Federal income tax on government bonds depends on which government issued them

U.S. Treasury bonds, notes, and bills are taxed at the federal level but exempt from state and local income taxes. Interest you earn is subject to federal income tax, but you do not pay state or local tax on that interest, no matter where you live. This is a real advantage if you live in a state with high income tax.

Municipal bonds issued by states, cities, and counties work differently. Interest from most municipal bonds is exempt from federal income tax. If you buy a bond issued by your own state or locality, the interest is usually also exempt from that state's and locality's income taxes. But if you buy a municipal bond from another state, you typically owe that other state's income tax on the interest, even though you are exempt from federal tax.

Bonds issued by U.S. territories — Puerto Rico, the U.S. Virgin Islands, and Guam — have their own tax rules. Interest from Puerto Rico bonds can be exempt from federal, state, and local taxes if you meet residency requirements, but the rules are strict and change based on which territory issued the bond.

Key Takeaways

  • Treasury bonds are taxed at the federal level but never at the state or local level, regardless of where you live.
  • Municipal bonds are usually exempt from federal income tax, and often exempt from state and local tax if issued by your own state or locality.
  • The tax treatment of bonds issued by U.S. territories depends on the specific territory and your residency status.
  • You must report all taxable bond interest on your federal tax return, even if it is not subject to state or local tax.

How Treasury bonds are taxed

Interest from Treasury bonds, Treasury notes, and Treasury bills is subject to federal income tax at your ordinary tax rate. You report this interest on your federal tax return in the year you receive it. The IRS treats Treasury interest the same as wages or other ordinary income — it is not taxed at a preferential rate.

The major tax advantage is that Treasury interest is completely exempt from state income tax and local income tax. This applies everywhere in the United States. If you live in New York, California, or any other state, you owe no state tax on Treasury interest. This makes Treasuries more attractive in high-tax states, where the state tax savings can be substantial.

Capital gains on Treasuries — the profit you make if you sell a Treasury before it matures at a price higher than you paid — are taxed at federal, state, and local levels like any other capital gain.

How municipal bonds are taxed

Interest from municipal bonds is exempt from federal income tax in almost all cases. This is the defining feature of municipal bonds and the reason investors often buy them. You do not report municipal bond interest on your federal tax return.

State and local tax treatment is more complicated. If you buy a municipal bond issued by your own state, the interest is usually exempt from your state's income tax. Many states also exempt interest from bonds issued by cities and counties within that state. But rules vary by state — some states tax all out-of-state municipal bond interest, while others exempt it.

If you buy a municipal bond issued by a different state, you typically owe income tax on that interest to your home state. For example, if you live in Massachusetts and buy a bond issued by California, you owe Massachusetts income tax on the interest but not California income tax. The bond is still exempt from federal tax.

Capital gains and bond sales before maturity

The tax exemption on municipal and Treasury bonds applies only to interest payments, not to capital gains. If you sell a bond before it matures and make a profit, that profit is a capital gain and is taxed at both federal and state levels.

For example, if you buy a Treasury bond for $10,000 and sell it for $11,000 before maturity, the $1,000 gain is subject to federal income tax and state income tax. The interest you received while holding the bond remains exempt from state tax (for Treasuries) or exempt from federal tax (for municipal bonds), but the gain from selling is taxed normally.

If you sell at a loss, you can deduct that loss against other capital gains or, in some cases, against ordinary income. The tax treatment of losses is the same for government bonds as for any other investment.

Reporting bond interest on your tax return

You must report all taxable bond interest on your federal tax return, even if it is not subject to state or local tax. Your bond issuer or broker sends you a Form 1099-INT showing the interest you earned. You report this on Schedule B of your Form 1040.

For municipal bonds, you do not report the interest itself on your federal return, but you may need to report it on your state return depending on where the bond was issued and where you live. Check your state's tax instructions or speak with a tax preparer about your specific situation.

If you hold bonds in a brokerage account, your broker tracks the interest and reports it to the IRS. If you hold physical bonds, you are responsible for tracking and reporting the interest yourself.

Original issue discount and market discount bonds

Some bonds are issued at a discount — meaning you pay less than the face value. The difference between what you pay and the face value is called original issue discount (OID). The tax treatment of OID is complex and depends on the type of bond and how much discount there is.

For Treasury bonds with OID, the discount is treated as interest and is subject to federal income tax but exempt from state and local tax. For municipal bonds with OID, the discount is usually exempt from federal tax, but the rules are technical and vary.

If you buy a bond on the secondary market at a discount (called market discount), the gain when the bond matures is taxed as ordinary income, not as a capital gain. This is different from the capital gains treatment that applies if you sell the bond before maturity. A tax professional can help you understand the implications for your specific bonds.

Series I and Series EE savings bonds

Series I and Series EE savings bonds are issued by the U.S. Treasury and have special tax rules. Interest is exempt from state and local income tax, just like other Treasury securities. At the federal level, you can choose when to report the interest — either each year as it accrues, or all at once when you cash in the bond.

If you use the proceeds to pay for may have access to education expenses, you may be able to exclude the interest from federal income tax entirely. This is called the education savings bond exclusion and has income limits and other requirements. Not all bonds and not all education expenses may have access to.

Frequently Asked Questions

Do I owe federal tax on municipal bond interest?

No. Interest from municipal bonds is exempt from federal income tax. You do not report it on your federal tax return. You may owe state or local tax depending on which state or locality issued the bond and where you live.

Are Treasury bonds taxed at the state level?

No. Treasury bonds are exempt from state and local income tax everywhere in the United States. You owe federal income tax on the interest, but not state or local tax.

What if I sell a bond for more than I paid for it?

The profit is a capital gain and is taxed at federal, state, and local levels. The tax exemption on bond interest does not cover capital gains. If you sell at a loss, you can deduct the loss against other capital gains or ordinary income, subject to IRS limits.

Do I have to report municipal bond interest on my state tax return?

It depends on which state issued the bond and where you live. If the bond was issued by your state or locality, the interest is usually exempt from state tax and you do not report it. If the bond was issued by another state, you typically owe tax to your home state and must report it. Check your state's tax instructions.

Can I avoid taxes on savings bonds if I use the money for education?

Possibly. Series I and Series EE savings bonds have an education savings bond exclusion that may let you exclude interest from federal tax if you use the proceeds for may have access to education expenses. The exclusion has income limits and other requirements. You must meet all conditions to use it.