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Exempt-Interest Dividend

Any dividend or part of it that a regulated investment company paid

What is an Exempt-Interest Dividend?

Exempt-interest dividend refers to any dividend or part of it that a regulated investment company paid. It is designated as such in a written notice that is mailed to the company’s shareholders within 45 days after the end of the taxable year.

 

Exempt-Interest Dividend

 

In the United States, there are some mutual funds that allow investors to invest in some types of municipal bonds or other types of investable securities that pay out tax-exempt interest.

Generally, in the US, one treats exempt interest earned from a dividend the same way as if you received a direct tax exemption. The dividends are subject to different rules and regulations, helping to clarify misconceptions or possible omissions in tax reporting.

 

Summary

  • In the United States, there are some mutual funds that allow investors to invest in some types of municipal bonds or other types of investable securities and gain tax-exempt interest.
  • Investment products that provide exempt-interest dividends carry the same risk factors as other security products but accrue a lower rate of interest and offer a poorer rate of return.
  • Some states may restrict the tax-free portion of the dividend to bonds that are purchased or belong to that state.

 

Importance of Exempt-Interest Dividend

  1. Exempt-interest dividends can affect the reporting of other exemptions on your taxes
  2. Can affect social security taxation
  3. Can be subject to alternative minimum tax (AMT)
  4. Must be reported legally and accurately on a tax return

 

Looking for Exempt-Interest Dividend – Who Should Seek It Out?

Investment products that have exempt-interest dividends carry the same risk factors as other security products but accrue a lower rate of interest and offer a poorer rate of return.

Thus, the taxation benefit will carry more weight for individuals who are higher earners and are taxed at a higher rate. When choosing an investment, the prudent investor must weigh all factors that include the effect of tax relief on their broader portfolio, as well as the total income they will be taxed on.

 

State Income Tax and Exempt-Interest Dividends

Depending on your state of residence if you are American, the interest that is federally exempt in the form of dividends is not necessarily exempt at the state level.

Some states may restrict the tax-free portion of the dividends to bonds that are purchased or belong to that particular state; thus, keeping holdings from multiple states and residing in another could make you open to local and state taxes you might’ve previously thought you would be exempt from.

It is why, in many scenarios, it is prudent to work with an accountant or do due diligence regarding which portion of your exempt-interest dividend is completely tax-free.

In North Carolina, for example, all taxpayers who receive interest on different notes and bonds from states outside of North Carolina must add the interest accrued to their North Carolina return. The only exemption to the regulation is if there is a statement from a supporting mutual fund showing that it is not taxable.

 

Alternative Minimum Tax (AMT) – Importance in Exempt-Interest Dividends

Tax-exempt interest dividends can still be subject to the alternative minimum tax (AMT). The AMT was largely designed to prevent high-income and high net worth individuals from using deductions like exempt-interest dividends to pay little or no income taxes.

To see if you are to pay an AMT in the United States, a specified IRS form must be filled out that helps you discover if you need to pay taxes in addition to your standard tax return.

The AMT prevents certain individuals from financing large capital projects like a shipping port through bonds and getting the interest exempted when they pay taxes on an already sizable income.

 

More Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Dividend Rate
  • Mutual Funds
  • Municipal Bond
  • Alternative Minimum Tax (AMT)

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