Tax-exempt interest is income from certain bonds and accounts that you do not report on your federal tax return

Tax-exempt interest is money you earn from lending to a government or organization, but the IRS does not count it as taxable income. The most common source is municipal bonds — debt issued by states, cities, counties, and some nonprofits. When you own a municipal bond, the issuer pays you interest, and that interest is exempt from federal income tax. Some municipal bonds are also exempt from state and local income tax if you live in the state that issued them.

You still receive a Form 1099-INT or Form 1099-OID from the bond issuer or your brokerage showing how much tax-exempt interest you earned. You report this amount on your tax return — but on a specific line that does not add to your taxable income. The IRS wants to know you received it; they just do not tax it.

Other sources of tax-exempt interest include U.S. savings bonds (Series EE and Series I bonds) when used for education, interest from certain state and local government bonds, and interest from bonds issued by Native American tribes. The rules for each type differ, and some have income limits or other conditions.

Key Takeaways

  • Tax-exempt interest from municipal bonds does not count toward your federal taxable income, even though you must report the amount on your return.
  • You will receive a Form 1099-INT or Form 1099-OID showing tax-exempt interest, and you report it on line 2a of Form 1040 (marked as tax-exempt).
  • Some municipal bonds are also exempt from state and local income tax if you live in the issuing state.
  • Series EE and Series I savings bonds used for may have access to education expenses may have tax-exempt interest, but you must meet income and other requirements.
  • Tax-exempt interest still counts toward certain income thresholds that determine whether you can claim other tax benefits.

Where tax-exempt interest comes from

Municipal bonds are the primary source. When a city, county, state, or local government agency needs to borrow money for a project — a new school, highway, water system, or hospital — they issue bonds. You lend them money by buying the bond, and they pay you interest over time. Congress exempts this interest from federal income tax to encourage people to lend to local governments at lower interest rates.

Certain nonprofit organizations also issue tax-exempt bonds. These include hospitals, universities, and housing organizations. The interest they pay is also exempt from federal tax, though the rules are stricter than for government bonds.

U.S. savings bonds (Series EE and Series I) can produce tax-exempt interest if you use the proceeds to pay for may have access to education expenses — tuition and fees at an accredited school or university. You must meet income limits, and the bond must have been issued to someone age 24 or older. The interest is exempt from federal tax, though you may still owe state tax.

How to report tax-exempt interest on Form 1040

You will receive a Form 1099-INT or Form 1099-OID from your brokerage, bank, or the bond issuer by January 31 of the year after you earned the interest. This form shows the amount of tax-exempt interest in a separate box, usually labeled "tax-exempt interest" or "tax-exempt OID."

On Form 1040, line 2a asks for "Interest." You enter the total of all interest income here, including tax-exempt interest. On line 2b, you enter only the taxable portion. The difference — the tax-exempt amount — goes on line 2c, which is labeled "Tax-exempt interest." This line does not add to your adjusted gross income (AGI).

If you use tax software, the program will ask whether you have tax-exempt interest. Enter the amount from your 1099 form, and the software will place it on the correct line automatically. Do not skip this step even though it does not reduce your tax bill — the IRS cross-checks the 1099 forms you receive against your return.

Why tax-exempt interest still matters for your taxes

Even though tax-exempt interest does not count as taxable income, it counts toward your modified adjusted gross income (MAGI) for certain purposes. This affects whether you can claim other tax benefits.

For example, if you are deciding whether you can contribute to a Roth IRA, the IRS includes tax-exempt interest when calculating your MAGI to see if you exceed the income limit. The same is true for the student loan interest deduction, the education credits (American Opportunity and Lifetime Learning), and the Earned Income Tax Credit (EITC). You may lose or reduce these benefits even though the tax-exempt interest itself is not taxed.

This is why it matters to report tax-exempt interest accurately. Omitting it could cause you to claim a benefit you do not actually may have access to for, which the IRS may catch during an audit.

State and local tax treatment of municipal bonds

Federal tax exemption is automatic for municipal bond interest. State and local tax treatment varies. If you live in the state that issued the bond, the interest is usually exempt from that state's income tax as well. For example, if you own a New York municipal bond and live in New York, the interest is exempt from both federal and New York state income tax.

If you own a bond issued by another state, the interest is still exempt from federal tax, but you must pay state income tax on it (unless your state has a reciprocal agreement or exempts all municipal bond interest). Some states — including Illinois, Iowa, Kansas, Louisiana, Mississippi, Missouri, Oklahoma, and South Carolina — exempt all municipal bond interest from state tax, regardless of where the bond was issued.

Check your state's tax rules or ask your tax preparer whether the municipal bonds you own are exempt from your state income tax. This information does not appear on the 1099 form; you have to research it separately.

Tax-exempt interest from savings bonds

Series EE and Series I savings bonds can produce tax-exempt interest, but only if you meet specific conditions. You must use the bond proceeds to pay for may have access to education expenses in the same year you redeem the bond. may have access to expenses include tuition and mandatory fees at an accredited school or university. Room and board, books, and supplies do not count.

You must have been age 24 or older when you purchased the bond. The bond must have been issued after 1989. And you must meet income limits — if your modified adjusted gross income exceeds a certain threshold (which changes each year), you lose the exemption partially or entirely.

To claim the exemption, you do not report the interest as tax-exempt on your Form 1040. Instead, you exclude it from income entirely by using Form 8815 (Exclusion of Interest from Series EE and I U.S. Savings Bonds Issued After 1989). You will receive a Form 1099-INT showing the interest, but you will not report it on line 2a if you may have access to for the exclusion.

Common mistakes when reporting tax-exempt interest

The most common error is omitting tax-exempt interest from your return entirely. Because it does not reduce your tax, people sometimes think they should not report it. This is wrong. The IRS receives a copy of your 1099 form and will notice if you do not report the amount. Even though you will not owe additional tax, the IRS may send you a notice asking why the amount is missing.

Another mistake is reporting tax-exempt interest as taxable interest on line 2b instead of line 2c. This inflates your AGI and MAGI, which can reduce other tax benefits you are may have access to to. Use the 1099 form to determine which portion is tax-exempt and which is taxable, and place each on the correct line.

A third error occurs with savings bonds. People sometimes claim the education exclusion on Form 8815 without checking whether they meet the income limits. If your income exceeds the threshold, you cannot exclude the interest, and filing Form 8815 incorrectly can trigger an audit. Review the income limits for the year you are filing before you claim the exclusion.

Frequently Asked Questions

Do I have to pay any tax on tax-exempt interest?

No federal income tax. However, you may owe state or local income tax depending on where you live and where the bond was issued. Some states exempt all municipal bond interest; others exempt only bonds issued within the state. Check your state's rules.

What if I sell a municipal bond before it matures?

The interest you earned up to the sale date is still tax-exempt. If you sell the bond for more than you paid, the profit (capital gain) is taxable. If you sell it for less, you have a capital loss, which may offset other gains. Report the capital gain or loss on Schedule D of your Form 1040.

Can I claim a loss on a municipal bond that lost value?

Yes. If you sell a municipal bond for less than you paid, you have a capital loss. You can use it to offset capital gains or up to $3,000 of ordinary income per year. Excess losses carry forward to future years. Report the loss on Schedule D.

Does tax-exempt interest count as income for Social Security taxation?

Yes. Tax-exempt interest is included in the formula that determines whether your Social Security benefits are taxable. Even though the interest itself is not taxed, it counts toward the income threshold that triggers taxation of your benefits.

What is the difference between a 1099-INT and a 1099-OID for tax-exempt interest?

Form 1099-INT reports regular interest payments. Form 1099-OID reports original issue discount — the difference between what you paid for a bond and its face value. Both can show tax-exempt amounts. Your brokerage will send the correct form based on how the bond was structured.