Treasury ETFs are not fully tax exempt. The interest they pay out is exempt from state and local income taxes, but it is fully taxable on your federal return as ordinary income, and any gain from selling your shares is taxable at both the federal and state level. Higher earners can also owe a 3.8% federal surtax on the interest. The state exemption is real and worth claiming, but getting it depends on what the fund holds and how you report the income.
Federal Tax on the Interest
Interest from the Treasuries inside the fund reaches you as dividend distributions, and the IRS taxes those distributions as ordinary income. The full amount stacks on top of your other earnings and is taxed at your marginal rate. For 2026, federal rates run from 10% to 37%. These payments do not qualify for the lower rates that apply to qualified dividends from stocks, because the underlying income comes from debt rather than corporate equity.
Your brokerage reports the payments on Form 1099-DIV and generally does not withhold federal tax unless you failed to provide a valid W-9.1Internal Revenue Service. About Form 1099-DIV, Dividends and Distributions You report the income on your return and pay through estimated payments during the year or at filing.
The State and Local Exemption
The main tax advantage of Treasury ETFs is that the interest portion of their dividends is exempt from state and local income taxes. Federal law prohibits states and their political subdivisions from taxing obligations of the U.S. government or the interest earned on them.2Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation That protection covers county and municipal income taxes too.
The exemption reaches only the share of the fund’s distributions that traces back to actual Treasury interest. If the fund holds non-Treasury assets, only the Treasury-derived portion qualifies. In states with high income tax rates, that carve-out can meaningfully lift after-tax returns compared with corporate bonds or CDs at similar pretax yields.
Gains on selling shares are a different animal and are not shielded by the state exemption. The statute routes gains and losses on government obligations to the Internal Revenue Code rather than the exclusion.2Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation
The 3.8% Net Investment Income Tax
Treasury interest escapes state tax but not the federal net investment income tax. The NIIT adds a 3.8% surtax on investment income once your modified adjusted gross income crosses a threshold. For 2026, the thresholds are $200,000 for single filers, $250,000 for married couples filing jointly, and $125,000 for married filing separately.3Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax The tax applies to the smaller of your net investment income or the amount your MAGI exceeds the threshold.
The statute defines net investment income to include gross income from interest and dividends, so Treasury ETF distributions count.3Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax Municipal bond interest, by contrast, is excluded from both regular federal tax and the NIIT. For high-income investors, the surtax pushes the effective federal ceiling on Treasury interest to 40.8% (37% plus 3.8%).
The NIIT thresholds are not indexed for inflation.4United States Congress. The 3.8% Net Investment Income Tax – Overview, Data, and Policy Options They have stayed at the same dollar amounts since 2013, so more taxpayers cross them each year through ordinary wage growth.
Capital Gains on Sold Shares
Selling Treasury ETF shares for more than you paid creates a capital gain, and this gain gets no state exemption. You will owe both federal and state tax on the profit.
The rate turns on your holding period. Sell within a year and the gain is taxed at your ordinary income rate. Hold more than a year and the gain qualifies for long-term rates of 0%, 15%, or 20% depending on taxable income.5Internal Revenue Service. Topic No. 409, Capital Gains and Losses For 2026, the 0% rate applies to joint filers with taxable income up to $98,900 and single filers up to $49,450. The 20% rate begins above $613,700 for joint filers and $545,500 for single filers. If your income exceeds the NIIT thresholds, add 3.8% on top.
What the Fund Actually Holds
Not every fund with “government” in its name delivers 100% state-exempt income. Two things drive the outcome: your state’s pass-through threshold, and what the fund holds beyond direct Treasuries.
Many states require a fund to hold at least a set percentage of assets in U.S. government obligations before shareholders can claim the exemption. Thresholds vary by jurisdiction and commonly sit around 50%, though some states set no minimum. If a fund falls below your state’s threshold, the entire dividend may become taxable at the state level, not just the non-Treasury slice.
Pure Treasury ETFs clear this bar easily and typically report 100% of their income as government-derived. Diversified bond ETFs often fall short. Whether a given fund’s percentage satisfies your state depends entirely on where you live.6Vanguard. U.S. Government Obligations Income Information
Repurchase agreements are the other pitfall. Some funds marketed as government funds hold a meaningful share of their assets in repos collateralized by Treasuries. Repo income generally does not qualify for the state exemption, even when the collateral is U.S. government debt. Before relying on the exemption, check whether the fund’s government obligation percentage includes or excludes repo income.
Treasury ETFs Inside an IRA or 401(k)
Holding Treasury ETFs inside a tax-advantaged retirement account is allowed, but it wastes the state exemption. Withdrawals from traditional retirement accounts are taxed as ordinary income at both federal and state levels, whatever generated the income inside the account. The character of the underlying investment does not pass through. To your state tax authority, a dollar of Treasury interest withdrawn from an IRA looks the same as a dollar of wages.
Since the state exemption is the main tax edge these funds have over comparable bond funds, the taxable brokerage account is where that edge shows up. If you are choosing between a corporate bond fund and a Treasury ETF for limited IRA space, the corporate bond fund is usually the better fit for the shelter, because it has no state exemption to lose.
How to Claim the Exemption on Your Return
Your brokerage’s Form 1099-DIV reports total ordinary dividends but does not break out the Treasury-derived portion.7Internal Revenue Service. Instructions for Form 1099-DIV To figure the exempt amount, you need a separate document from the fund sponsor: the U.S. Government Obligations Income report, sometimes called a Government Source Income report.
Fund companies publish these reports each year, listing the percentage of each fund’s income that came from direct U.S. government obligations.8iShares. iShares U.S. Government Source Income Information Multiply your total ordinary dividends from Form 1099-DIV (Box 1a) by the fund’s reported percentage. The result is the amount you subtract on your state return. Nothing changes on your federal return.
The 1099-DIV deadline for brokerages is early February, but the supplemental government obligation report often arrives later, sometimes in March. Filing your state return before the information is available can force an amendment. Checking the fund sponsor’s website directly is usually the fastest way to find the report once the calendar year closes.