Why does entering money in the exempt dividends increase my tax liability as calculated by Turbo Tax?

[AnthonyC · Accepted solution]

While tax-exempt dividends are exempt from direct taxation, they are included in some adjusted income formulas for determining items such the amount of taxable social security benefits, health care credits, and the alternative minimum tax.  

So, for example, by entering tax-exempt interest or dividends this could lead to having a greater amount of social security benefits taxed, which could reduce a refund.  This would be the most common scenario. 

Also, most of these items are not exempt from state taxation, so you would see a state refund reduced.