How Does Tax-Exempt Interest Income Affect FAFSA?

Eligibility for federal student financial aid is primarily based on income as reported for tax purposes. However, tax-exempt interest income can impact a student’s financial aid eligibility. Interest earned from municipal bonds is an example of this type of income. Although this income is not subject to federal income tax, it is included as part of the parents’ or student’s adjusted gross income (AGI) when completing the Free Application for Federal Student Aid (FAFSA). This means that higher tax-exempt interest earnings may reduce the amount of need-based aid a student qualifies for.

A financial advisor can help you use income and investment strategies to manage the impact of tax-exempt interest on FAFSA.

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How FAFSA Works

The Free Application for Federal Student Aid (FAFSA) determines a student’s eligibility for federal financial aid by assessing the applicant’s financial situation. The process starts with calculating the Student Aid Index (SAI) – formerly known as the Expected Family Contribution (EFC) – which estimates how much a family can contribute toward college costs.

FAFSA collects income and asset information from both the student and, if applicable, their parents. Key financial inputs include AGI, tax-exempt interest income, untaxed income and reportable assets. This data is used to generate the SAI, which schools then use to determine financial aid packages. A lower SAI generally means a student can receive more Pell Grants, Federal Work-Study, subsidized student loans and other need-based aid.

FAFSA doesn’t look only at income. The formula also considers household size, number of family members in college and cost of attendance (COA) at each school. It does not factor in liabilities like credit card debt or mortgage payments. Even though some forms of income, such as tax-exempt interest, do not increase taxable income, they still impact aid eligibility.

Types of Tax-Exempt Interest Income

Tax-exempt interest income primarily comes from certain types of bonds and investment funds. The most common sources include:

Municipal bonds: Issued by state and local governments to fund public projects, these bonds generate interest that is typically exempt from federal taxes and, in some cases, state and local taxes if the investor resides in the issuing state.
U.S. Treasury securities: Some Treasury-issued savings bonds, such as Series EE and Series I bonds, may offer tax benefits when used for qualified education expenses. Although exempt from federal taxes under certain conditions, they are still included in FAFSA calculations.
Tax-exempt bond funds: Mutual funds or exchange-traded funds (ETFs) that invest in municipal bonds can also provide tax-exempt interest income. While these funds offer diversification, their interest earnings remain reportable on FAFSA.

Since tax-exempt interest is factored into financial aid determinations, families holding significant investments in these assets should be aware of its potential impact on eligibility for need-based assistance.

Where to Find Your Tax-Exempt Interest Income

A mother and daughter looking up how to locate tax-exempt interest income.

Taxpayers can locate their tax-exempt interest income on their annual tax documents, primarily on IRS Form 1099-INT or IRS Form 1099-DIV. Financial institutions, such as banks or brokerage firms, issue these forms to report interest income, including tax-exempt amounts, for the year.

On Form 1099-INT, tax-exempt interest is listed in Box 8, while interest from private activity bonds, which may be subject to the alternative minimum tax (AMT), appears in Box 9. For investors in mutual funds or exchange-traded funds (ETFs) that hold municipal bonds, tax-exempt dividends are reported in Box 11 of Form 1099-DIV.

Additionally, this income is included on IRS Form 1040, the individual tax return. Even though it is not taxable at the federal level, it is still recorded on Line 2a. Taxpayers can refer to their investment account statements or consult their financial institution’s annual reports for further breakdowns of their tax-exempt holdings.

How to Report Tax-Exempt Income to FAFSA

When completing the FAFSA, tax-exempt interest income must be reported because it affects the SAI.

For example, suppose a parent earns $50,000 in taxable wages and receives $5,000 in tax-exempt interest from municipal bonds. Their AGI, as shown on IRS Form 1040 (Line 11), would reflect only the $50,000 in wages, excluding tax-exempt interest. However, when filling out FAFSA, the parent must separately report the $5,000 in tax-exempt interest, which FAFSA treats as untaxed income. This amount is entered under the Untaxed Income section, specifically the question asking for “tax-exempt interest income” from IRS Form 1040, Line 2a.

Even though tax-exempt interest does not increase taxable income, FAFSA includes it in financial aid calculations to assess total available resources. This means a household with substantial tax-exempt earnings may appear to have a higher ability to contribute to college costs, potentially reducing the student’s need-based aid eligibility, despite no additional federal tax liability on the income.

Bottom Line

A parent reviewing FAFSA documents with her children.

While tax-exempt interest income is not subject to federal taxes, it plays a role in financial aid calculations. FAFSA includes this income when assessing a family’s ability to pay for college, which can influence eligibility for need-based aid. Since FAFSA considers a broad range of financial factors, including untaxed income and household size, families may benefit from reviewing their financial picture before applying.

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