the 2023 tax year, the exemption is $81,300 for single filers and $126,500 for married couples filing jointly.
The goal of the AMT is to ensure that individuals pay a certain level of taxes rather than escaping their obligation through various tax breaks. Therefore, exempt-interest dividends can be subject to the AMT to ensure that some individuals are not avoiding paying their fair share.
IRS Form 6251 will help individuals determine if they owe an alternative minimum tax (AMT), or a tax software will automatically calculate it for them.
How Can I Avoid Paying Tax on Investment Income?
There are a number of investments and savings vehicles that yield returns that are tax-free at least at the federal level.
The biggest category of these is municipal bonds. These are issued by state and local governments and public institutions like school districts and water departments in order to raise money. The money may be used for specific projects that benefit the community, or it may go into the general fund.
In any case, the interest they pay their bondholders is free of federal tax. It may or may not be free of state and local tax. Each state and municipality sets its own rules, but often the interest is tax-exempt if it is issued in that state.
Keep in mind that municipal bonds pay a lower rate of return than corporate bonds in return for that tax break. They are a popular choice for high-net-worth investors who want to shelter some of their income from taxes.
Are Mutual Fund Distributions Taxable?
Almost always. The exception is the exempt-interest dividends that are paid to shareholders of mutual funds that invest some or all of their assets in tax-exempt municipal bonds.
The amount of taxable distributions and any tax-exempt distributions that you have received from a mutual fund will be recorded in the IRS Form 1099-DIV that you receive from the fund company after the end of the calendar year.
Why Does Tax-Exempt Interest Count as Taxable Income for Alternative Minimum Tax?
The alternative minimum tax is designed to capture some taxes from very high-income people who use every possible deduction and loophole to reduce or eliminate the taxes they owe.
Tax-exempt municipal bonds are a good way to reduce the taxes owed on unearned income. Adding those distributions to gross income for people at certain high income levels cuts off a potential strategy for avoiding the alternative minimum tax.
