Are Government Bonds Tax Free? Federal vs. State Rules

Government bonds are debt securities issued by a government entity to raise funds for public spending, such as for infrastructure projects or operational costs. When an investor purchases a bond, they are effectively lending money to the government. In return, the government promises to pay the investor periodic interest payments and to repay the principal amount when the bond reaches its maturity date. These investments are considered to have a low level of risk compared to other securities. The tax treatment of the interest earned from these bonds depends on which level of government issues them.

Taxation of Federal Government Bonds

The tax rule for bonds issued by the U.S. federal government is that the interest income is subject to federal income tax but is exempt from all state and local income taxes. This rule applies to federal debt, including Treasury Bills (T-bills), Treasury Notes (T-notes), Treasury Bonds (T-bonds), and popular U.S. Savings Bonds, such as Series EE and Series I. The interest is included with other taxable interest on a federal return, while it is subtracted or excluded from income on a state tax return.

This tax structure creates a benefit for investors, especially those residing in areas with high state and local income tax rates. For example, an investor who lives in a state with a 7% income tax and earns $1,000 in interest from a U.S. Treasury Note must report that income on their federal tax return. That $1,000 will be taxed at their ordinary federal income tax rate. However, they will not owe any state or local tax on that same $1,000, saving them $70 that they would have otherwise paid on other forms of interest income.

Taxation of State and Local Government Bonds

Bonds issued by state and local governments, often called municipal bonds or “munis,” have their own distinct set of tax rules. The rule for most municipal bonds is that the interest income they generate is exempt from federal income tax. This federal tax exemption makes them particularly attractive to investors in higher tax brackets, as the value of the exemption increases with an investor’s marginal tax rate.

At the state and local level, the taxability of municipal bond interest depends on where the bond was issued. If you purchase bonds issued by your own state of residence, or a city or county within it, the interest is also exempt from your state and local income taxes. This creates what is known as a “triple-tax-free” investment, as it is free from federal, state, and local income taxes.

Conversely, if you purchase a municipal bond issued by a different state, the interest income will be subject to your home state’s income tax. For instance, if a resident of California buys a bond issued by the state of New York, the interest is still exempt from federal income tax, but California will tax that interest income. This distinction between “in-state” and “out-of-state” bonds is a primary factor for municipal bond investors.

Special Tax Considerations for Government Bonds

The tax exemptions for government bonds apply only to the interest income. If an investor sells a government bond in the secondary market for a price higher than their purchase price, the resulting profit is a capital gain. This gain is taxable at both the federal and state levels.

Another consideration is the Alternative Minimum Tax (AMT), a parallel tax system that ensures high-income individuals pay a minimum amount of tax. Interest from certain municipal bonds, known as “private activity” bonds, is exempt from regular federal income tax but must be included as income when calculating the AMT. These bonds are issued by a state or local government to finance projects for a private entity, such as a new sports stadium or an airport terminal.

Tax-exempt interest can also have indirect tax consequences for retirees. Tax-exempt interest from municipal bonds must be included in the calculation of “provisional income,” which the IRS uses to determine how much of a person’s Social Security benefits are taxable. For joint filers, if their provisional income exceeds $44,000, up to 85% of their Social Security benefits could become taxable. This calculation includes half of their Social Security benefits plus other income, including tax-exempt interest.

Reporting Government Bond Interest on Tax Returns

Investors in government bonds receive specific forms from their broker or the bond issuer detailing their interest income. The primary form is Form 1099-INT, Interest Income, which is sent by the payer if you received $10 or more in interest. For bonds purchased at a discount to their face value, you might instead receive Form 1099-OID, Original Issue Discount.

On Form 1099-INT, different types of bond interest are reported in specific boxes. Taxable interest from federal government bonds is reported in Box 3, “Interest on U.S. Savings Bonds and Treasury obligations.” In contrast, tax-exempt interest from municipal bonds is reported in Box 8. If a portion of that municipal bond interest is subject to the Alternative Minimum Tax, that amount will be shown in Box 9.

This information is transferred to your Form 1040. The taxable interest from Box 3 of the 1099-INT is included on the “Taxable interest” line of your Form 1040, often detailed on Schedule B if the total amount exceeds $1,500. The tax-exempt interest from Box 8 must also be reported on your Form 1040 on the “Tax-exempt interest” line, which is line 2a on the current form. The IRS requires this information to be reported for calculations like the taxability of Social Security benefits.