How Do States Tax Exempt-Interest Dividends?

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.

What Are Exempt-Interest Dividends?

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).

States That Fully Exempt Exempt-Interest Dividends

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:

• Alaska
• Florida
• Nevada
• New Hampshire
• South Dakota
• Tennessee
• Texas
• Washington
• 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New Hampshire previously taxed interest and dividends, but repealed this tax in January 2025.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.​

States That Tax Out-of-State Municipal Bond Income

Most states exempt interest income from in-state municipal bonds but tax interest earned from out-of-state bonds. This practice encourages investment in local projects by making in-state bonds more attractive to residents.

For example, California residents may exclude interest income from California municipal bonds on their state tax returns but must include interest earned from bonds issued by other states. Similarly, New York provides tax exemptions for interest on its own municipal bonds but taxes interest from out-of-state bonds.

This approach aligns with the U.S. Supreme Court’s decision in Department of Revenue of Kentucky v. Davis. This case upheld the constitutionality of states taxing out-of-state municipal bond interest while exempting in-state interest.

States That Tax All Exempt-Interest Dividends

Some states tax all such dividends, regardless of the bond’s origin.

For example, Illinois taxes all exempt-interest dividends, even those from in-state municipal bonds. Similarly, Minnesota requires that 95% of a mutual fund’s tax-exempt interest dividends are derived from Minnesota obligations for the income to be exempt; otherwise, all such dividends are taxable. Additionally, Indiana taxes interest earned from out-of-state municipal bonds acquired after December 31, 2011, even when held indirectly through mutual funds.

In these states, mutual fund investors may not get state tax breaks. This reduces the tax efficiency of their municipal bond holdings.

Bottom Line

States vary widely in how they tax exempt-interest dividends. Some offer full exemptions, while others impose taxes based on where the bonds originate. The distinction between in-state and out-of-state municipal bonds can influence an investor’s tax burden, potentially affecting the overall return on investment.

Given the differences in tax treatment, investors may need to assess how exempt-interest dividends fit into their broader financial strategy. Staying informed about state tax policies and evaluating investment choices accordingly can help individuals manage tax exposure and optimize the benefits of municipal bond funds.

Tax Planning Tips

• If you’ve sold investments at a gain, you can sell underperforming assets at a loss to offset those gains and reduce taxable income. This strategy, known as tax-loss harvesting, can be used to offset up to $3,000 of ordinary income annually, with additional losses carried forward to future years.
• A financial advisor with tax expertise can help you build a tax strategy around your income and assets. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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