Navigating Tax Season: Tax-Exempt Interest & Form 1099

Alex Rasmussen |
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As tax season rolls around, many of us are looking forward to (with a hint of sarcasm!) the arrival of our Form 1099s. This form is packed with valuable information, but did you know it might not hold all of the information you need to minimize your taxes? 

Understanding Tax-Exempt Interest 

Interest from municipal bonds is usually free from federal income taxes, a fact well-known to many. But there's more to it. Most states, for example, won't tax interest from their own municipal bonds. Take South Carolina: it doesn't tax interest from its own municipal bonds but does tax interest from North Carolina bonds, and the reverse is true as well. 

Additionally, interest from bonds issued by U.S. territories like American Samoa, Guam, Puerto Rico, and others, is exempt from state income taxes. Plus, while U.S. Treasury bond interest is taxable federally, it's exempt from state taxes. 

The Complexity with Mutual Funds and ETFs 

For individual securities, your 1099 should reflect the correct tax treatment. Owning a U.S. Treasury security or a South Carolina municipal bond? The form will clearly indicate the tax-exempt interest. 

However, if you're invested in mutual funds or exchange-traded funds (ETFs) holding these securities, it gets trickier. Your 1099 might not spell out the income source by state, U.S. territory, or U.S. Treasury debt. This means you'll need to dig into the fund's details to uncover potential state tax exemptions. 

Good News for Diligent Investors 

Fortunately, most mutual funds and ETFs offer supplemental information to help you out. Let's say you have a municipal bond fund that paid $1,000 in exempt-interest dividends last year. This will appear in box 12 of your Form 1099-DIV. But if you rely solely on this form, you might end up paying state tax on all of it. 

Imagine if 3% of these dividends were from South Carolina and another 3% from U.S. territories. In this scenario, 6% ($60) of your dividend is exempt from South Carolina state tax. This principle also applies to funds with U.S. Treasury obligations. While the savings might seem small initially, they can add up significantly over time, and the information is readily available. 

 

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