Interest you earn on U.S. Treasury securities is exempt from state and local income tax under 31 U.S.C. § 3124.1Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation That covers Treasury bills, notes, bonds, and U.S. savings bonds. The interest is still federally taxable, but your state cannot touch it. On a state return, you claim the benefit by subtracting the qualifying interest from your state taxable income, using Box 3 of your Form 1099-INT or a percentage figure provided by your mutual fund.
Which Securities Qualify
The exemption is written broadly to cover “stocks and obligations of the United States Government,” but in practice it matters most for a specific list.
Treasury bills mature in one year or less and produce income through a discount rather than a coupon. That discount is exempt from state and local income tax.2TreasuryDirect. Interest Income Reporting for Marketable Treasury Securities Treasury notes (two- to ten-year maturities) and Treasury bonds (longer than ten years) pay semiannual coupon interest that is likewise exempt.
Treasury Inflation-Protected Securities (TIPS) have two income components: the coupon payments and the annual adjustment to principal for inflation. Both are exempt from state and local tax.3TreasuryDirect. Treasury Inflation-Protected Securities (TIPS)
Series EE and Series I savings bonds earn interest that is federally taxable but exempt from state and local income tax.4TreasuryDirect. Tax Information for EE and I Bonds Older Series HH bonds have all reached final maturity and no longer pay interest.5TreasuryDirect. HH Bonds
What Doesn’t Qualify
A government connection alone isn’t enough. Ginnie Mae (GNMA) mortgage-backed pass-through securities are issued by a government corporation, but their interest is generally subject to state and local income tax. Fannie Mae and Freddie Mac securities are also taxable at the state level because they come from government-sponsored enterprises rather than the government itself. Investors who assume any bond with a federal logo carries the exemption often report incorrectly.
Interest Is Exempt. Capital Gains Are Not.
This is the trap that catches active Treasury investors. Section 3124(a) shields the obligation and its interest from state taxation. Subsection (b) says the “tax treatment of gain and loss from the disposition of those obligations” follows the Internal Revenue Code, not the blanket exemption.1Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation
If you buy a Treasury note for $9,800 on the secondary market and sell it later for $10,200, the $400 profit is a capital gain that your state can tax. The coupon interest you collected while holding the note is still exempt. Keep the two categories cleanly separated on your records, especially if you trade rather than hold to maturity.
Mutual Funds and ETFs
Most people hold Treasuries through funds, and the exemption still applies through a pass-through rule. If a fund earns interest from qualifying federal obligations, that character flows to shareholders in proportion to the fund’s holdings. Sixty percent of income from federal sources means roughly sixty percent of your ordinary dividends from that fund qualifies for the state subtraction.
Some states require the fund to hold a minimum percentage of assets in federal obligations before any of the pass-through income qualifies. Most states set no threshold, but a handful use 50 percent, and at least one requires 80 percent. Check the rule in your state before claiming a subtraction on a fund that holds only a slice of Treasuries.
Your fund company publishes a supplemental tax statement each year, usually in January or February, that reports the exact percentage of ordinary dividends derived from federal obligations. Multiply your total ordinary dividends from the fund by that percentage to get your exempt amount.
Repurchase Agreement Income Doesn’t Count
Money market funds and short-term bond funds sometimes earn income through repurchase agreements, where the fund lends cash overnight and takes Treasury securities as collateral. Even though the collateral is federal, the income is interest on a loan, not interest paid by the U.S. government. States tax repo income in full. The percentage a fund reports as qualifying federal income already excludes repo income, so if you use that reported figure, the exclusion is handled for you.
How to Claim the Subtraction on Your State Return
Find the Right Number
On Form 1099-INT, interest on U.S. savings bonds and Treasury bills, notes, and bonds appears in Box 3, which is separated from other interest precisely because of its state tax treatment.6Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
For fund holdings, you won’t see anything in Box 3. Instead, pull the fund’s supplemental tax statement and multiply your ordinary dividends from that fund by the reported percentage of income from federal obligations.
Enter It as a State Subtraction
Every state that taxes interest income provides a line or schedule for subtractions from federal adjusted gross income. Labels vary, but look for wording like “U.S. government obligation interest” or “interest on federal obligations.” Tax software prompts for this figure in the state-specific portion of the interview. Enter the Box 3 amount from your 1099-INT plus any qualifying fund income you calculated.
Watch for Accrued Interest on Secondary-Market Purchases
If you bought a Treasury security between coupon dates on the secondary market, you paid accrued interest to the seller as part of the price. When your first coupon arrives, part of that payment is a return of what you already paid rather than new income to you. Don’t claim an exemption on the accrued-interest portion; it offsets your cost basis instead.
Keep the Paperwork
Hang on to your 1099-INT forms and fund supplemental statements. The IRS recommends keeping tax records for at least three years from the filing date.7Internal Revenue Service. How Long Should I Keep Records Your state’s retention period may be longer, so check before you shred. If the state questions the subtraction, you’ll need documentation showing the income came from qualifying federal obligations.
Two Narrow Exceptions to Know
Section 3124 lets states factor federal obligations into a tax calculation in only two situations.1Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation
- A nondiscriminatory corporate franchise tax (or a nonproperty tax standing in for one) can apply to a corporation even if it holds Treasury securities. The tax cannot single out federal obligations for harsher treatment than other assets.
- State estate and inheritance taxes can include the value of Treasury securities in a decedent’s gross estate. The interest was exempt during life; the underlying asset value is reachable at death.
For an individual filing an income tax return, neither exception changes anything about the interest subtraction.
If Your State Denies the Subtraction
State tax agencies sometimes reject the federal interest subtraction, either because the taxpayer didn’t document the source or because the state misapplied its rules. Section 3124 preempts state taxation of federal obligation interest under the Supremacy Clause, so the state cannot override the exemption through its own tax code.
Start with the administrative protest process your state provides. If you paid the disputed amount to stop penalties and interest from piling up, you can file a refund claim once the dispute is resolved in your favor. Deadlines for amended returns and refund claims vary by state, generally running one to five years from the original filing. Miss that window and you lose the right to recover the overpayment, even when the tax was clearly improper.