'Tax Exempt Income' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Tax Exempt Status means that certain transactions or earnings in the form of income will not be taxed at either the local, state, or even federal, (or a happy combination of all three) level. As taxpayers earn their income or sell some of their assets to realize a gain before the end of a given tax year, then they create a tax liability for themselves with the government. Tax deductions should never be confused with tax exemptions, since these deductions only lower the residents’ tax liabilities.
Tax exempt items are those which are entirely excluded from any forms of tax computations. Items which are tax exempt income might be reportable on the individuals’ (or otherwise business or not for profit organization entities’) tax returns only as information. It is important to note that these exempt items are not included in the tax calculations.
A common example of tax exempt income is municipal bonds which pay interest. Such bonds are those which cities and states issue in order to generate money for particular projects or general operations. For those taxpayers who gain interest income off of such municipals which are sold from the state in which they reside, this income becomes exempted from both state and federal taxes for them.
In these cases, taxpayers will be given a 1099-INT form to be utilized for all investment interest which they earned throughout the year. All tax-exempt interest will be reported on box eight of the tax form. Such interest earnings will only be reported for the purposes of providing information. It would not be covered in the calculations for personal income taxes. In other cases, interest earnings are fully taxable events.
There are some kinds of capital gains which can be classified as tax exempt income as well. For instance, these capital gains could be offset against other cases of capital losses in the same taxable year. As an example, investors who make $10,000 in capital gains and who also realize $5,000 in capital losses at the same time on a different asset or investment will only pay their taxes on the $5,000 net capital gains which remain after subtracting the capital losses from the capital gains in the same taxable year.
In many cases, when there are significant capital losses, these can be “carried forward” into the future to offset any capital gains for those coming years. American Federal tax codes also permit taxpayers to take a part of their capital gains from home sales and exclude them from federal taxes. This is permissible up to a specific and pre-set dollar amount. The rule became set up in order for those homeowners who sell their homes to be able to protect these gains from taxes so that they can help to fund their future retirements.
Another factor which affects tax exempt income is a calculation known as AMT, or alternative minimum tax. This secondary tax calculation can be required on some individual tax returns. Alternative Minimum Tax considers some previously ruled out as tax exempt items and puts it back into the personal tax calculation. As an example, income from municipal bonds is put back into the mix when using the AMT calculations. Taxpayers are often required to use an AMT calculation on their original tax returns so that they can be made to pay the higher amount of tax from the larger tax liability.