Exempt-interest dividends, often paid by municipal bond funds, are generally free from federal taxes. However, they may still be taxed at the state level. How states tax exempt-interest dividends depends on factors like the investor’s residency and where the bonds were issued. Some states exclude dividends from in-state municipal bonds while taxing those from out-of-state issuers. Others tax all exempt-interest dividends regardless of origin.
A financial advisor can help you navigate the tax implications of certain investments, including municipal bonds. Connect with an advisor today.
Exempt-interest dividends are distributions from mutual funds that invest in municipal bonds issued by state and local governments to finance public projects. These dividends represent the tax-free interest earned by the fund on its bond holdings, which passes to investors. Unlike traditional dividends from stocks or taxable bond funds, exempt-interest dividends do not stem from corporate earnings but rather from government-issued debt instruments.
The appeal of these dividends largely depends on an investor’s income level, portfolio strategy and long-term financial goals. Investors often use funds that generate exempt-interest dividends to manage tax-efficient income. This is especially true among those in higher tax brackets, where the benefits of tax-free earnings become more valuable.
While these dividends are not subject to federal income tax, investors must report these on their tax return. They count toward modified adjusted gross income (MAGI) and can affect Social Security taxation or one’s exposure to the alternative minimum tax (AMT).
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Nine states do not impose personal income taxes , thereby fully exempting exempt-interest dividends from taxation. In these states, residents can benefit from the federal tax-exempt status of these dividends without additional state tax implications. These states are:
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Alaska
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Florida
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Nevada
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New Hampshire
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South Dakota
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Tennessee
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Texas
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Washington
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Wyoming
New Hampshire previously taxed interest and dividends, but repealed this tax in January 2025.
It’s important to note that while these states offer full exemptions, tax regulations can change over time. Investors should consult with tax professionals or refer to state tax authorities to confirm current tax treatments of exempt-interest dividends in their respective states.
