dbr wrote:Yes, it goes on line 8b of the 1040. You will not be assessed federal tax on this amount. If you file a state income tax return you may be taxed on part or all of that.

+1

Federal tax return.Last year I noticed TaxACT listed TE interest in two places: (1) on form 1040 (above), and (2) on Sch B as both an addition to interest income (for completeness) and then as a subtraction from total interest. All I needed to do was answer the tax software 1099 questions and it completed the federal forms/return.

State tax return.For my state tax return, the process is a little more involved, if I don't want to over pay state income taxes. Read your state tax instructions closely for allowable TE-income deductions.

For my CO state return, the tax software **added the TE interest (from 1040) to my adjusted gross income (from 1040) to compute my state taxable income. This is guaranteed to be the highest state taxable income. But I can lower this amount if I compute the below deductions.

Deductions from state income taxes for TE income. My state allows the deduction from TE income (which is taxable for state purposes) that portion which is earned in the state. (Other states are less generous.) This information can be *computed from the tax information Vanguard send us. The computation is required as the tax software does not know about Vanguard's TE-bond state-investing percentages.

*The computation is simple enough. Vanguard's 1099(s) lists the amount(s) you earned from each TE bond fund, and the Vanguard tax information lists the state percentages. So if I earned $100 in TE interest from VMLTX (OP's example) and 1% came from CO, then I am allowed to deduct $1 on my state tax return.

Compute the (state) deductible amounts for each TE-bond fund.

Compute total deductible amount.

The tax software asked some question like, "How much tax-exempt interest to exclude from your state tax return?" Once I answered that, then the tax software has enough information to complete the TE-interest add-back portion of my state tax return/forms. **It was listed as a reduction in the TE-income add-back amount used to compute my state taxable income.

Instead of $100 in TE-interest add back on my state tax return, it became $99 in TE-interest add back.

Deductions from state income taxes for US Government interest. Notice some of your TE bond income may have come from US territories and possessions.

*Compute this amount and it should be listed as a state income tax subtraction for US Government Interest earned.

*If 1% of VMLTX's $100 TE interest came from US territories and possessions, then I can subtract $1 as US Government Interest income.

Bottom line. For OP's VMLTX example, I reduced my state taxable income by $2 by computing above deductions. And at my state's 5% flat tax rate, that reduces my state income taxes owed by 10 cents... which is rounded to $zero for this example. YMMV. That's all I remember from last year.

Edit. For completeness.
d.r.a, not dr.a.