Tax-exempt dividends are often taxable at the state level, even though they carry no federal tax. What decides it is where the underlying municipal bonds were issued: interest from bonds issued in your home state is generally exempt on your state return, and interest from bonds issued in other states is generally taxable. Investors who hold national municipal bond funds are the ones most likely to owe state tax on income they assumed was fully tax-free.
The In-State Versus Out-of-State Rule
Federal law under Internal Revenue Code Section 103 excludes interest on state and local government bonds from your federal gross income.1Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds A mutual fund or ETF holding those bonds passes the interest through to you as exempt-interest dividends. That federal exemption says nothing about what your state can do, and most states with an income tax set their own rules.
Bonds issued by your own state or a local government within it usually give you a double exemption: no federal tax and no state tax. States offer the break to lower borrowing costs for their own governments and to steer investment toward local infrastructure, schools, and public projects.
Bonds issued by another state are a different story. The majority of states that impose an income tax require you to include interest from out-of-state municipal bonds in your state taxable income. Your state has no incentive to forgo revenue on a bond that funded a highway or school somewhere else.
For a national municipal bond fund, this can be a large share of your dividends. If you live in a state with a 5% income tax and 80% of the fund’s tax-exempt income came from out-of-state issuers, that portion is fully state-taxable. Investors who miss this on their state return risk penalties and interest on the underreported amount.
A small number of jurisdictions depart from the general rule. At least one state and the District of Columbia exempt interest from all municipal bonds regardless of where they were issued, and a few others exempt out-of-state bonds only on a reciprocal basis. These exceptions are narrow, so confirm your own state’s rule rather than assuming you fall inside one.
The in-state exemption also has conditions when you invest through a fund. Only the portion of the fund’s dividends attributable to bonds issued in your state keeps the state-level exemption. Some states also require a minimum percentage of a fund’s assets to come from qualifying in-state or federal obligations before any of the dividends qualify. Check your state’s threshold before claiming the exemption.
If Your State Has No Income Tax
If you live in a state with no personal income tax, the state-level question doesn’t arise. There is no mechanism to collect tax on the dividends, and you don’t need to break down your fund’s income by state of issuance for state filing. Your only concern is the federal side.
A few states historically taxed investment income while exempting wages. Most of those carve-outs have been repealed or phased out, so if your understanding of your state’s rules is a few years old, confirm the current position before you file.
U.S. Territory Bonds Are Exempt Everywhere
Bonds issued by Puerto Rico, Guam, the U.S. Virgin Islands, American Samoa, and the Northern Mariana Islands are exempt from federal, state, and local income tax no matter where in the United States you live.2Internal Revenue Service. TEB Phase III – Lesson 4 TEB International US Territories/Possessions The Internal Revenue Code defines “State” to include U.S. possessions for Section 103 purposes,1Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds and a separate federal statute prohibits states from taxing the interest.3Office of the Law Revision Counsel. 48 USC 1670 – Industrial Development Bonds
When you work out the state-exempt share of your dividends, treat territorial bond income the same way you treat in-state income: it comes off your state taxable income. The tax benefit does not eliminate credit risk, so evaluate the issuer’s financial health the same way you would for any other bond.
How to Work Out the State-Taxable Share
Start with Form 1099-DIV. Box 12 reports total exempt-interest dividends paid by the fund during the year.4IRS.gov. Form 1099-DIV (Rev. January 2024) That figure is the amount excluded from your federal income. It does not break the income down by state of issuance, which is what you need for your state return.
Get the fund company’s supplemental tax report. It lists what percentage of the fund’s tax-exempt income came from each state and from U.S. territories. Multiply your Box 12 amount by the percentages for your home state and for territories to get the state-exempt portion. The remainder is the out-of-state share, which goes on your state return as taxable interest. Most fund companies publish these breakdowns on their websites by mid-February.
If you hold bonds directly rather than through a fund, the issuer information on your Form 1099-INT identifies the state of origin, so the sorting is straightforward.
If your 1099-DIV contains an error, contact the brokerage firm and request a corrected form. If the firm doesn’t issue one, you can contact the IRS at 800-829-1040. File your return with the figures you believe are correct and attach Form 8275 to explain the discrepancy, which helps limit penalties if the IRS questions the mismatch.5Internal Revenue Service. Challenging Information Returns
Exempt Dividends Can Still Raise Other Taxes
Even the portion of your dividends that escapes both federal and state income tax is not invisible to the rest of the tax code. Two spots catch retirees in particular.
The Social Security Administration counts tax-exempt interest when it calculates how much of your Social Security benefits are taxable. Your “combined income” is adjusted gross income plus tax-exempt interest plus half of your Social Security benefits. Once that figure exceeds $25,000 for an individual or $32,000 for a married couple filing jointly, up to 85% of your benefits become taxable.6Social Security Administration. Must I Pay Taxes on Social Security Benefits? The thresholds have not been indexed for inflation since the 1980s, so a sizable municipal bond portfolio can push you over them without much effort.
Medicare premiums work the same way. The income-related monthly adjustment amount (IRMAA) for Medicare Part B and Part D is based on modified adjusted gross income, which includes tax-exempt interest.7Social Security Administration. Premiums: Rules for Higher-Income Beneficiaries For 2026, the standard Part B premium is $202.90 per month, and IRMAA surcharges start once MAGI exceeds $109,000 for individual filers or $218,000 for joint filers. At the top bracket ($500,000 single, $750,000 joint), the monthly Part B premium rises to $689.90.8Medicare.gov. 2026 Medicare Costs Tax-exempt interest that lifts you into a higher IRMAA bracket can cost thousands of dollars a year in added premiums, even though the interest itself was never taxed.