Have you ever wondered why you need to report ‘Tax Exempt Interest’ on your 1040 tax return? If something is tax exempt, why would it need to get reported? You don’t pay taxes on it, do you? Look at line 8b of the 1040 tax return below, it asks you to report “Tax Exempt Interest.”
One would like to think that tax exempt interest is tax free, unfortunately, there are two cases where this is not the case. The first has to do with the Alternative Minimum Tax (AMT). The more common case is during retirement when tax exempt interest can CAUSE taxes on your Social Security benefit!
I often hear about the benefits of Tax Free Municipal Bonds, but keep in mind, you only benefit if you aren’t being taxed on them!
Let’s look through a couple of sample tax returns to help illustrate this point.
In both, examples on line 7, earned income, they have $100,000. However, the example on the left has no tax exempt interest, line 8b, and the one on the right, has $1 of tax exempt interest (look closely to find the “inside” column of 8b). Look at the total income on line 22.
It’s $100,000 for each example. So in this case, tax exempt interest really does mean, tax exempt! It’s working, you have an extra dollar of interest that doesn’t increase your taxes.
Now, let’s look at an example of a retired couple. In both examples, they have no earned income, they are taking $40,000 out of IRAs and getting $60,000 from Social Security. Look at what happens when we add one dollar to line 8b, tax exempt interest. (Look closely at each number and compare line 22).
Surprising!? By adding $1 dollar of tax “exempt” interest it CAUSING $1 more dollar of Social Security to be taxed and increasing your total income by $1 – going from $68,098 to $68,099.
What’s really happening here is that Tax Exempt Interest isn’t really tax exempt at all!
We call retirement ‘The Great Transition’ and what comes with it is a whole new set of rules. It is important to know how to best position yourself so you are in the most efficient tax position!