# Exempt-Interest Dividends: Tax Advantages and Reporting Guide

## What Is an Exempt-Interest Dividend?

An exempt-interest dividend is a dividend that investors often receive from municipal bonds. which means it isn't taxed by the federal government. It is popular with investors who want tax-efficient income. These dividends still need to be reported on tax forms like 1040 and 1099-DIV, and they may be subject to state taxes or the [alternative minimum tax (AMT)](https://www.investopedia.com/terms/a/alternativeminimumtax.asp). They can help investors reduce their taxes while they earn income.

### Key Takeaways

*   Exempt-interest dividends from mutual funds investing in municipal bonds are not subject to federal income tax.  
    
*   These dividends may still be subject to state income tax or the alternative minimum tax (AMT).  
    
*   High-net-worth investors often choose municipal bonds for potential tax savings despite lower returns.  
    
*   Exempt-interest dividends must be reported on federal tax returns, but they do not incur federal tax liability.  
    
*   The AMT ensures high-income individuals pay a minimum tax, even with tax-exempt dividends.

### Where Do I Report Exempt-Interest Dividends?

You report the total of your exempt-interest dividends for the year on line 2a of your Form 1040. The amount you received will appear in box 12 of the Form 1099-DIV you received from the fund provider. You will not owe federal taxes on this money.

## How Dividends Function

A [dividend](https://www.investopedia.com/terms/d/dividend.asp) is a distribution of a portion of a company's profits to its [shareholders](https://www.investopedia.com/terms/s/shareholder.asp). In most cases, it is not an incurred mandatory cost and is not classified as an expense. Dividends are authorized and deducted only after net earnings are determined.

Dividends are commonly paid to owners of common stock shares. Shareholders receive dividend payments periodically throughout the year, commonly every quarter.

For example, Apple's dividend as of Feb. 2, 2023, was $0.23 per share. Apple makes four dividend payments a year, all of which are taxable.  

## How Exempt-Interest Dividends Function

An exempt-interest dividend is a payment from a [mutual fund](https://www.investopedia.com/terms/m/mutualfund.asp) that is not subject to federal income tax. These dividends are mainly found in municipal bonds and in the mutual funds that invest in those bonds.

People with high net worths are more likely to invest in municipal bonds because the tax savings outweigh the relatively low returns provided by the investments. High-net-worth individuals are subject to higher taxes, so low-tax investments are a popular choice.

Municipal bonds exempt from taxes typically raise money for community-beneficial projects.

Exempt-interest dividend tax benefits don't matter if the bonds are in an [individual retirement account (IRA)](https://www.investopedia.com/terms/i/ira.asp). This is because all dividends and interest held within an IRA are tax-exempt.

## State Tax Implications of Exempt-Interest Dividends

Dividend interest might be taxed by states, depending on where you and the bonds are located.

Depending on the state, all of your dividend interest may be exempt, or only the portion of it that comes from bonds that are issued in the state where you are filing your taxes.

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.

## Navigating the Alternative Minimum Tax (AMT) With Exempt-Interest

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 2024 tax year, the exemption is $85,700 for single filers and $133,300 for married couples filing jointly. For the 2025 tax year, the exemptions are $88,100 and $137,000, respectively.

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](https://www.investopedia.com/terms/t/tax-break.asp). 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](https://www.investopedia.com/terms/f/form-6251.asp) 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](https://www.investopedia.com/terms/t/tax-exempt-sector.asp#:~:text=Types%20of%20Tax%2DExempt%20Bonds,-There%20are%20two&text=The%20tax%2Dexempt%20sector%20includes,repay%20any%20GO%20bond%20obligations.) 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. The money may be used for a specific project that benefits 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.

Remember, municipal bonds offer lower returns than corporate bonds due to their tax breaks. High-net-worth investors often choose them to shield some income from taxes.  

## Are Mutual Fund Distributions Taxable?

Mutual fund distributions are almost always taxable.

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 receive from a mutual fund will be recorded on the IRS Form 1099-DIV that the fund company sends 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 strategy for avoiding the alternative minimum tax.

## The Bottom Line

Exempt-interest dividends from municipal bonds can give investors a tax advantage because they aren't taxed at the federal level. But they may face state taxes or the AMT. These dividends are especially useful for HNWIs who want tax-efficient income. Although they aren't taxed, these dividends must be reported on federal tax returns using Form 1040, with details shown on Form 1099-DIV. Make sure that you consult a financial professional if you're unsure of how the rules for state or AMT liabilities apply to your situation.  

> **Article Sources**
>
> 1.  Apple Inc. "[Dividend History](https://investor.apple.com/dividend-history/default.aspx)."
>     
> 2.  Internal Revenue Service. "[IRS Provides Tax Inflation Adjustments for Tax Year 2024](https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2024)."
>     
> 3.  Internal Revenue Service. "[IRS releases tax inflation adjustments for tax year 2025](https://www.irs.gov/newsroom/irs-releases-tax-inflation-adjustments-for-tax-year-2025)."
>     
> 4.  Internal Revenue Service. "[Topic No. 556 Alternative Minimum Tax](https://www.irs.gov/taxtopics/tc556)."
>     
> 5.  Internal Revenue Service. "[About Form 6251, Alternative Minimum Tax - Individuals](https://www.irs.gov/forms-pubs/about-form-6251)."