Generally, interest paid by federal government bonds is exempt from state income tax, but, in the past, I’ve noticed some tax preparers did not properly exempt that interest income.
If an investor owns treasury bonds directly, the interest generated by those bonds is listed separately on the 1099 so it’s quite clear to the tax preparer how much to exclude from the state return as in the example below:
The issue is created, however, when treasury interest comes from mutual funds, ETFs and money market funds. The interest from those sources is all rolled up on the 1099 under “non-qualified dividends” so it’s not clear how much of that came from treasury bonds versus other bonds (e.g. corporate bonds).
Funds paying interest from treasury obligations are certainly easier to spot when the fund name contains the word “Treasury” or “Government,” but based on my experience some tax preparers aren’t even catching that. They’re simply pulling the sub-total from that section of the 1099 into the tax returns.
Funds paying treasury interest is even harder to spot when the word “Treasury” or “Government” are not included in the name of the fund but there is still a portion of interest income generated from federal government bond obligations.
Let me share some examples:
Here we see three funds that have paid ordinary, non-qualified dividends. The Vanguard Total World is a stock fund so I’ll ignore that because if there is any treasury interest included it would likely be miniscule.
However, I’d assume almost all the interest from the iShares 7-10 year Treasury ETF and the Schwab Government Money Fund are generated from U.S. government bond obligations and likely should be excluded from the state tax return (we can determine the exact portion of interest from U.S. government obligations…more on that below).
In this particular case, it’s not a lot of interest so even if it were missed by the tax preparer it’s not likely to have a significant impact on the investor’s taxes (although “significant” is relative and different for each household).
However, for some investors with larger positions in these mutual funds and ETFs the tax can be quite significant.
Here’s another example.
In this case, there is over $100,000 of interest generated from U.S. government bond obligations which should likely be exempt from state income taxes. Depending on your state tax rate this could amount to $0 to $14,000 of tax savings!
So, how do we know exactly how much interest in each fund is generated from U.S. government bond obligations?
I would hope that tax preparers have access to these resources or have built in functionality into their tax prep software. However, if that’s not the case, fund sponsors release supplementary tax information each year detailing the exact percentage of interest that came from government bond obligations.
Here is supplementary tax information for three fund families I commonly use within portfolios for reference:
2024 Vanguard Government Bond Obligations
2024 iShares Supplementary Tax Information
2024 Schwab Supplementary Tax Information
The takeaway: If you have significant non-qualified dividends generated within a non-qualified (taxable) account (listed on your 1099), confirm with your tax preparer whether any of that should be exempt from state income taxes.
Disclosure:
I am not a CPA or a tax professional and do not prepare tax returns so always consult with your tax preparer.
