Treasury bonds are taxed as ordinary income at the federal level, exempt from state and local income tax, and subject to capital gains rules if you sell before maturity. That state-tax exemption is the main reason investors in high-tax states favor Treasuries over comparable corporate bonds. The full picture depends on which Treasury you hold, whether you sell early, and whether your income crosses the threshold for the 3.8% Net Investment Income Tax.
Federal Tax Yes, State Tax No
Federal law bars states and localities from taxing U.S. government obligations or the interest they pay.1Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation Every dollar of coupon interest, T-Bill discount, and savings bond interest escapes state and local income tax.2Internal Revenue Service. Topic No. 403, Interest Received If you live somewhere with a steep state income tax, that raises your effective after-tax yield above a corporate bond paying the same nominal rate.
The exemption is narrower than it first sounds. It covers interest only. If you sell a Treasury for a profit before it matures, the resulting capital gain is fully taxable by your state. The federal statute leaves gains and losses to the Internal Revenue Code, and the Code does not shield them from state taxation.1Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation
Coupon Interest
Treasury notes and bonds pay interest every six months. Those payments are ordinary income at the federal level, taxed at the same rates as your wages. For 2026, federal ordinary-income rates run from 10% up to 37% at the top.3Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
Most individuals report on the cash method: interest goes on the return for the year you actually received it. Your broker or TreasuryDirect account issues Form 1099-INT with Treasury interest in Box 3.4Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID That figure flows to Schedule B on Form 1040 when your total interest exceeds $1,500.5Internal Revenue Service. Instructions for Schedule B (Form 1040)
How T-Bills Are Different
Treasury bills don’t pay periodic coupons. You buy them below face value and receive the full face amount at maturity, and the difference is your income.6TreasuryDirect. Treasury Bills In Depth Even though it arrives as a lump sum, this discount income is taxed as ordinary interest, not as a capital gain. Tax is generally due when the bill matures or when you sell it, whichever comes first. If you sell early for more than your purchase price, the portion representing accrued discount is ordinary income; any excess above that may be a short-term capital gain, since T-Bills mature in a year or less.
Selling Before Maturity
Sell a note or bond before it matures and you have a capital gain or loss. The amount equals your sale price minus your adjusted basis, which is generally your purchase price plus any previously taxed accrued discount or OID. How the gain is taxed depends on how long you held it.
- Held one year or less: taxed at ordinary income rates, up to 37% for 2026.
- Held more than one year: taxed at long-term capital gains rates of 0%, 15%, or 20% depending on total taxable income. For a 2026 single filer, the 0% rate applies up to $49,450 of long-term gains and the 20% rate begins above $545,500.
Unlike interest, these gains are not exempt from state tax. Your state can tax the profit from selling a Treasury the same way it taxes any other investment gain.1Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation Capital losses offset gains dollar for dollar, and up to $3,000 of net loss can offset ordinary income each year ($1,500 if married filing separately), with any remainder carrying forward indefinitely.7Internal Revenue Service. Topic No. 409, Capital Gains and Losses
Phantom Income on TIPS and STRIPS
Two categories of Treasury securities can produce a tax bill before you see any cash. The IRS calls it original issue discount (OID); investors call it phantom income.
TIPS
Treasury Inflation-Protected Securities pay a fixed coupon rate on a principal that adjusts every six months with the Consumer Price Index.8TreasuryDirect. Treasury Inflation-Protected Securities (TIPS) When inflation rises, principal goes up and so does each coupon in dollar terms. The upward principal adjustment itself is taxable in the year it happens, even though you won’t touch that extra principal until maturity.9Internal Revenue Service. Publication 550, Investment Income and Expenses
Each year in a taxable account you’ll owe federal tax on two things: the coupon you actually received and the inflation adjustment you didn’t. Both are ordinary income. The adjustment shows up on Form 1099-OID, and it increases your basis so you aren’t taxed again on that amount at maturity. A deflationary year produces a negative adjustment that reduces OID.
Zero-Coupon STRIPS
STRIPS are created by splitting a Treasury bond’s coupons and principal into separate zero-coupon securities sold at deep discounts. You pay far less than face value and receive the full amount at maturity, with nothing in between. Even so, you must report a portion of the total discount as OID income every year you hold the STRIP.10Office of the Law Revision Counsel. 26 USC 1272 – Current Inclusion in Income of Original Issue Discount The accrual uses a constant-yield method, so the taxable amount grows each year as maturity approaches. Each year’s accrual raises your basis, and no additional tax is owed on those amounts at payout.11Office of the Law Revision Counsel. 26 USC 1286 – Tax Treatment of Stripped Bonds Paying tax annually without matching cash is why advisors often suggest holding STRIPS inside tax-advantaged accounts.
Savings Bonds: Series EE and I
Series EE and I savings bond interest follows the same federal-taxable, state-exempt pattern.12TreasuryDirect. Tax Information for EE and I Bonds The difference is timing: you choose when to pay the federal tax.
The default is deferral. You owe nothing year to year, and the full accumulated interest hits your return when you cash the bond or it reaches final maturity. You can instead elect to report interest annually as it accrues. Once you make that election, it applies to all your savings bonds, including any you acquire later.
Education Exclusion
Cash Series EE or I bonds issued after 1989 and use the proceeds for qualifying higher education expenses, and you may be able to exclude some or all of the interest from federal income.13Internal Revenue Service. About Form 8815, Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989 You must have been at least 24 when the bonds were issued, the bonds must be in your name, and you can’t file married filing separately.
Income limits apply. For 2025, the exclusion begins to phase out at modified adjusted gross income of $99,500 for single filers and $149,250 for married joint filers, disappearing entirely at $114,500 and $179,250.14Internal Revenue Service. Publication 970, Tax Benefits for Education The thresholds are adjusted annually for inflation. You claim the exclusion on Form 8815 and report it on Schedule B.
The 3.8% Net Investment Income Tax
Higher-income investors owe an additional 3.8% surtax on net investment income. It kicks in when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married joint filers, and those thresholds are not adjusted for inflation.15Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
Treasury coupon interest, TIPS inflation adjustments, STRIPS OID accruals, and capital gains from selling Treasuries all count as net investment income for NIIT purposes.15Internal Revenue Service. Questions and Answers on the Net Investment Income Tax A high-income single filer in the 37% bracket can face a combined 40.8% federal rate on Treasury interest. That is easy to miss when comparing yields, and it eats into the state-tax edge.
Treasuries in Retirement Accounts
Hold Treasuries inside a traditional IRA or 401(k) and you skip the annual tax on interest, OID, and phantom income while the account grows. The trade: distributions are taxed as ordinary income at both the federal and state level regardless of what the account holds. The state exemption you’d get in a taxable brokerage account is effectively lost, because money leaving the IRA is classified as a retirement distribution rather than Treasury interest.
Roth IRAs flip the math. No deduction going in, but qualified distributions come out entirely tax-free at both levels. For TIPS and STRIPS, a Roth removes the phantom-income headache completely: no annual tax on inflation adjustments or OID, and no tax at withdrawal. If you’re holding Treasuries in a taxable account specifically for the state-tax exemption, don’t move them into a traditional retirement account, or you’ll convert state-exempt interest into fully state-taxable distributions later.
The Forms You’ll See
Your broker or TreasuryDirect issues the paperwork each year:
- Form 1099-INT, Box 3 reports interest from notes, bonds, and T-Bills. This amount is exempt from state and local tax.4Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
- Form 1099-OID reports phantom income from TIPS inflation adjustments and STRIPS accruals. Box 8 specifically covers OID on U.S. Treasury obligations.4Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
- Schedule B aggregates all interest income when the total exceeds $1,500.5Internal Revenue Service. Instructions for Schedule B (Form 1040)
- Form 1099-B reports proceeds from selling a Treasury before maturity, with acquisition date and cost basis.16Internal Revenue Service. About Form 1099-B, Proceeds From Broker and Barter Exchange Transactions
- Form 8949 and Schedule D calculate and report the resulting capital gains or losses.17Internal Revenue Service. About Form 8949, Sales and Other Dispositions of Capital Assets
If you own Treasuries through a mutual fund or ETF rather than directly, you’ll need to calculate the portion of fund income attributable to Treasury obligations to claim the state exemption. Fund companies typically publish that percentage after year-end, and it does not appear on your 1099 automatically.
At Death and by Gift
Treasury securities held at death are included in the decedent’s gross estate. The state-tax exemption does not extend to estate or inheritance taxes, so state-level obligations may still apply depending on where the decedent lived. For 2026, the federal estate tax exemption is $15,000,000 per person, reflecting the increase enacted by the One, Big, Beautiful Bill signed in July 2025.18Internal Revenue Service. What’s New – Estate and Gift Tax
Gifting Treasuries during your lifetime is straightforward within limits. The 2026 annual gift tax exclusion is $19,000 per recipient, and gifts within that amount require no gift tax return and don’t reduce your lifetime exemption.3Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 The recipient inherits your basis and holding period, so any built-in gain or accrued market discount travels with the security.