Exempt-interest dividends are dividends issued to investors in mutual funds that are not taxed by the federal government. Mutual funds that qualify for the tax exemption are typically invested in municipal bonds, although some tax-exempt bonds may be issued by not-for-profit organizations.
Exempt-interest dividends are popular with many high-net-worth individuals seeking to minimize their tax burden. Learn about how exempt-interest dividends are earned, reported, and used to legally avoid taxes.
Definition and Example of Exempt-Interest Dividends
Generally speaking, investors must pay taxes on investment earnings including dividends, direct monetary distributions to shareholders. Dividends from certain types of mutual funds, however, are not subject to federal income taxes. These dividends are known as exempt-interest dividends.
Mutual funds that remit exempt-interest dividends are typically invested, in whole or in part, in municipal bonds, which are not subject to federal taxation, and in many cases are not subject to state taxation. Some not-for-profit entities may also issue tax-exempt bonds.
Some examples of funds that may pay out tax-exempt interest include Vanguard Massachusetts Tax-Exempt Fund (VMATX), which seeks to invest in securities exempt from federal and Massachusetts personal income taxes. Another example is Fidelity Conservative Income Municipal Bond Fund (FCRDX), which aims to invest 80% of its assets into municipal debt securities not subject to federal income taxes.
How Exempt-Interest Dividends Work
Generally speaking, all forms of income, including investment dividends, are subject to taxation by the federal government. While most dividends are distributed to shareholders by corporations, mutual funds, which is a type of professionally managed investment fund, may also issue dividends. Specific types of mutual funds, such as those invested in municipal bonds, issue dividends that are not subject to federal taxation.
State and local bonds have been exempt from taxation since the inception of the income tax in 1913. The federal government created the exemption in order to encourage state and local investment in infrastructure projects. Municipal bonds are generally rated higher and are considered safer than corporate bonds. As a result, mutual funds composed of municipal bonds are a popular investment for high net worth individuals looking to minimize their federal tax burden, even though state and local bonds tend to generate low rates of return.
Exempt-interest dividends, though not taxable, must still be reported to the IRS.
Mutual funds that issue dividends send shareholders Form 1099-INT, which details the amount of interest income, the payers and shareholders identifying information, and tax information. Shareholders are then obligated to report their earnings as income on their Form 1040.
It should be noted that municipal bonds cannot be used to avoid paying taxes entirely. In 1969, the United States Congress enacted the Individual Alternative Minimum Tax (AMT). The AMT was designed to prevent high-income individuals from using loopholes to avoid paying taxes entirely. The AMT was designed to ensure that everyone remits a baseline of taxes to the federal government. Thus, investors who earn income via exempt-interest dividends may still be liable for taxes under the AMT.
While many states mimic the federal government and avoid taxing municipal bond earnings, most states impose a tax on state and local bonds that were issued in other states. Most fund companies will provide you with detailed documentation about how to calculate your tax-exempt interest by state if you invest in qualifying mutual funds.
A few states tax even state and local bonds issued in their own state. Indeed, state governments are levying taxes on a growing percentage of municipal bonds.
Pros and Cons of Exempt-Interest Dividends
Useful in tax planning
Need to report on tax return
- Useful in tax planning: High-net-worth individuals can use exempt-interest dividends to minimize their tax burden.
- Reliable: Exempt-interest dividends are usually reliable and the underlying bonds are considered to carry a low risk of default compared to other types such as corporate bonds.
- Need to report on tax return: Even though exempt-interest dividends are not taxable, investors still need to report them to the IRS on their tax return.
What Exempt-Interest Dividends Mean For Individual Investors?
The benefit of exempt-interest dividends is that they are typically not subject to federal income taxes. However, mutual funds that pay out such dividends invest in securities that may yield a low rate of return.
An investment into such funds purely for a tax savings purpose may only make sense if the amount of tax saved is substantial.
Also bear in mind that these dividends may be subject to state taxes or, in the case of high-income earners, AMT.
- Exempt-interest dividends are dividend payments distributed by mutual funds that are not subject to federal taxation.
- Mutual funds that issue exempt-interest dividends are typically invested in municipal bonds, which are not subject to federal taxes.
- Mutual funds that issue exempt-interest dividends are popular with high net worth individuals who wish to shield their assets from higher tax rates.
- Exempt-interest dividends cannot necessarily be completely shielded from taxation due to the Alternative Minimum Tax or specific state tax rules.