Tax-Exempt Income

Tax-exempt income is income that the Internal Revenue Code excludes from gross income, so that it is never taxed at the federal level in the first place. Section 61(a) opens "Except as otherwise provided in this subtitle, gross income means all income from whatever source derived," and the exclusions are the exceptions that opening clause anticipates. The best-known is section 103(a): "gross income does not include interest on any State or local bond." Others include gifts and inheritances under section 102, life insurance proceeds paid by reason of death under section 101(a), damages for personal physical injury under section 104(a)(2), employer-provided health coverage under section 106, and qualified scholarships under section 117.

Two neighboring ideas get confused with it constantly. A tax deduction reduces income that was counted; an exclusion means the income was never counted. And tax deferral, which is what a traditional retirement account provides, postpones the tax rather than removing it. Only an exclusion means the money is never taxed.

Where the exclusion sits is what distinguishes tax-exempt income from tax-free growth. Interest on a municipal bond is excluded because of what the income is, wherever the bond happens to be held, with no account type and no conditions to satisfy. Tax-free growth inside a Roth account or a health savings account is a property of the wrapper rather than of the investment inside it, and it depends on satisfying the account's own rules. That is why holding a municipal bond inside a Roth account adds nothing: the interest was already excluded, and the contribution room has been spent on income that needed no shelter.

The exclusion is federal, and states go their own way. A state that taxes income commonly exempts interest on bonds it or its own subdivisions issued while taxing interest on other states' bonds. Employer-provided benefits, in contrast, tend to follow the federal treatment closely. There is no shortcut here: state conformity is a separate question for each item.

Excluded income still shows up, and in places that cost money. Tax-exempt interest is reported to you on Form 1099-INT and entered on your Form 1040 even though it is not taxed. More consequentially, several "modified adjusted gross income" definitions add it back. Section 86(b)(2)(B) increases modified adjusted gross income by "the amount of interest received or accrued by the taxpayer during the taxable year which is exempt from tax," which is the measure that determines how much of a Social Security benefit becomes taxable. Someone who moves a portfolio into municipal bonds specifically to reduce reported income may find that particular figure unchanged.

The exclusion is not free. Section 265(a)(1) disallows deductions allocable to tax-exempt income, and section 265(a)(2) disallows interest on debt "incurred or continued to purchase or carry obligations the interest on which is wholly exempt," which is why buying municipal bonds on margin is self-defeating. Separately, section 57(a)(5) makes interest on specified private activity bonds a preference item for the alternative minimum tax, and section 103(b) excludes non-qualified private activity bonds, arbitrage bonds and unregistered bonds from the exclusion altogether. "Most" municipal interest is exempt is the accurate hedge, not "all."

A category worth separating out: income that is exempt to one person and taxable to another. Life insurance death benefits are excluded to the beneficiary under section 101(a) but the policy's cash value is a different question entirely. Gifts and inheritances are excluded to the recipient under section 102 while the transfer tax system operates on the giver. The exclusion attaches to a person and a receipt, not to the money itself.

Excluded income is handled by leaving it out. There is no line where it is added and then removed. Tax-exempt interest gets a reporting line on Form 1040 so the IRS can see it and so the figures that add it back can be computed, but it does not flow into taxable income. Most other exclusions have no line at all: an inheritance and an employer's share of a health premium simply never appear.

What the exclusion is worth depends entirely on the recipient's marginal tax rate, which is why the same tax-exempt bond is a good buy for one household and a poor one for another. Comparing a tax-exempt yield with a taxable yield is done with a tax-equivalent yield calculation.

A hypothetical example of the add-back. Rosa's only income is $40,000 of Social Security benefits and $30,000 of interest from municipal bonds. Not one dollar of the municipal interest is taxable. But the measure that decides whether her Social Security benefits are taxable counts half her benefits, which is $20,000, plus the full $30,000 of tax-exempt interest, for $50,000. That is well above the $25,000 base amount section 86(c)(1)(A) sets for a single filer, so a portion of her benefits becomes taxable that would not have been if she had held no municipal bonds at all. The tax-exempt interest was never taxed; it still changed her bill. The arithmetic for how much of the benefit becomes taxable belongs to provisional income.

Pros

• The income is never taxed federally, rather than merely deferred, so there is no future rate risk attached to it.
• The benefit rises with the recipient's marginal rate, which makes it most valuable to the households facing the highest rates.
• Excluded amounts need no deduction, no itemizing, and no threshold to clear, so the benefit is not lost to a standard deduction or a phase-out.
• Some exclusions, such as employer health coverage, escape payroll tax as well as income tax.

Cons

• Tax-exempt bonds generally pay lower stated yields precisely because the interest is exempt, so part of the benefit is already priced into what you are paid.
• Expenses and interest allocable to producing tax-exempt income are disallowed under section 265, and margin interest used to carry exempt bonds is disallowed outright.
• Tax-exempt interest is added back in several income tests, so it can raise the taxable share of Social Security benefits and other income-tested amounts.
• Interest on specified private activity bonds is a preference item for the alternative minimum tax, so exempt for regular tax is not always exempt.
• State treatment varies, and out-of-state municipal interest is commonly taxable at home.
• For someone in a low bracket, the exclusion is worth little and a taxable alternative often pays more after tax.