Are T-Bills Really Taxed at State Level? (w/Examples) + FAQs

No, the interest you earn from U.S. Treasury Bills (T-Bills) is not taxed at the state or local level. This rule is absolute for your personal income tax return, no matter which state you live in. However, the “state tax-free” promise comes with critical exceptions that can cost you money if you are not aware of them.

The primary conflict arises from a specific federal law, 31 U.S. Code § 3124, which creates the state tax exemption but also allows for specific loopholes. The most significant loophole permits states to impose “nondiscriminatory franchise taxes” on corporations, which can indirectly tax T-bill interest. This creates a confusing reality where the same T-bill interest is tax-free for an individual but can be taxed if held inside a business entity in certain states.

This isn’t a small issue; millions of investors mistakenly overpay state taxes on Treasury income, especially when that income comes from mutual funds or ETFs. The problem is so widespread because the tax forms you receive often don’t clearly separate this state tax-free income, leaving you to do the complex work yourself.

Here is what you will learn to solve these problems and save money:

🏛️ The Law Explained: Understand the exact federal law that makes your T-bill interest state tax-free and, more importantly, the specific exceptions that states can use to tax it anyway.
🏢 Business vs. Individual: Discover why holding a T-bill in your personal account is treated differently than holding it in a corporation or trust, and see which states use this loophole.
🔎 The Mutual Fund Trap: Learn the single biggest mistake investors make with money market funds and ETFs that hold T-bills, and get the step-by-step process to find the hidden tax savings your broker doesn’t report.
✍️ Tax Form Deep Dive: Get a line-by-line guide to correctly reporting T-bill interest on your federal and state tax returns, including how to handle it in software like TurboTax and H&R Block.
💡 Smart Investment Choices: See real-world scenarios comparing T-bills to other investments like CDs and corporate bonds, so you can calculate the true after-tax winner for your money.

The Core Rule: Why Your State Can’t Touch T-Bill Interest

The United States government needs to borrow money to fund its operations, from building roads to paying soldiers. It does this by selling Treasury securities, like T-bills, to investors like you. To make these investments more attractive, the federal government made a powerful promise backed by law.

That promise is found in a federal statute: 31 U.S. Code § 3124. This law explicitly states that “Stocks and obligations of the United States Government are exempt from taxation by a State or political subdivision of a State”. This is not a suggestion; it is a command that overrides any state’s attempt to levy an income tax on the interest you earn from federal debt.

This rule applies to all direct U.S. government obligations, including Treasury Bills (T-Bills), Treasury Notes (T-Notes), Treasury Bonds (T-Bonds), and U.S. Savings Bonds. Whether you live in a high-tax state like California or a state with no income tax like Florida, the rule is the same: you pay federal income tax on the interest, but you pay zero state or local income tax.

The reason for this law is simple: to help the federal government borrow money at a lower cost. By making the interest tax-free at the state level, the government makes its bonds a better deal for you, especially if you’re in a high tax bracket. This increased demand allows the government to pay slightly less interest, saving taxpayers money.

The First Big Exception: The “Franchise Tax” Loophole for Businesses

While federal law protects your personal T-bill interest from state income tax, it leaves a door open for states to tax that same interest when it’s earned by a business. This is the most significant and confusing exception to the “state tax-free” rule. It all comes down to the difference between an income tax and a franchise tax.

An income tax is a tax on profits. Federal law forbids states from charging income tax on Treasury interest. A franchise tax, however, is a tax a state charges a business for the “privilege” of existing or operating in that state. Because the tax is on the privilege and not the income itself, states are allowed to calculate the value of that privilege using income that includes U.S. Treasury interest.

The federal law, 31 U.S.C. § 3124, specifically allows for “a nondiscriminatory franchise tax or another nonproperty tax instead of a franchise tax, imposed on a corporation”. “Nondiscriminatory” simply means the state can’t single out federal bonds; if it includes interest from U.S. Treasuries in its franchise tax calculation, it must also include interest from its own state and local bonds.

This creates a major split. An individual investor holding a T-bill is fully protected. But a corporation or, in some states, a business trust holding the exact same T-bill might have to pay state tax on the interest it produces.

How Different States Handle the Franchise Tax Loophole

Several states have designed their business taxes as franchise or excise taxes, allowing them to legally include interest from federal bonds in the tax base for corporations. This is a critical detail for any business owner or investor using a legal entity to hold assets.

California: The state makes a sharp distinction. Businesses subject to the corporate income tax do not pay state tax on Treasury interest. However, businesses subject to the corporate franchise tax must include interest from federal, state, and local bonds when calculating the tax. A trust that is not a business may file a Fiduciary Income Tax Return (Form 541) instead.
Massachusetts: The state imposes a “Corporate Excise Tax,” which acts as a franchise tax. Because of this structure, corporations in Massachusetts must include interest earned from U.S. government bonds in their tax calculations. A Massachusetts Business Trust (MBT), however, is generally taxed as an individual, not a corporation, which can be a strategic way to avoid this entity-level tax.
Tennessee: Tennessee charges most businesses both a franchise tax (based on net worth or property value) and an excise tax (based on net earnings). Since these are privilege taxes, interest from U.S. Treasuries can be included in the calculation. Certain trusts, like a Tennessee Investment Service Trust (TIST), are structured specifically to be classified as non-business entities to avoid these taxes.
Texas: Texas is a notable exception. While it has a broad franchise tax that applies to most business entities, including trusts, its law specifically excludes interest from federal obligations from the calculation. This makes Texas a more favorable state for businesses holding Treasury securities.

The table below shows how different states treat T-bill interest for businesses subject to these special taxes.

The Second Big Exception: Estate and Inheritance Taxes

The second major exception to the “state tax-free” rule applies after you die. While the income your T-bills generate during your life is protected from state income tax, the value of those T-bills can be taxed by your state as part of your estate.

Federal law (31 U.S.C. § 3124) clearly states that the exemption does not apply to “an estate or inheritance tax”. This means that when you pass away, the total value of your T-bills is added to your estate’s worth for the purpose of calculating these specific “death taxes.” This can come as a surprise to families who assumed these assets were completely free from state taxation.

It’s important to know the difference between these two types of taxes:

Estate Tax: This is a tax on the total value of a person’s assets after they die. The tax is paid by the estate itself before any money is distributed to heirs.
Inheritance Tax: This tax is paid by the people who receive the inheritance. The tax rate often depends on the heir’s relationship to the person who died (spouses are usually exempt, while a distant cousin would pay a higher rate).

As of 2024, only a minority of states still levy these taxes. Twelve states and the District of Columbia have an estate tax, and six states have an inheritance tax. Maryland is the only state that has both. If you live in one of these states, your portfolio of “state tax-free” T-bills is fully exposed to this separate form of state taxation.

The table below lists the states with these taxes and their exemption amounts for 2024. If your estate’s value is below the exemption, no tax is due.

Reporting T-Bill Interest: A Step-by-Step Guide for Individuals

Knowing the rules is only half the battle; you have to report the income correctly on your tax return to get the savings. The process is different depending on whether you own T-bills directly or through a fund.

How to Report T-Bills You Own Directly

If you buy T-bills directly from TreasuryDirect or through a brokerage like Fidelity or Schwab, the process is straightforward. At the end of the year, you will receive a tax form called 1099-INT.

Step 1: Find Your T-Bill Interest on Form 1099-INT

Your tax form has different boxes for different types of interest. This is the most important detail.

Box 1 is for fully taxable interest, like from a bank savings account or a corporate bond. This interest is taxed by the federal government AND your state.
Box 3 is specifically for “Interest on U.S. Savings Bonds and Treasury obligations”. The amount in this box is taxable at the federal level but is 100% exempt from state and local income taxes.

When you get your 1099-INT, the number in Box 3 is the one you need to pay close attention to for your state tax return.

Step 2: Report the Interest on Your Federal Tax Return (Form 1040)

On your federal return, the interest from both Box 1 and Box 3 is added together and reported as taxable interest income. If your total interest income is more than $1,500, you must list each source on Schedule B of your Form 1040. Your federal tax software will handle this automatically when you enter the numbers from your 1099-INT.

Step 3: Subtract the Interest on Your State Tax Return

This is the crucial step where you save money. Most state tax returns start with your Federal Adjusted Gross Income (AGI), which already includes your T-bill interest. You must manually subtract it to remove it from your state’s calculation.

Every state has a different form or line for this, but the concept is the same. It’s usually called a “subtraction,” “modification,” or “adjustment.”

California: You subtract the amount from Box 3 on Schedule CA (540), Line 2, Column B. The instructions are very clear that interest from U.S. Treasury bills, notes, and bonds goes here.
New York: The subtraction is made on Form IT-225, New York State Modifications. You enter the amount of interest from U.S. government obligations in the section for subtractions from federal AGI.
Illinois: You report the subtraction on Schedule M, Other Additions and Subtractions for Individuals. The instructions specify that income from U.S. Treasury bonds, bills, and notes should be entered here.
Pennsylvania: The subtraction is handled on PA-40 Schedule A, Interest Income. Line 8 of this schedule is specifically for “Interest from Direct Obligations of the U.S. Government”.
Other States: States like Utah (Form TC-40A) and Nebraska (Schedule I) have similar forms where you list the amount from Box 3 to reduce your state taxable income.

The Mutual Fund and ETF Trap: A Hidden Tax Mistake

For millions of investors who own T-bills through money market funds (like VMFXX or VUSXX), bond funds, or ETFs, the tax situation is far more complicated. This is where most people overpay their state taxes without even realizing it.

The Problem: Your 1099-DIV Doesn’t Tell the Whole Story

When you own a fund, you don’t receive a 1099-INT. Instead, you get a Form 1099-DIV, which reports “Dividends and Distributions.” The entire dividend your fund paid you is usually lumped together in Box 1a, “Total ordinary dividends”.

There is no standard, IRS-mandated box on the 1099-DIV to report the portion of your dividend that came from state tax-free U.S. Treasury interest. Because it’s not broken out for you, many investors—and even some tax preparers—mistakenly treat the entire dividend as fully taxable at the state level. This is a costly error.

The Solution: You Have to Do the Detective Work

To claim your rightful state tax deduction, you must take a few extra steps. The burden is on you, the investor, to find the information and calculate the exempt amount.

Find the “U.S. Government Obligations” Percentage: In late January or early February, your fund company (like Vanguard, Fidelity, or Schwab) will publish a supplemental tax document on its website. This document is often called the “U.S. Government Obligations Income Information” report. It lists each fund and the exact percentage of its income that came from U.S. government sources during the year.
Calculate Your State Tax-Exempt Amount: Once you have the percentage, the math is simple. Multiply the total ordinary dividend you received from the fund (from your 1099-DIV, Box 1a) by that percentage.
- Example: You received $1,000 in dividends from the Vanguard Federal Money Market Fund (VMFXX). You look up Vanguard’s report and find that for 2024, 59.87% of VMFXX’s income came from U.S. government obligations.
- Your state tax-exempt income is: $1,000 x 59.87% = $598.70.
Manually Subtract it on Your State Return: You then take this calculated amount ($598.70) and subtract it on your state tax return, using the same line or form you would for directly held T-bills.

The All-or-Nothing Rule in CA, NY, and CT

To make things even more complex, a few high-tax states have a strict, all-or-nothing rule. In California, New York, and Connecticut, a fund’s dividends only qualify for the state tax exemption if the fund held at least 50% of its total assets in U.S. government obligations at the end of each quarter of the year.

If a fund’s holdings dip below 50% on just one of those four quarterly measurement dates, investors in those three states lose the entire state tax exemption for that year. A fund that earned 49.9% of its income from Treasuries gives you a 0% state tax break, not a 49.9% break. The fund company’s supplemental tax report will typically have a note or an asterisk indicating which funds met this tough standard.

Real-World Scenarios: Putting It All Together

Let’s look at three common scenarios to see how these rules play out with real numbers.

Scenario 1: The Direct T-Bill Investor in a High-Tax State

Maria lives in New York and is in a high state and local tax bracket. She wants a safe place for her emergency fund and decides to buy $20,000 worth of 52-week T-bills directly through TreasuryDirect. At maturity, she earns $1,000 in interest.

Action	Consequence
Maria receives a 1099-INT with $1,000 in Box 3.	This income is fully taxable on her federal return.
She enters the 1099-INT into her tax software.	The software adds $1,000 to her federal taxable income.
On her New York return, she enters $1,000 as a subtraction for U.S. government interest.	Her New York taxable income is reduced by $1,000, saving her from paying state and local income tax on that amount.

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Scenario 2: The Money Market Fund Investor in California

David lives in California and keeps his cash in the Vanguard Federal Money Market Fund (VMFXX). He receives a 1099-DIV showing a total dividend of $5,000 in Box 1a. He knows that some of this might be state tax-free, so he does his homework.

Action	Consequence
David goes to Vanguard’s website and finds the “U.S. Government Obligations” report.	He sees that for 2024, VMFXX derived 59.87% of its income from U.S. obligations and has an asterisk noting it met the 50% quarterly asset test for California.
He calculates his exempt portion: $5,000 x 59.87% = $2,993.50.	This is the amount he can subtract on his California tax return.
In his tax software, after entering his 1099-DIV, he finds the option for “A portion of these dividends is U.S. Government interest” and enters $2,993.50.	His California taxable income is reduced by nearly $3,000, saving him hundreds of dollars in state tax that he would have otherwise overpaid.

Scenario 3: The ETF Investor Who Misses the 50% Rule

In 2023, Sarah, a New York resident, invested in a money market fund that she thought was mostly Treasuries. She received a $2,000 dividend. She heard about the state tax break and went to the fund’s website to get the percentage.

Action	Consequence
Sarah finds the fund’s tax document.	It shows that the fund earned 49.37% of its income from U.S. government obligations.
She reads the fine print.	The document notes that because the fund’s holdings dropped below the 50% asset requirement during one quarter, it does not qualify for the state tax exemption in NY, CA, or CT.
She prepares her New York tax return.	She cannot subtract any portion of her $2,000 dividend. The entire amount is fully taxable at the state level, resulting in a higher tax bill than she expected.

Do’s and Don’ts for Handling Treasury Tax Reporting

Navigating these rules can be tricky. Following a clear set of do’s and don’ts can help you maximize your tax savings and avoid common errors.

Do’s	Don’ts
✅ DO check Box 3 of your 1099-INT. This is the magic number for your state tax subtraction if you own Treasuries directly.	❌ DON’T assume your tax software will automatically find the subtraction. You often have to manually indicate that a portion of your income is from U.S. government sources.
✅ DO proactively search for your fund’s “U.S. Government Obligations” percentage online each year. This information is almost never on your 1099-DIV.	❌ DON’T use last year’s percentage. A fund’s holdings change, so the percentage of state tax-free income can vary significantly from one year to the next.
✅ DO check the fine print for the 50% asset rule if you live in California, New York, or Connecticut. It’s an all-or-nothing test that can eliminate your tax break.	❌ DON’T just look at a fund’s name. A “Treasury Obligations Fund” might hold repurchase agreements that don’t qualify, while a “Federal Money Market Fund” might.
✅ DO keep a copy of the fund’s supplemental tax document with your tax records. This is your proof in case your state ever questions the subtraction.	❌ DON’T forget to subtract the exempt income on your state return. This is the most common and costly mistake, as it means you’re voluntarily overpaying your taxes.
✅ DO double-check the work of your tax preparer. Many professionals are not aware of this nuance, especially for mutual funds, and may miss the deduction unless you point it out.	❌ DON’T confuse capital gains with interest. If you sell a T-bill before maturity for a profit, that gain is a taxable capital gain at both the federal and state levels.

T-Bills vs. Other Investments: A Tax-Adjusted Showdown

The state tax exemption is the T-bill’s superpower. It can make a T-bill with a lower interest rate more profitable than another investment with a higher rate, once taxes are paid. Let’s compare a T-bill to a Certificate of Deposit (CD) and a high-grade corporate bond.

To make a fair comparison, we need to calculate the tax-equivalent yield. This tells you what interest rate a fully taxable investment (like a CD) would need to offer to match the after-tax return of a T-bill.

Let’s assume an investor is in the 24% federal tax bracket and a 9% state tax bracket.

Investment Type	Pre-Tax Yield	Federal Tax?	State Tax?	After-Tax Yield Calculation	True After-Tax Yield
U.S. T-Bill	4.19%	Yes (24%)	No	4.19% x (1 – 0.24)	3.18%
1-Year Bank CD	4.32%	Yes (24%)	Yes (9%)	4.32% x (1 – 0.24 – 0.09)	2.90%
AAA Corporate Bond	5.08%	Yes (24%)	Yes (9%)	5.08% x (1 – 0.24 – 0.09)	3.40%

In this example, even though the CD has a higher starting yield (4.32% vs. 4.19%), the T-bill provides a better after-tax return (3.18% vs. 2.90%) because of the state tax savings. The AAA corporate bond, with its higher yield, comes out on top even after being fully taxed. This calculation is essential for making smart investment decisions.

Pros and Cons of Investing in T-Bills

T-bills are a powerful tool for cash management and portfolio safety, but they aren’t the right fit for every goal. Understanding their advantages and disadvantages is key.

Pros	Cons
👍 Ultimate Safety: T-bills are backed by the full faith and credit of the U.S. government, meaning there is virtually zero risk of losing your principal investment.	👎 Lower Returns: The trade-off for safety is a lower yield compared to riskier investments like corporate bonds or stocks.
👍 State and Local Tax Exemption: The interest is not taxed by your state or city, which significantly boosts your after-tax return, especially in high-tax states.	👎 Interest Rate Risk: If interest rates rise after you buy a T-bill, you are locked into a lower rate, making your investment less attractive compared to newer T-bills.
👍 High Liquidity: You can easily sell T-bills on the secondary market before they mature if you need to access your cash.	👎 No Regular Income Stream: Unlike T-notes or T-bonds, T-bills do not pay periodic interest. You only receive your return at maturity, which may not be ideal for those needing regular cash flow.
👍 Short-Term Flexibility: With maturities of one year or less, T-bills are perfect for parking cash needed for short-term goals like a down payment or a tax bill.	👎 Inflation Risk: If the inflation rate is higher than your T-bill’s yield, your investment is losing purchasing power over time.
👍 Low Minimum Investment: You can start investing in T-bills with as little as $100, making them accessible to almost everyone.	👎 Federal Taxes Still Apply: While you save on state taxes, the interest is still fully taxable at your ordinary federal income tax rate.

Mistakes to Avoid

Many investors leave money on the table or make incorrect filings because of a few common, avoidable mistakes.

Mistake 1: Forgetting the Subtraction. The most frequent error is simply forgetting to subtract the U.S. Treasury interest on the state tax return. This happens when investors see the interest on their federal return and assume it’s also taxable by the state, leading to direct overpayment of state tax.
Mistake 2: Ignoring Mutual Fund Dividends. A huge number of investors are unaware that a portion of the dividends from their money market or bond funds is state tax-exempt. They enter the total dividend from their 1099-DIV and never perform the extra steps to calculate and subtract the exempt portion.
Mistake 3: Using the Wrong Line on the State Form. Some states have very specific instructions. For example, California requires the subtraction to be on Line 2 (Taxable Interest) of Schedule CA, but some tax software has mistakenly placed it on Line 3 (Dividends), which is technically incorrect according to state instructions.
Mistake 4: Not Checking the 50% Rule. Residents of California, New York, and Connecticut often fail to verify if their mutual fund met the strict 50% quarterly asset test. Claiming the exemption for a fund that failed this test could lead to an incorrect tax filing and potential issues if audited.

Frequently Asked Questions (FAQs)

Yes or No first, then a maximum of 35 words.

What is the main difference between a T-Bill, T-Note, and T-Bond? Yes, the main difference is their maturity time. T-bills mature in one year or less, T-notes in two to 10 years, and T-bonds in 20 to 30 years. T-notes and T-bonds also pay interest semi-annually.

How is the interest on a T-Bill paid? Yes, it’s paid at maturity. You buy a T-bill at a discount to its face value (e.g., pay $990 for a $1,000 bill). The difference you receive when it matures is your interest income.

Do I pay state tax on T-bills if I live in a state with no income tax? No. The state tax exemption is irrelevant in states like Florida or Texas that have no state income tax to begin with. There is no state tax from which the interest needs to be exempted.

Is profit from selling a T-Bill before maturity taxed by states? No, not entirely. The portion of your gain that represents accrued interest is exempt from state tax. However, any profit above that accrued interest is a short-term capital gain, which is fully taxable by states.

Are T-Bills subject to capital gains tax? No, not if held to maturity; the income is treated as interest. A capital gain or loss can only occur if you sell the T-bill on the secondary market before it matures for a different price.

What is the difference between a franchise tax and an income tax? Yes, they are different. An income tax is on profits. A franchise tax is a fee for the privilege of doing business in a state, often based on net worth, and can apply even if there’s no profit.

Are U.S. Savings Bonds taxed the same way as T-Bills? Yes, the interest is federally taxable but exempt from state and local income taxes. Savings bonds offer an extra benefit: the federal tax can often be deferred until you cash the bond.