You bought some Treasury bonds. Maybe it was a hedge against a shaky stock market, or perhaps you just liked the idea of a "risk-free" return backed by the full faith and credit of the U.S. government. But now, tax season is looming, and you’re staring at your 1099-INT wondering: do you pay taxes on treasury bonds, or does the government give you a pass since you lent them the money?
The answer is a classic "yes and no."
Treasury securities—which include T-bills, T-notes, and T-bonds—occupy a weird, privileged middle ground in the American tax code. They aren't totally tax-free like some municipal bonds, but they aren't fully taxed like the interest you earn from a high-yield savings account or a corporate bond from Apple or Ford. Basically, Uncle Sam wants his cut of the interest, but he’s willing to tell your governor and your mayor to back off.
The Federal Government Always Gets Paid
Let’s get the heavy lifting out of the way first. At the federal level, the interest you earn on U.S. Treasury bonds is fully taxable. You have to report it as "interest income" on your federal income tax return.
It’s taxed at your ordinary income tax rate.
This is an important distinction because some people mistakenly believe bond interest might qualify for the lower long-term capital gains rates. It doesn’t. If you are in the 24% tax bracket, that interest is getting hit with a 24% tax. It’s no different than the money you earn at your 9-to-5 job.
However, how and when you pay that tax depends entirely on the type of Treasury security you hold. For example, if you have a Treasury bill (T-bill) with a six-month duration, you don't actually receive "interest payments" every month. Instead, you buy the bill at a discount—say, $970—and it matures at $1,000. That $30 difference is your interest. You owe taxes on that $30 in the year the bill matures.
With Treasury bonds (which have maturities of 20 to 30 years) or Treasury notes (2 to 10 years), you usually get semiannual interest payments. You owe federal tax on those payments in the year you receive them. Simple.
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The "Secret" Perk: State and Local Tax Exemptions
This is where things get interesting. This is the part that makes Treasuries a darling for investors in high-tax states like California, New York, or New Jersey.
The interest on U.S. Treasury securities is exempt from state and local income taxes.
Think about that for a second. If you live in New York City, you’re usually getting hit with federal tax, state tax, and city tax. But with Treasury interest, those last two layers just... vanish. It’s a massive advantage. If you’re comparing a corporate bond paying 5% and a Treasury bond paying 4.5%, the Treasury might actually put more money in your pocket after taxes if your state takes a big bite out of your income.
Honestly, it’s one of the few remaining "loopholes" for the average person. You don't need a fancy offshore account. You just need a Treasury Direct account or a brokerage.
Does this apply everywhere?
Pretty much. Whether you are in a state with a flat tax or a progressive one, they generally cannot touch your Treasury interest. However, there is always a catch: this exemption only applies to the interest. If you sell a Treasury bond on the secondary market for more than you paid for it—making a capital gain—the state will likely want a piece of that profit.
What About Series I Savings Bonds?
Savings bonds are the quirky cousins of the Treasury world. You’ve probably heard of I-Bonds, especially when inflation was skyrocketing. They follow slightly different rules.
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With I-Bonds, you have a choice. You can either pay taxes on the interest every year as it accrues, or you can defer the tax until you cash the bond in or it reaches final maturity (which is usually 30 years). Most people choose to defer. Why pay today what you can pay in three decades?
But wait, there’s an even better deal. If you use the interest from Series I or Series EE bonds to pay for qualified higher education expenses, you might be able to avoid federal taxes altogether.
There are income limits, though. If you make too much money, the IRS says "no thanks" to the tax break. For 2024 and 2025, those limits have shifted upward, so it’s worth checking the current IRS Form 8815 to see if you qualify. It’s a great way to fund a 529 plan or pay tuition while sticking it to the taxman—legally, of course.
The Inflation Trap: TIPS and Your Tax Bill
Treasury Inflation-Protected Securities, or TIPS, are a bit of a headache at tax time. These are bonds where the principal increases with inflation (measured by the CPI).
Here’s the annoying part: the IRS considers that "principal adjustment" to be taxable income in the year it happens. Even though you don't actually get the cash in your hand until the bond matures years later.
People call this "phantom income."
You’re paying taxes on money you haven't technically received yet. Because of this, most financial advisors—the real ones, like those you'd find at Vanguard or Schwab—suggest holding TIPS inside a tax-advantaged account like an IRA or a 401(k). That way, you don't have to worry about the annual tax bill on your inflation adjustments.
Selling Before Maturity: The Capital Gains Factor
So far, we’ve talked about interest. But what if you sell your bond?
If you bought a 10-year Treasury note and interest rates fell, the value of your bond probably went up. If you sell it to another investor on the secondary market for a profit, that is a capital gain.
- Short-term capital gains: If you held the bond for a year or less, it’s taxed as ordinary income.
- Long-term capital gains: If you held it for more than a year, you get the lower 0%, 15%, or 20% rates.
And remember: unlike interest, capital gains on Treasuries are usually taxable at the state level.
Real-World Example: The "Tax-Equivalent Yield"
To really understand if do you pay taxes on treasury bonds in a way that hurts your portfolio, you have to look at the tax-equivalent yield.
Imagine you live in a state with a 6% income tax. You’re looking at a corporate bond paying 5% and a Treasury bond paying 4.7%. At first glance, the corporate bond looks better. It’s 5%, right?
But you have to pay that 6% state tax on the corporate bond. After state taxes, that 5% bond is actually only paying you 4.7%. Suddenly, the Treasury bond—which is also paying 4.7% but is exempt from state tax—is the winner. And that’s before we even talk about the fact that the Treasury is much safer than a corporate loan.
Common Misconceptions That Trip People Up
I see this all the time on finance forums. Someone thinks that because it’s a "government" bond, it’s totally tax-free. They confuse Treasuries with Municipal Bonds (Munis).
Munis are issued by cities or states, and they are often exempt from federal taxes. Treasuries are the opposite: they are exempt from state taxes. It’s a mirror image. If you’re in a high federal tax bracket but a low-tax state (like Florida or Texas), Munis might be better. If you’re in a high-tax state, Treasuries are a strong contender.
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Another weird one? Social Security. If your total income (including your tax-exempt interest) crosses a certain threshold, a larger portion of your Social Security benefits might become taxable. So, while the Treasury interest itself isn't taxed by the state, it could indirectly trigger a higher federal tax bill on your retirement benefits.
Reporting It to the IRS
When you own Treasuries through a broker (like Fidelity, E*Trade, or Vanguard), they’ll send you a 1099-INT. Box 3 is usually where the "Interest on U.S. Savings Bonds and Treas. Obligations" sits.
If you bought them directly from the government via TreasuryDirect, you have to log in and download your 1099-INT yourself. They don't mail them. Don't forget this! The IRS gets a copy, and if you don't report it, you’ll get one of those dreaded automated letters six months later.
Actionable Next Steps for Bond Holders
If you’re currently holding or considering buying Treasury bonds, don't just let the tax bill happen to you. Take control of the math.
- Audit your location: If you live in a state with zero income tax (Florida, Texas, Nevada, Washington, Wyoming, South Dakota, Tennessee), the state-tax exemption on Treasuries doesn't give you any extra "alpha." You can choose your investments based purely on federal tax impact and yield.
- Check your I-Bond dates: If you have I-Bonds and your income is low this year, you might actually want to report the interest annually rather than deferring it. This is a rare move, but if you’re a student or temporarily unemployed, you could "wash" the interest through a 0% tax bracket.
- Move TIPS to an IRA: If you are holding TIPS in a taxable brokerage account, you’re creating a "phantom income" tax liability. Look into moving those to a Roth or Traditional IRA to shield that annual inflation adjustment from the IRS.
- Calculate the Spread: Before buying your next bond, use a Tax-Equivalent Yield calculator. Compare the Treasury rate against a CD or corporate bond after factoring in your specific state and local tax rates. Often, the "lower" Treasury rate is actually the higher earner.
- Keep your 1099-INTs organized: Especially if you use TreasuryDirect. Set a calendar reminder for late January to log in and pull your documents so you aren't scrambling in April.