With Treasury yields at multi-year highs, many investors are turning to Treasury-focused ETFs, money market funds, and broad bond index funds to capture attractive returns. However, a common tax reporting issue could cost you: misreported Treasury distributions. If you live in a state with income taxes, failing to properly categorize Treasury income could mean overpaying. Here’s how to avoid this mistake.
The Problem: Treasury Distributions Are Often Misreported
Interest from Treasury securities (T-bills, T-notes, T-bonds) is exempt from state and local taxes under federal law. This exemption applies to distributions from ETFs and money market funds that primarily invest in Treasuries.
However, fund distributions don’t always isolate the Treasury-derived portion on 1099 tax forms. Custodians rely on fund companies to classify income based on IRS categories (e.g., qualified dividends, non-qualified dividends, short-term capital gains), and there is currently no mechanism to report Treasury income separately within this system. As a result, investors may end up paying unnecessary state taxes, particularly in high-tax states like California, New York, and Connecticut, which require at least 50% of a fund’s holdings to be in Treasuries for state tax exemption.
For example, if you’re earning a 5% yield on Treasury bills but the income is not separately reported as Treasury income, you could end up paying an extra 50+ basis points in state taxes in a state like California; money that should stay in your pocket. Even diversified bond funds with Treasuries, as well as alternative funds that use T-bills as collateral, may include income that should be state-tax-exempt, but the burden is on investors to adjust for this on their returns.
Why This Happens
- Fund Distributions Are Not Automatically Separated: Custodians report fund income as categorized by the fund companies themselves, and there’s currently no IRS-mandated way to separately track Treasury-derived distributions.
- Mixed Fund Holdings: Some ETFs and money market funds contain both Treasury and non-Treasury securities, making it harder to isolate the tax-exempt portion.
- Investors Unaware: Fund names don’t always reflect tax treatment. For example, there is a fund company with a “U.S. Treasury Money Fund” that is almost purely Treasury income, but its “Treasury Obligations Money Fund” only qualifies ~30% of its income as government obligations with the rest is in repos (which don’t count as Treasuries for tax purposes).
How to Fix This When Filing Your Taxes
To ensure you’re not overpaying, manually separate Treasury income from other taxable distributions. Here’s how:
- Review Your 1099 Forms: Check your 1099-DIV or 1099-INT for distributions from Treasury ETFs, money market funds, or bond index funds.
- Check Fund Documentation: Funds often provide a tax supplement or website breakdown showing the percentage of income from Treasuries (states like California, New York, and Connecticut require a 50%+ allocation within a fund to Treasuries for tax-exempt treatment, where other states may provide partial exemption).
- Calculate the Exempt Portion: Multiply your total distribution by the Treasury income percentage. Example: If you received $1,000 in distributions and 55% came from Treasuries, then $550 is potentially state-tax-exempt.
- Report Correctly on Your State Return: Most states have a specific line or schedule for exempt income. Be sure to report the Treasury portion separately.
- DIY Software & Tax Preparers: If using TurboTax or other tax software, look for prompts to input Treasury income details. Many tax professionals miss this detail, so it’s worth verifying their work.
Pro Tip: Keep Detailed Records
To make this process easier, maintain detailed records of your investments and the tax-exempt percentages provided by your funds. This will save you time and ensure accuracy when filing.
Other Bonds With Similar Tax Treatment
Though this article focuses on Treasuries, other government-backed bonds receive the same state tax exemption. U.S. Savings Bonds, as well as debt issued by Federal Farm Credit Banks, Federal Home Loan Banks, the Student Loan Marketing Association (Sallie Mae), and the Tennessee Valley Authority (TVA), also qualify for this treatment. TVA even highlights this exemption in its investor materials, making it worthwhile to check whether your holdings qualify.
The Bottom Line
With Treasury yields elevated, it’s critical to ensure you’re not overpaying state taxes due to reporting errors. Manually separating Treasury distributions, even from broader bond index fund, can save you hundreds or even thousands of dollars, especially in high-tax states.
Review your tax documents carefully, check fund reports, and consult a tax professional if needed. A little extra effort now could lead to significant savings.
Special thanks to Mike Lambrakis for his help reviewing this piece. Follow him on LinkedIn.
Disclaimer: This blog post is for informational purposes only and does not constitute tax advice. Please consult a qualified tax professional for guidance specific to your situation.
Disclosures
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward-looking statements cannot be guaranteed.
This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.
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