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Tax-exempt interest sounds like free money. And in a way, it is — the IRS doesn’t tax it.

But here’s the catch: you still have to report it.

A lot of people see “tax-exempt” and think they can ignore it on their tax return. Wrong. Even though you don’t owe federal income tax on it, the IRS still wants to know how much you received. 

It goes on Form 1040, Line 2a — right there on the first page of your tax return.

Why does the IRS care if it’s not taxable? Because tax-exempt interest can affect other parts of your return — like whether you owe Alternative Minimum Tax, how much of your Social Security is taxable, and whether you qualify for certain deductions and credits.

This article explains exactly what tax-exempt interest is, where it comes from, how to report it correctly on Form 1040, and why ignoring it can cause problems.

What Is Tax-Exempt Interest Income?

Tax-exempt interest income is interest you earn from certain bonds or securities that the federal government doesn’t tax.

Most interest you earn — from savings accounts, CDs, corporate bonds, or Treasury bonds — is fully taxable. But interest from municipal bonds (bonds issued by state and local governments) is typically exempt from federal income tax.

Here’s what “tax-exempt” actually means:

• You don’t pay federal income tax on the interest
• You still might owe state tax, depending on where you live and which bonds you own
• Some bonds are “double tax-exempt” (federal + state) or even “triple tax-exempt” (federal + state + local)

Example: You live in California and buy a California municipal bond. The interest is exempt from federal tax and California state tax. 

But if you buy a New York municipal bond while living in California, you’ll owe California state tax on that interest — even though it’s still federally tax-exempt.

Why Some Interest Is Tax-Exempt

So why does the federal government give up tax revenue on municipal bonds?

Simple: incentive.

State and local governments need money to build schools, roads, bridges, hospitals, and water systems. But they can’t print money like the federal government can. They have to borrow it by issuing bonds.

To make those bonds attractive to investors, Congress gave them a tax break. If you buy a municipal bond, you don’t pay federal income tax on the interest.

Example: A corporate bond pays 5% interest (taxable). A municipal bond pays 3.5% interest (tax-exempt). If you’re in the 24% federal tax bracket, the corporate bond’s after-tax return is 3.8% (5% minus 24% tax). 

The municipal bond’s after-tax return is 3.5% — but with less risk.

For high-income earners in the 35% or 37% tax brackets, municipal bonds often deliver better after-tax returns than taxable bonds.

Types of Tax-Exempt Interest Income

Below are the types of Tax Exempt you can find in the IRS forms: 

Municipal Bonds (Munis)

Municipal bonds are the main source of tax-exempt interest. These are bonds issued by state governments, city governments, school districts, water authorities, and other public entities.

The state tax exemption:

If you buy a bond issued by your own state, the interest is usually exempt from both federal and state tax. That’s called a “double tax-exempt” bond.

Example: You live in New York and buy a New York municipal bond. The interest is exempt from federal tax and New York state tax.

But if you buy a California bond while living in New York, you’ll owe New York state tax on that interest — even though it’s still federally tax-exempt.

The private activity bond exception:

Not all municipal bonds are tax-exempt. Some are called private activity bonds (PABs) — bonds issued by governments but used to finance private projects like stadiums or airports.

Interest from private activity bonds may be tax-exempt for regular income tax but taxable under the Alternative Minimum Tax (AMT). Your brokerage statement will tell you if a bond is a private activity bond.

U.S. Savings Bonds

U.S. Savings Bonds (Series EE and Series I) are issued by the federal government. Interest from savings bonds is taxable at the federal level but exempt from state and local taxes.

But there’s an exception: the Education Savings Bond Program.

How it works:

If you use the proceeds from Series EE or Series I bonds to pay for qualified higher education expenses (tuition and fees), the interest can be excluded from federal income tax.

To qualify, you must:

• Buy the bond in your name (or jointly with a spouse)
• Be at least 24 years old when you bought the bond
• Use the money for qualified education expenses for yourself, your spouse, or your dependents
• Have income below the IRS phase-out limits

If you meet the requirements, the interest is tax-exempt at the federal level. You report it on Form 8815, and it gets excluded from your taxable income.

Federal Obligations and Other Special Cases

U.S. Treasury securities (Treasury bills, notes, and bonds) are taxable at the federal level but exempt from state and local taxes. This is the opposite of municipal bonds.

Bonds from U.S. territories:

Bonds issued by U.S. territories — like Puerto Rico, the U.S. Virgin Islands, and Guam — are triple tax-exempt: exempt from federal, state, and local taxes in all 50 states.

Where and How to Report Tax-Exempt Interest on Form 1040

All tax-exempt interest goes on Form 1040, Line 2a.

Here’s what you do:

1. Add up all the tax-exempt interest you received during the year
2. Enter the total on Line 2a
3. Move on

That’s it. You don’t calculate tax on it. You just report the number.

Example: You received $2,400 in interest from California municipal bonds and $600 from a New York municipal bond. Your total tax-exempt interest is $3,000. That goes on Line 2a.

Why does the IRS care if it’s not taxable?

Because tax-exempt interest affects:

• Modified adjusted gross income (MAGI) — Many tax benefits phase out based on your MAGI. Tax-exempt interest gets added into your MAGI for those calculations.
• Social Security taxability — Tax-exempt interest is part of the formula that determines how much of your Social Security benefits are taxable.
• Alternative Minimum Tax (AMT) — Interest from certain private activity bonds is tax-exempt for regular income tax but gets added back if you’re subject to AMT.
• IRS verification — Your broker reports your tax-exempt interest to the IRS. If their records don’t match yours, you’ll get a letter.

Form 1099-INT: Understanding Box 8

Form 1099-INT is the tax form that reports interest income. You get one from every financial institution that paid you at least $10 in interest during the year.

Box 8 is where tax-exempt interest lives. That’s the number you use to fill out Line 2a.

Example: Your Form 1099-INT shows:

• Box 1 (Taxable Interest): $450
• Box 8 (Tax-Exempt Interest): $2,400

You report $450 on Form 1040, Line 2b (taxable interest) and $2,400 on Line 2a (tax-exempt interest).

If you have multiple Forms 1099-INT, add up all the Box 8 amounts and report the sum on Line 2a.

Private activity bonds and Box 9:

If you own private activity bonds, the interest shows up in Box 8 and also in Box 9 (“Specified private activity bond interest”). If you’re subject to AMT, you’ll need to add the Box 9 amount back into your income on Form 6251.

Schedule B Considerations

You must file Schedule B if you received more than $1,500 in taxable interest or dividends during the year.

Tax-exempt interest doesn’t go in Schedule B Part I. It’s already reported on Line 2a of Form 1040. You don’t break it down by source on Schedule B.

Exception: Some states want more detail on which bonds you own and where they were issued. Check your state’s tax forms.

Example Scenario: Reporting Tax-Exempt Interest

Meet Sarah. She’s a software engineer living in New York earning $95,000 a year. She owns:

• A savings account that earned $380 in interest
• $30,000 in New York municipal bonds that paid $1,200 in tax-exempt interest
• $20,000 in California municipal bonds that paid $750 in tax-exempt interest
• $15,000 in corporate bonds that paid $600 in taxable interest

Sarah’s Forms 1099-INT:

Form 1: Box 1 = $380, Box 8 = $0
Form 2: Box 1 = $0, Box 8 = $1,950
Form 3: Box 1 = $600, Box 8 = $0

Reporting on Form 1040:

• Line 1 (Wages): $95,000
• Line 2a (Tax-exempt interest): $1,950 (total from Box 8)
• Line 2b (Taxable interest): $980 (total from Box 1)

Her AGI is $95,980.

But Wait — Tax-Exempt Interest Still Matters

Even though that $1,950 doesn’t get taxed directly, it can affect other parts of Sarah’s return.

Impact on MAGI: Many tax benefits phase out based on Modified Adjusted Gross Income. Sarah’s MAGI for Roth IRA purposes is $95,980 (AGI) + $1,950 (tax-exempt interest) = $97,930.

Impact on Social Security: When Sarah starts collecting Social Security later, the IRS will use tax-exempt interest in the formula to determine how much of her benefits are taxable.

State Tax Considerations:

On Sarah’s federal return, all $1,950 goes on Line 2a. But on her New York state return:

• $1,200 from New York bonds: Tax-exempt
• $750 from California bonds: Tax-exempt federally, but taxable in New York

New York will add back the $750 from California bonds and tax it at the state level.

Additional Considerations

Sometimes, the IRS requires your bank or brokerage to withhold 24% of your interest payments and send it to the government. This is called backup withholding, and it can apply to tax-exempt interest.

When does backup withholding apply?

• You didn’t provide your Social Security number
• The IRS notified your institution that you provided an incorrect SSN
• You failed to report interest or dividend income on a previous tax return

How to avoid it: Provide accurate taxpayer identification information when you open accounts. Fill out Form W-9 correctly.

Impact on Other Tax Items

Social Security benefits: Tax-exempt interest can make more of your Social Security taxable. The IRS calculates “combined income” = AGI + Tax-Exempt Interest + 50% of Social Security Benefits. If combined income exceeds certain thresholds, up to 85% of benefits become taxable.

Tax credits and deductions: Tax-exempt interest gets added into your MAGI, which affects eligibility for premium tax credits, IRA deductions, Roth IRA contributions, student loan interest deductions, and education credits.

Alternative Minimum Tax (AMT): Private activity bonds are tax-exempt for regular income tax but taxable under AMT. If you’re subject to AMT, you report private activity bond interest on Form 6251.

Educational Savings Bond Program

Interest from Series EE and Series I savings bonds can be excluded from federal income tax if used for qualified education expenses.

Eligibility requirements:

• You purchased the bonds in your own name
• You were at least 24 years old when you bought them
• The bonds are Series EE or Series I issued after 1989
• You use the proceeds for tuition and fees (not room and board)
• Your income is below the IRS phase-out limits

You claim the exclusion using Form 8815.

Federal vs. State Treatment of Tax-Exempt Interest

Municipal Bonds: It Depends on Where You Live

In-state bonds: Usually exempt at both federal and state levels.

Example: You live in California and buy California bonds. The interest is exempt from federal tax and California state tax.

Out-of-state bonds: Exempt federally, but usually taxable at the state level.

Example: You live in New Jersey and buy California bonds. The interest is exempt from federal tax but taxable on your New Jersey return.

States with no income tax: If you live in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, or Wyoming, all municipal bond interest is tax-free.

States that tax all municipal bond interest: Illinois, Iowa, Oklahoma, and Wisconsin tax all municipal bond interest, even in-state bonds.

U.S. Treasury Securities: The Reverse Situation

Interest from U.S. Treasury securities is taxable federally but exempt from state and local taxes.

On your federal return, the interest goes on Line 2b (taxable). On your state return, you subtract it from your taxable income.

U.S. Territory Bonds

Bonds issued by U.S. territories (Puerto Rico, Guam, U.S. Virgin Islands) are triple tax-exempt in all 50 states — exempt from federal, state, and local taxes.

IRS Resources and Publications

IRS Publication 550: Investment Income and Expenses

The comprehensive guide to reporting investment income, including tax-exempt interest. It covers municipal bonds, savings bonds, Treasury securities, and special situations like the Alternative Minimum Tax.

Form 1099-INT Instructions

Explains what each box on Form 1099-INT means and where to report it on your tax return. Short and straightforward.

Form 1040 Instructions

The official guide to filling out your tax return, including where tax-exempt interest goes (Line 2a) and why you need to report it.

Other Resources:

• IRS Publication 970 – Tax Benefits for Education (for the Education Savings Bond Program)
• Form 8815 Instructions – Exclusion of Interest from Savings Bonds
• Form 6251 Instructions – Alternative Minimum Tax

All available free at IRS.gov.

Mistakes to Avoid

Mistake #1: Not reporting tax-exempt interest at all

Even though it’s not taxable, you must report it on Line 2a. Your broker already reported it to the IRS. If you don’t report it, you’ll get a letter.

Mistake #2: Putting tax-exempt interest on the wrong line

Tax-exempt interest goes on Line 2a. Taxable interest goes on Line 2b. Don’t mix them up.

Mistake #3: Assuming federal tax-exempt means state tax-exempt

Out-of-state municipal bonds are usually taxable at the state level. Check your state’s rules.

Mistake #4: Not keeping your Forms 1099-INT

Keep them for at least three years. You’ll need them if the IRS questions your return.

Mistake #5: Forgetting about private activity bonds and AMT

If Box 9 of your Form 1099-INT has a number, check if you’re subject to AMT. That “tax-exempt” interest might not be fully tax-exempt.

Mistake #6: Not adjusting for nominee interest

If you share an account with someone who’s not your spouse, you may need to issue them a Form 1099-INT for their share of the interest.

Conclusion

Tax-exempt interest means you don’t pay federal income tax on it. But you still report it on Line 2a of Form 1040.

Why? Because the IRS uses that number to calculate other parts of your return — like Social Security taxability and eligibility for certain credits.

Three things to remember:

1. Report it on Line 2a — even though it’s not taxable
2. Check your state’s rules — out-of-state bonds might be taxable at the state level
3. Keep your Forms 1099-INT — you’ll need them if questions come up

If you own bonds from multiple states or you’re dealing with private activity bonds, talk to a tax professional. They’ll make sure you’re reporting everything correctly.

Tax-exempt interest is a great tax break. Just report it right so you can enjoy it.