Federally exempt income is sometimes taxable in Maryland and sometimes not. Maryland starts its calculation with your federal adjusted gross income and then applies its own additions and subtractions, so a few things the IRS leaves out get pulled back in on your Maryland return, while other income the IRS taxes gets subtracted out. The item that catches the most filers is interest from out-of-state municipal bonds, which is federally tax-free but fully taxable in Maryland.
How Maryland Adjusts Federal AGI
Maryland doesn’t recompute your income from scratch. Your Maryland taxable income begins with the federal AGI from your 1040, and the state then applies two lists of modifications set out in the Tax-General Article, Title 10 of the Maryland Code.1Justia. Maryland Code Tax – General Title 10 – Income Tax Additions are amounts Maryland taxes even though the federal government doesn’t. Subtractions are amounts the federal government taxes but Maryland lets you exclude. After both lists are applied, you get to Maryland adjusted gross income, and from there you take the Maryland standard or itemized deduction to reach taxable income.
The practical takeaway: don’t assume federal exempt status carries over, and don’t assume federally taxable income is taxable here either. Both directions need to be checked.
Federally Exempt Income That Maryland Still Taxes
Interest on Out-of-State Municipal Bonds
The most common addition is interest from state and local government bonds issued outside Maryland. Federal law generally treats municipal bond interest as tax-free. Maryland honors that treatment for bonds issued by Maryland and its political subdivisions, but not for bonds issued by any other state or its political subdivisions or authorities.2Maryland General Assembly. Maryland Code Tax – General 10-204 If you hold bonds from Virginia, California, or anywhere else, that interest gets added back on your Maryland return.
The Comptroller’s office has confirmed that municipal or state obligations from jurisdictions other than Maryland are subject to Maryland income tax.3Comptroller of Maryland. Administrative Release No. 13
Diversified municipal bond funds create an extra step. Only the portion of the fund’s exempt-interest dividends attributable to Maryland obligations qualifies for the subtraction; the rest is taxable at the state level, even though none of it appeared as taxable income on your federal return. Fund companies typically publish a state-by-state breakdown each year, and you’ll need it to split your fund distributions correctly.
Other Add-Backs Under §10-204
Out-of-state bond interest is the most common addition, but §10-204 lists other amounts excluded from federal AGI that Maryland requires you to add back. Income from partnerships, S corporations, and trusts also flows through to individual Maryland returns based on each owner’s distributive share, and any portion that was excluded federally but doesn’t qualify for a Maryland exemption has to be included.
Federally Taxed Income That Maryland Exempts
Social Security and Railroad Retirement
Maryland fully exempts Social Security benefits. If any portion of your Social Security shows up as taxable on your federal return, you subtract the entire amount on your Maryland return. Railroad Retirement benefits get the same treatment.4Comptroller of Maryland. Technical Bulletin 51 – Senior Citizens and Maryland Income Tax The subtraction goes on line 11 of Form 502 and on Part 5 of Form 502R.
The Pension Exclusion
Maryland allows a pension exclusion of up to $39,500 for tax year 2024, with periodic inflation adjustments, for residents who are 65 or older, totally disabled, or whose spouse is totally disabled.4Comptroller of Maryland. Technical Bulletin 51 – Senior Citizens and Maryland Income Tax It applies to taxable pension, annuity, or endowment income from a qualified employee retirement system under Internal Revenue Code section 401(a), 403, or 457(b).
Watch the boundary here: traditional IRAs, Roth IRAs, rollover IRAs, SEPs, Keogh plans, ineligible deferred compensation plans, and foreign retirement income do not qualify. If your retirement money comes from any of those, this exclusion isn’t available. Claim the exclusion on Form 502R, attached to your return.
Military Retirement and Overseas Military Pay
Maryland allows a subtraction for military retirement income under Tax-General Article §10-207.5Maryland General Assembly. Maryland Code Tax – General 10-207 HB0800, passed in the 2025 session, increased the subtraction from $12,500 to $20,000 for qualifying individuals under age 55.6Maryland General Assembly. HB0800 – 2025 Regular Session A separate subtraction covers overseas military pay for active-duty service members stationed outside the United States; it phases out as total military pay rises above $15,000 and disappears at $30,000. Retirement pay and active-duty overseas pay are distinct provisions and shouldn’t be combined.
Interest on U.S. Government Obligations
Interest and dividends from U.S. government obligations, including Treasury bonds, notes, bills, and savings bonds, are subtracted from Maryland taxable income. The subtraction also reaches distributions from mutual funds that hold U.S. government obligations, to the extent those distributions are attributable to the government holdings.5Maryland General Assembly. Maryland Code Tax – General 10-207 Fund companies publish the percentage each year; use that to calculate how much of your fund’s distributions qualifies.
Where These Adjustments Go on Your Return
Maryland residents file Form 502. Nonresidents use Form 505.7Comptroller of Maryland. 2025 Maryland Form 505 Nonresident Income Tax Return Additions such as out-of-state bond interest are reported in the additions section of the form. Subtractions such as Social Security, the pension exclusion, and U.S. government obligation interest are itemized on Form 502SU and attached to the return.8Comptroller of Maryland. Individual Income Tax Forms Getting these modifications wrong is one of the most common filing errors the Comptroller’s office sees.
On the federal side, tax-exempt interest still has to be reported on Form 1040, line 2a. Payers issue Form 1099-INT (box 8 for tax-exempt stated interest) or Form 1099-OID (box 11 for tax-exempt original issue discount), and exempt-interest dividends from a mutual fund show up in box 12 of Form 1099-DIV.9Internal Revenue Service. Instructions for Form 1040 and 1040-SR Federal reporting doesn’t trigger federal tax on those amounts, but the numbers feed directly into Maryland’s addition calculation for out-of-state bonds.
Residency Changes the Answer
Maryland taxes residents on income from all sources, wherever earned. Nonresidents owe Maryland tax only on income from Maryland sources, and part-year residents file as residents for the portion of the year they lived in the state.7Comptroller of Maryland. 2025 Maryland Form 505 Nonresident Income Tax Return
That distinction matters for federally exempt income. A Maryland resident holding out-of-state municipal bonds owes Maryland tax on the interest no matter where the bonds were issued. A nonresident holding the same bonds owes Maryland nothing on that interest unless it’s tied to a Maryland business or property. If you’re a Maryland resident earning income in another state that also taxes it, the credit for taxes paid to other states, claimed on Form 502CR, helps prevent double taxation.