Interest from direct U.S. Treasury securities is exempt from every state and local income tax, and that is the core of the state tax exclusions from government obligations that federal law guarantees to bondholders. The exclusion reaches Treasury bills, notes, bonds, savings bonds, and TIPS, plus a short list of federal agencies whose own statutes grant the same treatment. It does not automatically reach everything with “federal” or “government” in the name, and it does not survive intact when you own the debt through a mutual fund that doesn’t meet your state’s threshold rules. Getting the benefit means knowing which instruments qualify and taking the subtraction correctly on your state return.
Which Treasury Securities Qualify
All direct obligations of the U.S. Treasury are exempt from state and local income tax. That covers Treasury bills, Treasury notes, and Treasury bonds. Interest is federally taxable but state-exempt.1Internal Revenue Service. Topic No. 403, Interest Received
U.S. Savings Bonds, both Series EE and Series I, get the same treatment. Federal income tax applies to the interest; state and local tax does not, regardless of when you bought the bonds or when you report the interest.2TreasuryDirect. Tax Information for EE and I Bonds
Treasury Inflation-Protected Securities qualify as well. Both the semiannual interest payments and the annual inflation adjustment to principal are exempt from state and local income tax.3TreasuryDirect. Treasury Inflation-Protected Securities (TIPS) TIPS holders owe federal tax each year on the inflation adjustment even though they don’t receive it until maturity. That phantom income is still state-exempt.
The exemption is grounded in 31 U.S.C. § 3124, which forbids any state or local tax that would require a federal obligation or its interest to be counted in computing the tax. The only carve-outs are nondiscriminatory corporate franchise taxes and estate or inheritance taxes.4Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation
One important limit: the exclusion covers interest, not capital gains. Sell a Treasury bond before maturity at a profit and the gain is generally subject to both federal and state income tax. Section 3124 protects the obligation and its interest, not trading profits on the secondary market.4Office of the Law Revision Counsel. 31 USC 3124 – Exemption From Taxation
Which Federal Agencies Qualify and Which Don’t
This is where most taxpayers get tripped up. Agency debt is not automatically Treasury debt. Whether the interest is state-exempt depends on the agency’s authorizing statute and whether its bonds are direct obligations of the United States.
Some federal instrumentalities have Congress-granted exemptions written into their enabling legislation. Federal Farm Credit Banks are a clear example. Under 12 U.S.C. § 2023, their bonds and the income from those bonds are exempt from all state, municipal, and local taxation.5Office of the Law Revision Counsel. 12 USC 2023 – Taxation The Tennessee Valley Authority receives similar treatment under its own act. For these issuers, the interest is treated the same as Treasury interest at the state level.
Government-sponsored enterprises are a different story. Fannie Mae and Freddie Mac debt is not a direct obligation of the United States. Their bonds carry an implied backing rather than a statutory guarantee, and their enabling legislation does not grant a state tax exemption. Interest from Fannie Mae and Freddie Mac bonds is generally subject to state income tax.
Ginnie Mae catches people off guard. It is a full-faith-and-credit agency of the U.S. government, unlike Fannie and Freddie, but Ginnie Mae mortgage-backed securities represent pools of underlying mortgages. Interest on those securities is generally subject to both federal and state income tax. Owning a Ginnie Mae is not the same as owning a Treasury for state tax purposes.
Check the specific agency before assuming the interest is state-exempt. The word “government” in an issuer’s name tells you nothing about how its debt is taxed.
Municipal Bond Interest at the State Level
Municipal bonds sit on a different track. For federal purposes, interest on state and local bonds is generally excluded from gross income under 26 U.S.C. § 103.6Office of the Law Revision Counsel. 26 US Code 103 – Interest on State and Local Bonds State treatment depends on where the bond was issued.
In-State Bonds
Most states exempt interest on bonds issued by their own state or local entities. The policy is deliberate: keeping borrowing costs down for local roads, schools, and infrastructure. A resident holding a bond from a transit authority or school district in their home state typically pays no federal, state, or local income tax on the interest.7Municipal Securities Rulemaking Board. Tax Treatment A few states handle their own bonds differently and a few exempt municipal interest regardless of source, so confirm your own state’s rule.
Out-of-State Bonds
Interest from another state’s bonds is generally taxable in your home state. Intergovernmental tax immunity applies between the federal government and the states, not between two states. Your home state has no obligation to give favorable treatment to another state’s debt.7Municipal Securities Rulemaking Board. Tax Treatment A national municipal bond fund that holds paper from dozens of states may throw off income that is federally tax-free but partly or fully taxable at the state level.
U.S. Territory Bonds
Bonds issued by U.S. territories occupy a unique position: the interest is typically exempt from federal, state, and local income tax regardless of where the bondholder lives. Under 48 U.S.C. § 745, bonds issued by the government of Puerto Rico or by its authority are exempt from taxation by any state, territory, or local jurisdiction.8Office of the Law Revision Counsel. 48 US Code 745 – Tax Exempt Bonds Bonds from Guam, the U.S. Virgin Islands, American Samoa, and the Commonwealth of the Northern Mariana Islands receive comparable treatment.9Internal Revenue Service. TEB International – US Territories / Possessions
Private Activity Bonds
Not all municipal bonds serve purely public purposes. Private activity bonds are issued by state or local governments but primarily benefit a private entity, such as a company building a manufacturing facility or a nonprofit hospital. Interest is generally excluded from regular federal income tax, but it can trigger the federal Alternative Minimum Tax as a preference item. Qualified 501(c)(3) bonds and certain other categories are excepted.6Office of the Law Revision Counsel. 26 US Code 103 – Interest on State and Local Bonds Where a state uses federal AGI or federal taxable income as its starting point and conforms to federal AMT rules, that interest can end up taxable at the state level too.
Mutual Funds: Thresholds and the Repo Trap
Owning Treasuries directly is clean. Owning them through a mutual fund or ETF adds a layer that costs many investors their exclusion without them realizing it.
State Percentage Thresholds
Many states require a fund to hold a minimum percentage of assets in direct U.S. government obligations before its distributions can pass through as state-exempt. Several major states set the threshold at 50% of fund assets measured at each quarter-end within the tax year. If the fund falls below the threshold, the entire distribution may be taxable at the state level, not just the non-qualifying portion.
Fund companies publish annual reports showing what percentage of each fund’s income came from U.S. government obligations. These reports usually appear on the fund company’s tax center page by mid-February. Review them every year for any government bond fund held in a taxable account. Composition can shift enough between years to cross a state’s threshold in either direction.
Repurchase Agreements
Money market funds that call themselves “Treasury” or “government” funds sometimes invest heavily in repurchase agreements collateralized by Treasuries. A repo is a short-term lending arrangement where the fund buys Treasuries from a counterparty with an agreement to sell them back at a slightly higher price. Even with Treasury collateral, the income is considered interest on a commercial lending transaction, not interest on the underlying security, and it does not qualify for the state exclusion. A fund that is 70% repos and 30% Treasuries might pass through only 30% of its income as state-exempt despite what its name suggests.
How to Claim the Exclusion on Your State Return
Claiming the exclusion means identifying the qualifying income and subtracting it on your state return. Start with the information your broker or fund company sent you.
Form 1099-INT reports interest in several boxes. Box 3 covers interest on U.S. Savings Bonds and Treasury obligations, separate from the general interest in Box 1.10Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID That Box 3 amount is typically the figure you’ll use for the state subtraction. For mutual fund investors, the fund company’s annual government income report gives the percentage of distributions that qualifies. Multiply your total taxable distribution by that percentage to get the excludable amount.
On the state return, the exclusion appears as a subtraction modification. You start with your federal adjusted gross income, which already includes the interest, and subtract the qualifying government obligation interest to arrive at state taxable income. Each state has its own form and line for the adjustment, but the mechanics are the same everywhere.
Keep your 1099-INT forms, mutual fund tax statements, and any supporting schedules. If the state audits the return, you’ll need to show that the interest you excluded came from qualifying obligations. The common mistake is excluding interest from agency debt that doesn’t qualify or fund income that didn’t meet the state’s threshold. The fund company’s annual tax supplement breaks the income down by source and states explicitly which states’ thresholds the fund did or didn’t meet.
If You Live in a State With No Income Tax
Nine states impose no personal income tax. If you live in one of them, there is no state tax to be excluded from, and none of the subtraction mechanics above apply to your state return. The federal rules still govern. If you later move to an income-tax state, these exclusions become immediately relevant to how you hold Treasuries, agency debt, and bond funds.