Tax-exempt interest
Also: tax-exempt interest, tax-free interest, muni interest, exempt-interest dividends
Interest income that is not subject to federal income tax, most commonly interest on state and local government bonds. Reported on Form 1040 Line 2a but excluded from taxable income.
Tax-exempt interest is interest income that escapes federal income tax under IRC Section 103, primarily interest on state and local government bonds and exempt-interest dividends from municipal bond funds. While federally exempt, tax-exempt interest counts in several adjacent calculations: it increases MAGI for purposes of the Social Security taxability formula and the Net Investment Income Tax MAGI threshold, and certain private-activity bond interest is an AMT preference item. It is reported on Form 1040 Line 2a for disclosure but not added to AGI.
Example: a retiree has $60,000 of Social Security income and $40,000 of tax-exempt muni interest. The tax-exempt income is used in the provisional income formula, which causes 85% of Social Security to become taxable. The muni interest itself remains federally exempt, but it shifted Social Security into the taxable zone.
Common mistake: ignoring tax-exempt interest when calculating the NIIT MAGI threshold. MAGI for NIIT explicitly adds back tax-exempt interest in certain cases, although the standard NIIT calculation does not.
Tax-exempt interest matters for high-bracket filers holding muni-heavy portfolios, for retirees managing Social Security taxability, and at AMT-preference bond holders.