First, let me explain tax-exempt interest. If you purchased state or local bonds (or obligations), you’ll receive interest income and that income isn’t taxable on your federal return (yeah!). That’s why the interest is called tax-exempt.
So why do you have to enter it on your tax return? Even though the interest isn’t taxable, it can affect other amounts on your tax return. When TurboTax figures out if you are eligible for the earned income credit, your tax-exempt interest is included in the calculation. It’s the same for determining how much of your social security income is taxable.
States are very happy that you have to enter the amount because generally you pay state taxes on that interest income. If you have bonds from your resident state, the chances are good that you won’t have to pay state taxes. (One more yeah!)
Here’s an example. Harry and Sally both live in California. Harry receives tax-exempt interest from a California bond; Sally receives tax-exempt interest from an Oregon bond. Harry’s tax-exempt interest will not be taxable on his federal and California returns. Sally tax-exempt interest will not be taxable on her federal return but will be taxable on her California return. (Isn’t it fun learning about tax-exempt interest?)
Now back to your tax returns.
In prior years, you spent time searching through your broker’s statements to find your total tax-exempt interest so you could enter it on your return. If it was from your resident state bond, it wasn’t even taxable on the federal return! Or maybe you didn’t report it at all even if it may have been taxable on your state tax return.
Well, Congress figured out that you might not be reporting it.
Starting in 2006, your tax-exempt interest income will now be reported the same way your regular interest income has always been reported – on a form 1099-INT. So you won’t need to be searching through your files. What’s more, now the entire world (at least the IRS and all the states) will know the total of your tax exempt income. I’m sure that states are smiling!
If you received tax-exempt interest in 2006, be sure to read this posting. Your tax-exempt interest will now be reported on your 1099-INT.