States Don't Tax Treasuries Directly. But File With Care in These 3. — Barrons.com

By Karen Hube

If you aren't careful on your 2024 state tax return, you may end up needlessly paying state taxes on the interest income earned on U.S. Treasuries and government agency bonds within your exchange-traded funds, mutual funds and money-market funds.

Income earned on Treasuries and some agency bonds is exempt from state taxes. But when these securities are part of a fund portfolio with other investments whose income is taxable, such as corporate bonds, the nontaxable and taxable incomes get lumped together on the Form 1099-DIV you receive from you fund custodian.

Unless you or your accountant is researching how much of a fund's income is attributable to Treasuries and agency bonds, you may be missing out on their tax break and overpaying your state tax bill, says Brian Jacobs, a portfolio manager at Aptus Capital Advisors.

"When rates were 0% it didn't matter but now that we're looking at interest of 4% or 5%, we're talking about potentially big dollar amounts, " Jacobs says. "The state tax is a meaningful amount for a lot of people especially in high tax states."

Even if an accountant or tax preparation software asks if you have income from Treasuries or agency bonds, it can be easy to overlook.

You would probably expect that a core bond fund would hold Treasuries. For example, the Fidelity Investment Grade Bond ETF holds 46% of its assets in Treasuries and in 2024, 46.4% of the fund's income came from Treasuries.

But it isn't always obvious by a fund's name or its target exposure that it holds government or agency bonds, says Mike Lambrakis, chief investment officer at Ares Financial Consulting.

Consider commodity ETFs. Many will buy futures contracts to mirror a commodity index, and the contracts are typically secured with Treasuries.

"When a fund buys $100 of commodity exposure using futures, it typically only needs to commit around $10 as margin deposited with a clearing house. The remaining $90 stays in its account and most funds invest that balance in short-term assets such as Treasuries," Lambrakis says.

In Vanguard's Commodity Strategy Admiral Fund, 93.4% of 2024 income came from Treasuries. In iShares Bloomberg Roll Select Commodity Strategy ETF, 40.1% of income flowed from Treasuries last year.

Investors may also falsely assume that a fund with the word Treasury in its name kicks off mostly state tax-free income.

But some Treasury money-market funds have less than half their portfolios in Treasuries, because they use repurchase agreements to try to earn returns on excess cash, Lambrakis says.

For example, only 32.1% of income in the Schwab Treasury Obligations Money Fund came from Treasuries last year, "because nearly two-thirds of the portfolio is in repos," Lambrakis says

While repurchase agreements are usually collateralized with Treasuries, their gains are subject to both federal and state taxes.

There are more complications for taxpayers who live in California, New York or Connecticut.

In these states, while income from individual Treasuries or certain agency bonds is always exempt from state taxes, when the income is generated within a fund it can only be exempted from state income taxes if at least 50% of the fund portfolio is allocated to the government securities at the end of each quarter of the tax year.

If you held, say, iShares Short Duration Bond Active ETF in 2024, which kicked off 22.8% of its 2024 income from Treasuries, the income wouldn't be tax-free in California, New York and Connecticut because the fund's allocation to government obligations fell short of 50%.

While all Treasuries, including notes, bills, bonds and Treasury inflation-protected securities (TIPS) can potentially be exempt from state taxes, only certain agency bonds are tax exempt at the state level.

For example, income from Fannie Mae and Freddie Mac bonds, which are issued by the Fannie Mae and the Federal Home Loan Mortgage Corporation, aren't state tax-free.

But income from bonds issued by the Federal Home Loan Banks, Federal Farm Credit Banks Funding Corporation and Tennessee Valley Authority can be exempted from state income for tax purposes.

Income from all government and agency bonds is subject to federal taxes.

If you held iShares Agency Bond ETF last year, its 51.6% of income from bonds issued by the Federal Home Loan Banks, Federal Farm Credit Banks and Tennessee Valley Authority would be state tax-free, even in California, New York and Connecticut because those bonds made up more than 50% of the portfolio.

To find out how much of your fund's income was generated by Treasuries and state tax-free agency bonds, you can look for a report on your fund company's website.

Most fund companies issue reports in February listing their funds and the percentage of income attributable to government obligations in the prior year.

For the benefit of investors in California, New York and Connecticut, the reports will typically note which funds have more than 50% of their portfolios invested in Treasuries and state tax-free agency bonds.

Of course, if the tax-free interest is a small percentage, it may not be worth finding and crunching the numbers, says Mark Cortazzo, senior vice president at Wealth Enhancement Group.

"Ask yourself, is the juice worth the squeeze? In some cases, your accountant hunting down the numbers could cost you more than your tax savings," Cortazzo says. "But we have some clients earning $50,000 in interest from a fund and virtually none of it is taxable at the state level. That's something you don't want to miss."

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