Treasury bills are paying real money again. The three-month T-bill yielded 4.28% as of late September, and the one-year paid 4.59%, according to the Treasury Department. The national average savings account paid 0.37% in September, according to FDIC figures tracked by the Federal Reserve of St. Louis.
We’ve previously covered why T-bills deserve a spot for your cash in “5 Reasons to Invest Like Warren Buffett and Park Your Cash in T-Bills Now.”
Today I want to zero in on one of those reasons, because it’s the one people fumble most: state taxes.
Here’s the rule, straight from the IRS. Uncle Sam taxes the interest on Treasury bills, notes and bonds. Your state and city can’t touch it.
That’s worth real money. Say you have $100,000 in three-month T-bills at 4.28%. That’s about $4,280 a year in interest. If your state taxes income at 5%, the exemption is worth about $214 a year. In a higher-tax state, it’s worth more.
No, $214 won’t change your life. But it’s your money. I’ve been a CPA since 1981, and I don’t like watching anybody hand the government money it has no right to.
One caveat up front: This only matters if your state has an income tax. Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas and Wyoming don’t, according to the Tax Foundation. Washington taxes only capital gains. (More on that in “There Are Now 8 States With No Income Tax Whatsoever.”)
Everywhere else, the break isn’t automatic. Here are five ways savers end up paying tax they don’t owe.
1. Your 1099 buries it
Treasury interest is supposed to land in Box 3 of your Form 1099-INT, labeled “Interest on U.S. Savings Bonds and Treasury Obligations,” according to IRS instructions. Ordinary bank interest goes in Box 1.
T-bills add a twist. You buy them at a discount and get the full face value back at maturity. That difference is your interest, and it’s reported in that same Box 3, according to IRS Publication 550.
The trouble is that a brokerage 1099 can run a dozen pages, and Box 3 is easy to miss. Look for it on every 1099-INT you receive.
2. Your tax software won’t subtract it unless you tell it to
On your federal return, Treasury interest is taxable like any other interest. The break happens on your state return, where it’s subtracted. California residents do it on Schedule CA, and New Yorkers use Form IT-225.
Tax software generally handles the subtraction when you enter each box where it belongs. But if you type everything into the Box 1 field to save time, the software has no way of knowing that part of it came from Treasurys.
Your state will happily tax the whole thing.
If someone else prepares your return, make sure that person sees the Box 3 number, too.
3. Your ‘government’ fund may not qualify
This is the trap that catches smart people. You didn’t buy T-bills directly. You bought a Treasury or government money market fund, or an exchange-traded fund.
Funds pay dividends, not interest, and some states pass the exemption through only if the fund holds enough U.S. government debt:
- California requires at least 50% of a fund’s assets to be in qualifying U.S. obligations (or California municipal bonds). If the fund falls short, none of the dividend is exempt, according to the state’s Franchise Tax Board.
- Connecticut requires the fund to hold at least 50% at the close of each quarter of its tax year, according to the state Department of Revenue Services.
- New York also uses a 50% test, and repurchase agreements don’t count toward it, according to state tax guidance.
So a “government” fund loaded with repurchase agreements or agency bonds can flunk the test, and in those states, the whole dividend gets taxed.
Before you file, check your fund company’s year-end tax information for the percentage of income that came from U.S. government obligations. If you’re choosing a fund, a Treasury-only fund is the cleanest way to keep the break.
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4. Not everything with ‘government’ in its name is exempt
The exemption covers debt issued by the U.S. Treasury. It doesn’t cover everything with a federal connection.
California, for example, allows no subtraction for interest on securities from Fannie Mae, Freddie Mac or Ginnie Mae. Connecticut lists those as taxable, too, along with interest from repurchase agreements, which it treats as paid by the seller rather than by the government.
Savings bonds are a different story. California’s instructions include U.S. savings bonds in the interest residents can subtract, right alongside T-bills, notes and bonds.
5. You can amend your return and get it back
If you realize you’ve been paying state tax on Treasury interest, you may be able to get it back by amending your state return. The deadlines vary by state.
In California, you generally have until the later of four years from the original due date or one year from the date you overpaid, according to the Franchise Tax Board.
In New York, it’s generally the later of three years from when you filed or two years from when you paid, according to the state. Check your own state’s tax agency for its rules.
A few years of a couple hundred dollars adds up. It’s worth an hour with your old returns.
The bottom line
When you compare a T-bill with a bank account or CD, compare what you keep, not just the rate. In a state with a 5% income tax, a T-bill paying 4.28% is roughly equal to a fully taxable bank rate of about 4.5%.
So before you move money, run that math. You can compare current savings and CD rates in our Solutions Center, then check them against what Treasurys pay after tax.
Treasurys are one of the few places the government gives you a tax break without making you jump through hoops. Just make sure you actually take it.
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