How Treasury Bills Are Taxed at Federal and State Level

*Treasury bills are taxed at the federal level as ordinary income on the discount gain, but they are completely exempt from state and local income tax. A T-bill purchased at a discount and held to maturity generates income equal to the difference between the purchase price and face value, taxed at your marginal federal rate; the same gain is not taxable by your state.

Federal Tax Treatment: Ordinary Income on Discount

When you buy a Treasury bill, you pay less than its face (par) value. A $10,000 bill might sell for $9,950; when it matures, you receive $10,000. That $50 difference is your income. The IRS treats this discount gain as ordinary interest income, not a capital gain, and it is taxed at your top marginal tax bracket—the same rate as a salary bonus or interest on a savings account.

Here is the key distinction: if you hold the T-bill to maturity, the entire discount is ordinary income, period. It does not matter that the T-bill is a government security. The IRS code explicitly treats short-term Treasury bill discount income as ordinary income. This is a common point of confusion; many people assume government debt is taxed preferentially, but in fact only the state/local exemption applies.

The mechanics are straightforward. If you buy a 13-week (91-day) T-bill for $9,975 and receive $10,000 at maturity, you report $25 as ordinary interest income in the year the T-bill matures. If you buy a 52-week (364-day) bill for $9,800 and hold it to maturity for $10,000, you report $200 as ordinary interest income. Multiply that by your federal tax bracket—if you are in the 37% bracket, that $200 is worth $74 of tax liability to you.

State and Local Tax Exemption

Here is the major tax advantage of Treasury bills: the income is completely exempt from state income tax, city tax, or any other state-level levy. This exemption applies uniformly across all 50 states and all municipalities. It stems from 31 U.S.C. § 3124, which provides that interest on federal debt obligations is not subject to state or local tax.

The exemption is absolute. If you live in California (13.3% top state rate), New York City (8.8% combined state and city), or any other high-tax jurisdiction, you owe zero state tax on Treasury bill income. Your state cannot tax it, and neither can your city or county.

For high-income investors in steep-tax states, this exemption is economically significant. Consider an investor in the 37% federal bracket who also faces 13.3% California state tax (total marginal rate of ~50%). A $10,000 Treasury bill discount that yields $100 of income costs $37 in federal tax, but zero in state tax. Compare that to a corporate bond yielding the same $100 discount: that same investor owes $37 federal plus $13.30 state, for a combined $50.30 cost. The Treasury bill saves the $13.30—a 13% improvement in after-tax yield. Over a portfolio of T-bills, this compounds.

Sale Before Maturity: Capital Gains Rule

If you sell a Treasury bill before it matures, the tax treatment differs. Your gain or loss becomes a capital gain or loss, which can be either short-term (ordinary rates) or long-term (preferential rates), depending on your holding period.

For example: you buy a one-year T-bill for $9,500 and sell it after five months for $9,750. You realize a $250 gain. Because you held it less than one year, it is short-term capital gain, taxed as ordinary income. But the state-tax exemption still applies—that $250 gain is not subject to state tax, even though it is a short-term gain.

If you held the same T-bill for 13 months and sold it for a gain, the gain would still be exempt from state tax (because it is Treasury income), but at the federal level you would receive the benefit of long-term capital gains rates, which are lower than ordinary rates for most investors.

Reporting and Documentation

Form 1099-B and 1099-INT

Your broker or Treasury Direct account issues a Form 1099-B (for brokered transactions) or Form 1099-INT (for direct Treasury holdings through TreasuryDirect), reporting the discount income. You report this on your Form 1040 Schedule B (interest and ordinary income).

If you sold a T-bill before maturity, the broker also reports the transaction on 1099-B, and you must report the capital gain or loss on Schedule D and Form 8949 (Sales of Capital Assets).

Tax-Loss Harvesting

Investors sometimes use Treasury bills in tax-loss harvesting strategies. If you sell a T-bill at a loss (you might sell before maturity if interest rates have risen, lowering the market price of the bill), you can offset other capital gains. However, you must be mindful of the wash-sale rule: if you sell at a loss and repurchase the same or substantially identical T-bill within 30 days, the loss is disallowed. Since all Treasury bills of the same maturity date are substantially identical, the rule applies strictly within the T-bill universe.

Zero Coupon Treatment

Treasury bills are zero-coupon instruments—they pay no interim interest, only a lump sum at maturity. This differs from Treasury notes or bonds, which pay semi-annual coupons. For a coupon-paying Treasury, you must recognize interest income each year even if you do not receive the cash (accrual-basis taxation). For T-bills, because there is no coupon, you recognize all income upon maturity (or sale).

This can be advantageous for certain liquidity strategies, because you defer the cash outflow until the bill matures, but you must still recognize the tax liability in the year of maturity, even if you reinvest the proceeds.

Mutual Funds and Money-Market Funds Holding T-Bills

If you own a Treasury bill indirectly through a money-market fund or bond fund, the fund distributes T-bill income to you as a dividend. That income is still ordinary income (not capital gain) and still exempt from state tax. The fund itself does not owe state tax on that income, and neither does the shareholder receiving the distribution.

Some money-market funds market themselves as “tax-exempt” or “tax-advantaged” precisely because they hold Treasury bills and other government securities. The state-tax exemption is real and meaningful, but the federal tax liability remains.

Planning Implications

Treasury bills are attractive to investors in high-tax states or those in the highest federal brackets, because the state-tax exemption is economically valuable. However, they are not exempt from federal tax, and the discount income is taxed at ordinary rates (not preferential capital-gains rates, unless you sell early and qualify for long-term gains).

For retirees or lower-income investors, T-bills may be less attractive on a after-tax basis than Treasuries held in a 401k plan or traditional IRA, where all interest is tax-deferred. But for high-income earners, the state-tax exemption alone can make T-bills more efficient than corporate bonds or money-market funds holding commercial paper.

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