Exempt-interest dividends are a class of mutual fund distribution not subject to federal income taxes. They are uncommon, if not relatively rare, and only apply to specific funds that invest in asset categories like qualifying municipal bonds. When analyzing mutual funds or bonds as a potential investment, it’s best to make sure your financial plan is set. You can use the help of a financial advisor to oversee your assets or help put you on the right investment path.
What Is an Exempt-Interest Dividend?
An exempt-interest dividend is a yield issued by certain, qualifying mutual funds. Investors who receive exempt-interest dividends do not have to pay federal income taxes on this money, although they may owe state taxes depending on their jurisdiction.
Mutual funds are portfolio-based assets that issue returns based on the value of their underlying investments. The firm which manages a mutual fund will purchase a group of assets, such as a collection of stocks and bonds and will represent all of those assets together as a single investment. Investors can then buy shares and will receive capital gains and yields based on their proportional ownership of the overall portfolio.
For example, if collectively all of the stocks and bonds in a mutual fund’s portfolio paid a yield of $500 in a given year and you owned shares worth 1% of that fund’s portfolio, you would receive a yield of $5 from your investment. The return that you receive from any given mutual fund will depend entirely on what assets the fund has chosen to invest in.
Some mutual funds invest in state, municipal and nonprofit bonds. These are bond instruments issued by state governments, municipal governments and qualifying nonprofit organizations. Investors are not required to pay taxes on the interest payments they receive from any of these instruments.
The same is true whether you own these bonds individually or collectively. When a mutual fund is made up of qualifying, tax-exempt bonds, the dividends it issues to its investors are similarly untaxed. In this case, the mutual fund will issue exempt-interest dividends. Investors don’t owe federal income or capital gains taxes on those dividends, although they may owe state taxes depending on their local income tax laws. This is as opposed to standard dividend payments, which can be taxed as either ordinary income or capital gains.
Should You Invest Toward Exempt-Interest Dividends?
Usefully, this category of investment is a stable way to generate long-term yields. The bonds that pay tax-exempt interest tend to be extremely reliable. States and municipalities almost never default on their debt (in fact, by law many cannot do so). The same is true of nonprofits large enough to issue bonds. Combined with the nature of bonds, which typically don’t mature for decades, this makes for a very reliable asset.
In addition, your yields will be functionally increased by the value of your tax savings. For example, say your income would put any mutual fund dividend payments in the 15% tax bracket. That functionally increases your gains from an exempt-interest dividend by the same amount (the money you didn’t lose).
However, investors should balance this against the low returns typical of this asset class. Precisely because governments almost never miss their payments, they also can pay extremely low rates of interest. The same stability that makes this a reliable asset also makes it one with a relatively low yield. That’s generally true even after you account for the tax savings inherent to an exempt-interest mutual fund.
Investors should keep this in mind. Exempt-interest dividends are excellent for tax planning purposes and reliability, but also don’t tend to generate strong yields. Weighing the pros and cons will help you determine if it is a good investment for your financial goals.
Bottom Line
Exempt-interest dividends are yields that you receive from qualifying mutual funds that have invested in a certain category of bonds. You do not have to pay federal income or capital gains taxes on this category of yields, although you may have to pay state taxes. This can be a good investment for those wanting to earn from dividends, depending on the goals of the investor.
Tips for Investing in Bonds
- Bonds can be a good addition to your total financial plan, depending on what your goals are. You may benefit from speaking with a financial advisor who can help you figure out your right asset allocation. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Bonds are generally reliable, often provode a reasonable rate of return (at least compared to other asset classes with similar stability) and, best of all, they pay active yields. If we’ve got your interest in getting some getting some interest, here’s how to get started.
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