How is tax-exempt interest income generally treated?

Tax-exempt interest income is generally excluded from taxable income, which is reflected in the correct answer. This treatment applies to interest earned from specific types of investments, most notably municipal bonds, where the interest is not subject to federal income tax and often not subject to state or local taxes as well.

While there are certain exceptions, such as tax-exempt interest that may become taxable under specific circumstances (e.g., when used to calculate the alternative minimum tax), the fundamental principle is that tax-exempt interest is not included in the taxpayer's gross income. This characteristic allows investors to benefit from a higher effective yield on investments that produce tax-exempt interest compared to taxable securities, as they do not need to account for tax liabilities on that income when calculating their total tax burden.

In summary, tax-exempt interest income stands apart from standard taxable income, emphasizing the importance of understanding which types of income are tax-free and the potential benefits of investing in tax-exempt securities.