In some cases, a taxpayer may have earned tax-exempt interest. Most tax-exempt interest is earned by owning municipal bonds, either directly or indirectly via mutual fund ownership. Municipal bonds are issued by both federal and state governments. For federal tax purposes1, all interest income earned through both federal and state municipal bond ownership is tax-exempt. Despite its tax-free status, each interest-paying municipality or institution will usually send the taxpayer a Form 1099-INT, listing how much tax-exempt interest was paid to the taxpayer. The taxpayer will use this form to report his/her tax-exempt interest income on Form 1040, Line 8b.
Interest earned from the following sources is not to be listed as tax-exempt income on Form 1040, Line 8b: an IRA, a health savings account, an Archer or Medicare Advantage MSA, or a Coverdell education savings account.
1Note on state tax treatment of municipal bond interest: Each state has particular taxing rules regarding its treatment of state-issued municipal bonds. Arizona, for example, exempts interest income earned from Arizona-issued municipal bonds but taxes interest income earned on bonds issued by other states. Moreover, many states tax all state-issued municipal bond interest income while others choose to exempt all interest income earned on any state-issued municipal bond.
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