Federally Tax-Exempt Interest & Dividend Income

The Internal Revenue Service taxes your income, including that stemming from investments. The United States uses a graduated tax rate system, meaning that the more you earn, the higher your tax bracket. By careful choice, you can put some of your investments into the zero tax bracket, free from federal income tax.

Interest

You collect interest when you lend money. One way to lend money is to buy the debt securities of a corporation or governmental entity. Corporate bonds and debt issued by the federal government pay interest that the IRS taxes at your marginal tax bracket -- the amount of tax you pay on the “last dollar” of annual income. However, states and local governments can issue municipal bonds paying interest that is free from federal taxes. To be tax exempt, the bonds must raise money used for the general good of the community, not for some private concern. The higher your bracket, the greater the tax savings you’ll enjoy from a tax-free municipal bond. Interest you earn from U.S. Treasury debt is usually free of state and local income taxes.

Dividends

Dividends are payments by corporations to shareholders of cash or additional stock. Most dividends qualify for the same low rates the IRS uses to tax long-term capital gains. For dividends to qualify, a corporation must pay taxes on its earnings, and its shares must be readily tradable in the United States. Nonqualified dividends, such as those issued by nonprofit organizations or obscure foreign corporations, get taxed at your marginal tax rate. To take advantage of the lower taxes on qualified dividends, you must meet the IRS holding period requirement for the dividend-paying stock.

Holding Period

When a corporation’s board of directors declares a dividend, it also announces the payment date and the ex-dividend date, the first date on which the stock trades without the current dividend. To take advantage of the tax break on a qualified dividend, you must hold the shares for at least 61 days surrounding the ex-dividend date. For dividends on preferred stock, you must hold the shares for 91 days if the dividends stem from a period of 366 days or more. You must hold mutual fund shares for 61 days to get the qualified dividend tax break.

Dividend Tax Rate

You might be able to avoid taxes on qualified dividends. For 2013, if you earn less than $400,000 in modified adjusted gross income -- the threshold is $450,000 for couples filing jointly -- and your tax bracket is below 25 percent, your qualified dividends are tax-free. Your broker or bond dealer issues IRS Form 1099-INT shortly after the end of the year, telling you how much taxable and tax-free interest you earned in the previous year. A mutual fund provides this same information on Form 1099-DIV, a form that also allows mutual funds and brokers to report the amount of qualified and nonqualified dividends you received. You use these forms to fill out Form 1040 when filing your tax return.