U.S. Treasury Securities: Federal Tax, State Exemption, and TIPS

U.S. Treasury securities receive a split tax treatment: interest is fully taxable at ordinary federal rates but exempt from state and local income taxes, while capital gains from selling Treasuries before maturity are taxable at every level of government. This treatment covers the full lineup of Treasury debt, including T-bills, T-notes, T-bonds, Treasury Inflation-Protected Securities (TIPS), and Series EE and I savings bonds. For an investor in a high-tax state, the state exemption alone can add several percentage points to the effective after-tax yield compared to a corporate bond paying the same coupon.

Federal Tax on Treasury Interest

Interest from Treasury notes and bonds is ordinary income taxed at your marginal federal rate, which for 2026 ranges from 10 percent to 37 percent. Federal law defines gross income to include interest from all sources, and Treasury debt is not carved out.¹ Semiannual coupon payments get reported as interest income in the year received.

T-bills work differently because they pay no coupon. You buy at a discount and collect the face value at maturity, and that difference is original issue discount, which the IRS treats as interest in the year the bill matures or is sold.² Because T-bills mature in one year or less, the discount does not accrue in pieces the way it does on longer instruments. The full amount is reported when you receive payment.

Buying a Treasury note or bond on the secondary market below face value creates a market discount. When the bond matures or you sell it, gain up to the amount of the accrued market discount is taxed as ordinary income rather than at capital gains rates.³ Only the portion of the gain above the accrued market discount qualifies for capital gains treatment. Investors expecting a clean capital gain on a discounted bond often miss this.

State and Local Exemption for Treasury Interest

Federal law exempts obligations of the United States government from taxation by any state or political subdivision.⁴ The exemption reaches every category of Treasury debt: T-bills, notes, bonds, TIPS coupons and inflation adjustments, and savings bond interest.

Most states require Treasury interest to be included on the state return and then subtracted as an adjustment or deduction. Depending on your state tax bracket, the exemption is worth anywhere from under 2 percent to over 13 percent compared to holding a fully taxable bond at the same yield. Two statutory exceptions exist: states can impose nondiscriminatory franchise taxes on corporations that hold Treasuries, and they can include Treasuries in a decedent’s estate for state estate or inheritance tax purposes.⁴

Capital Gains Are Not Exempt

The exemption applies only to interest. Capital gains from selling Treasuries on the secondary market are taxable by your state just like gains on any other security. The exemption statute directs that gain and loss from disposing of government obligations is governed by the Internal Revenue Code, leaving states full taxing authority over the profit.⁴ Confusing exempt interest with taxable capital gains is one of the most common errors on state returns involving Treasuries.

Mutual Funds and ETFs Holding Treasuries

If you own a fund that holds Treasury securities, you can claim the state exemption on the portion of its ordinary dividends derived from Treasury interest. Fund companies publish the qualifying percentage each year, usually in early February. Some states require a minimum percentage of government-obligation holdings before any of the fund’s income qualifies. Check the fund’s annual tax supplement and your state’s rules before taking the deduction.

TIPS and Phantom Income

TIPS adjust their principal value semiannually based on changes in the Consumer Price Index. The IRS treats each upward adjustment as taxable income in the year it occurs, even though no cash reaches you until you sell the bond or it matures.⁵ You owe federal tax on both the coupon and the inflation adjustment to principal. This is widely called phantom income because the tax bill arrives long before the money does.

In periods of high inflation, tax on phantom income can actually exceed the cash coupon, producing negative after-tax cash flow in a taxable account. If deflation shrinks the principal, the decrease can offset other taxable interest for the year. Holding TIPS inside a tax-deferred account such as a traditional IRA or 401(k) avoids the phantom income problem entirely because nothing is taxed until distribution. The state and local exemption still applies to both the coupon and the inflation adjustment.⁵

Capital Gains and Losses

Selling a Treasury security before maturity creates a capital gain or loss. Held one year or less, the gain is short-term and taxed at your ordinary income rate. Held more than a year, the gain is long-term and qualifies for reduced rates of 0, 15, or 20 percent depending on your total taxable income. When capital losses exceed gains, up to $3,000 of the net loss can be deducted against ordinary income ($1,500 if married filing separately), and the rest carries forward.⁶

Wash Sales Apply to Treasuries

Sell a Treasury at a loss and buy a substantially identical security within 30 days before or after the sale, and you cannot deduct the loss.⁷ The rule covers all “stock or securities,” and Treasuries fit that definition. Buying back the same CUSIP inside the 61-day window triggers the rule. A Treasury with a different maturity or coupon is generally not considered substantially identical, but the IRS has never drawn a bright line, so the closer the replacement resembles what was sold, the more risk you take.

Savings Bond Interest: Defer or Report Annually

Series EE and I savings bonds let you choose when federal tax on the interest gets paid. Under the default approach, all interest is deferred until the bond is redeemed or reaches final maturity at 30 years, whichever comes first.⁸ Under the accrual approach, the annual increase in redemption value is reported each year. Most individual investors defer so the bond compounds for decades without an annual tax drag.⁹

Switching from deferral to annual reporting requires no IRS permission, but in the year of the change you report all previously unreported interest on every savings bond you own. Going back the other way requires attaching a statement to the return; the IRS grants permission automatically if the format is right.⁸ Whichever method you pick applies to all your savings bonds, not just some.¹⁰

The 30-year maturity date is itself a tax event, and people forget. Once a savings bond stops earning interest, all deferred interest becomes taxable in that year whether or not the bond gets redeemed. Investors who bought decades ago and let bonds sit can face a large unexpected bill.

Education Exclusion

Cash Series EE or I bonds issued after 1989 and use the proceeds for qualified higher education expenses, and you can exclude some or all of the interest from federal tax by filing Form 8815.¹¹ Income limits apply and are adjusted each year. For 2025, the exclusion phased out between $96,800 and $114,500 of modified adjusted gross income for single filers and between $145,200 and $179,250 for married joint filers. Married filing separately cannot claim it.

The 3.8 Percent Net Investment Income Tax

Higher-income investors pay an extra 3.8 percent on Treasury interest and capital gains through the Net Investment Income Tax. It applies when modified adjusted gross income exceeds $200,000 (single or head of household), $250,000 (married filing jointly), or $125,000 (married filing separately).¹² The tax is 3.8 percent of the lesser of your net investment income or the excess of MAGI over the threshold.

Net investment income includes interest, dividends, capital gains, and rental income, and Treasury interest counts in full.¹³ The state exemption offers no protection here because the NIIT is federal. The thresholds are not indexed for inflation, so more investors cross them each year. For someone above the threshold, the effective federal rate on Treasury interest is the marginal bracket plus 3.8 percent.

Estate Tax

Treasury securities held at death are in the decedent’s gross estate for federal estate tax purposes, like any other financial asset. For 2026, the federal estate tax filing threshold is $15,000,000, with rates reaching 40 percent above that.¹⁴

The state exemption for Treasury interest does not shield the securities from state estate or inheritance tax. The exemption statute specifically allows those levies.⁴ If your state imposes its own estate or inheritance tax with a lower exemption than the federal figure, a Treasury portfolio can be hit at the state level even when no federal estate tax is owed.

Reporting Treasury Income on Your Return

The form to watch is the 1099-INT, and the line to watch is Box 3. Treasury interest is reported in Box 3, separate from other taxable interest in Box 1.¹⁵ That separation is what enables the state subtraction. Including Box 3 amounts in state taxable income without taking the deduction leads to overpaying state tax with no notice from the state that anything is wrong.

If you bought a Treasury at a premium above face value, Box 12 shows the amortized bond premium for the year, which reduces reportable interest.¹⁶ Some brokers net the premium against interest and report only the reduced figure in Box 3; others report the full interest in Box 3 with the premium separately in Box 12. Confirm which method your broker uses before entering figures.

T-bills and other discount securities generate a Form 1099-OID, reporting the difference between purchase price and face value as interest.² Selling Treasuries on the secondary market produces a Form 1099-B showing proceeds and cost basis for the capital gain or loss calculation.¹⁷ For securities held at TreasuryDirect, 1099 forms appear in your online account at the start of each year.¹⁸ Brokerage firms usually fold Treasury income into their consolidated year-end statement. Either way, pulling the Box 3 figure accurately is the single most important step for capturing the state exemption you’re entitled to.

1
Office of the Law Revision Counsel. 26 USC 61 – Gross Income Defined
2
Internal Revenue Service. Instructions for Forms 1099-OID
3
Office of the Law Revision Counsel. 26 USC 1276 – Disposition Gain Representing Accrued Market Discount Treated as Ordinary Income
4
Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation
5
TreasuryDirect. Treasury Inflation-Protected Securities (TIPS)
6
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
7
Office of the Law Revision Counsel. 26 USC 1091 – Loss From Wash Sales of Stock or Securities
8
Internal Revenue Service. Publication 550, Investment Income and Expenses
9
TreasuryDirect. EE Bonds
10
Office of the Law Revision Counsel. 26 USC 454 – Obligations Issued at Discount
11
Internal Revenue Service. Form 8815 – Exclusion of Interest From Series EE and I US Savings Bonds Issued After 1989
12
Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
13
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
14
Internal Revenue Service. Whats New – Estate and Gift Tax
15
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
16
Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
17
Internal Revenue Service. Instructions for Form 1099-B
18
TreasuryDirect. Tax Forms and Tax Withholding