What Are Exempt-Interest Dividends?

Exempt-interest dividends are a class of mutual fund distribution that are not subject to federal income taxes. They’re 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 work with 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 type of income paid to investors by certain qualifying mutual funds. These dividends are exempt from federal income tax, although investors may still owe state or local taxes depending on where they live. Exempt-interest dividends offer a potential tax advantage for investors seeking income-producing assets.

Mutual funds are pooled investment vehicles that generate returns based on the performance of their underlying assets. A fund manager selects a mix of investments — such as stocks, bonds or other securities — and packages them into a single investment product. Investors purchase shares in the fund and receive returns in proportion to their ownership.

For example, if a mutual fund’s investments generate a total annual yield of $500, and you own 1% of the fund, you would receive $5 in income. The actual return you earn depends entirely on the assets held within the fund’s portfolio.

How Exempt-Interest Dividends Work

Some mutual funds specifically invest in tax-exempt securities, such as bonds issued by state and local governments or qualified nonprofit organizations. Interest income from these bonds is generally exempt from federal income tax, and in some cases, state and local taxes, as well.

When a mutual fund holds these types of tax-exempt bonds, it can pass the tax benefits on to investors in the form of exempt-interest dividends. These dividends are not subject to federal income tax, unlike standard dividends, which are typically taxed as either ordinary income or capital gains. However, state tax treatment varies, and some jurisdictions may still tax this income.

Exempt-interest dividends can be a valuable tool for investors in higher tax brackets who want to reduce their taxable income while generating consistent investment returns. As always, it’s a good idea to consult a financial advisor or tax professional to determine how these dividends fit into your overall investment and tax strategy.

Why Invest in Exempt-Interest Dividends?

An investor weighs the benefits vs the risks of an investment.

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.

How to Invest in Exempt-Interest Dividends

Investing in exempt-interest dividends typically involves purchasing shares in mutual funds that hold tax-exempt municipal bonds. These funds are commonly referred to as municipal bond funds or tax-exempt bond funds.

To get started, identify mutual funds that specialize in tax-exempt municipal bonds. You can find these funds through brokerage platforms, mutual fund providers or with the help of a financial advisor. Be sure to review the fund’s prospectus to confirm that it primarily invests in federally tax-exempt securities. Some funds may also offer double tax-exempt or triple tax-exempt status. This means they’re free from not only federal taxes but also state and local taxes — particularly beneficial if you live in the same state the bonds were issued.

When evaluating municipal bond funds, pay close attention to factors such as the fund’s credit quality, duration, yield and expense ratio. Funds that invest in higher-rated bonds may offer lower yields, but carry less risk. Conversely, funds holding lower-rated bonds may offer higher income but come with increased credit risk.

Keep in mind that while exempt-interest dividends can lower your tax liability, they may still be subject to the alternative minimum tax (AMT) and state income tax, depending on your location and tax situation.

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 financial advisors who serve your area. 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 provide 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.