Are both Coupon Interest and Accrued Market Discount Income from US Treasuries exempt from State income tax?

Thanks for this explanation! I'm in a similar situation but with a twist - I elected NOT to accrue market discount annually on my federal return (which I believe is an option), and instead will report it all when I sell or when the bonds mature. In that case, would the market discount still be exempt from state tax when I eventually recognize it?

Yes, the timing of when you recognize the market discount doesn't change its tax-exempt status at the state level. If you've elected not to accrue market discount annually (which is indeed an option), when you eventually recognize that income upon sale or maturity, it would still be exempt from state taxation. Remember that when you do recognize it, you'll want to make sure you identify it properly on your state return as income derived from US Treasury obligations so you can exclude it. Some states may require you to provide documentation showing the source of this income, especially if it appears as a capital gain rather than interest income when recognized all at once.

Does it work with any tax software? I use FreeTaxUSA and I'm having similar issues with my Treasury bonds. Also, does it handle other federal obligation interest like from Fannie Mae or is it just for Treasury securities?

I'm curious how this works. Does it just tell you what should be exempt or does it actually help you fill out the forms? Because honestly the hardest part for me is figuring out WHERE on my state forms to make these adjustments.

It works regardless of what tax software you're using - it's more about analyzing your documents and providing guidance on what's taxable vs exempt. It's particularly helpful for Treasury securities, but it also handles other federal obligations including certain agency bonds. The analysis shows which income sources qualify for state tax exemption. The tool doesn't fill out the forms for you, but it provides specific guidance on where to make adjustments on your state forms. It gave me step-by-step instructions for my state (California) showing exactly which line items needed adjustment and how to document it. This was actually the most valuable part because the state forms can be really unclear about where these adjustments belong.

Wait, is this for real? How does it work? I always thought those "skip the line" services were scams. The IRS and state tax departments have awful phone systems but I didn't think there was any way around them.

Seems sketchy to me. The state tax departments are deliberately understaffed - why would they let some service bypass their queues? And even if you get through, most phone reps give incorrect information half the time anyway.

It's completely legitimate. It uses a callback system that navigates the phone trees and holds your place in line, then connects you when a representative is available. It's not bypassing anything - it's just automating the waiting process so you don't have to sit on hold for hours. I was skeptical too, but it actually works as advertised. The difference is that instead of YOU having to navigate complicated phone menus and wait on hold, their system does it and then calls you when an actual human is on the line. And regarding incorrect information - I specifically asked for a senior tax specialist who could address state taxation of federal obligations, and they transferred me to someone who clearly knew the rules.

But isn't market discount treated as interest income for federal tax purposes? I thought Section 1276 of the tax code treats it as interest income, not capital gains? If it's interest income federally and derived from a Treasury, shouldn't it be exempt from state tax like other Treasury interest?

You're right that market discount is generally treated as interest income for federal purposes (unless you elect otherwise), but some states make a distinction in their tax codes between "direct" Treasury interest and market discount. The federal exemption at the state level is technically for "interest" on federal obligations. Most states interpret this broadly to include all forms of income from Treasuries, but a few states have taken the position that market discount doesn't fall under this protection because it's not "direct interest" from the federal government - rather, it's a function of secondary market pricing. This is why it's so important to check your specific state's guidance or get confirmation from your state tax department. In most cases, you'll find that market discount is exempt, but there are exceptions.

This is so confusing. I'm using H&R Block software and I can't even find where my accrued market discount is being reported. Is there a specific form or line number where this typically shows up? I have a bunch of Treasury bills I bought below par value last year.

@Santiago Martinez - The accrued market discount typically shows up on Schedule B Interest (and Ordinary Dividends on) your federal return, but it might not be clearly labeled as such. Look for any entries that show income from your Treasury bills that aren t'the regular interest payments. In H&R Block, when you entered your 1099-OID or brokerage statements, the software should have captured this information. You might see it listed alongside your other Treasury interest, or it could be in a separate section if you have OID reporting. For your state return, you ll'want to look for a section about subtractions "from income or" federal "obligations -" this is where you d'exclude both the regular Treasury interest AND any accrued market discount from state taxation. If H&R Block isn t'automatically excluding the market discount portion, you may need to make a manual adjustment. The key is making sure ALL income derived from your Treasury bills both (stated interest and market discount gets) the same state tax exemption treatment.

This is really helpful! I'm new to investing in Treasury securities and had no idea about the state tax exemption. I just started buying T-bills through Treasury Direct and was wondering how this would affect my state taxes. From what I'm reading here, it sounds like I need to be careful about how my tax software handles this. Should I be keeping separate records of all my Treasury income to make sure I can properly exclude it on my state return? And does it matter that I'm buying directly from the Treasury rather than through a broker? Also, when you mention Section 1278 election - is that something I need to actively choose, or does it happen automatically? I want to make sure I'm handling this correctly from the start rather than trying to figure it out at tax time.

Great questions! Yes, definitely keep separate records of all your Treasury income - this will make tax time much easier. Whether you buy through Treasury Direct or a broker doesn't change the tax treatment, but it might affect how you receive your tax documents. With Treasury Direct, you'll get 1099-INT forms showing your interest income, and if you buy bills at a discount, you might also get 1099-OID forms for the discount amount. Brokers typically provide similar information but may format it differently on their consolidated 1099s. Regarding the Section 1278 election - this only applies to bonds you purchase at a market discount (meaning you bought them in the secondary market below their adjusted issue price). For Treasury bills bought directly from Treasury at auction, this usually doesn't apply since T-bills are typically sold at a discount from face value by design, and that discount is treated as interest income, not market discount. The election is something you actively choose when you first acquire market discount bonds. If you don't make the election, you'll recognize the market discount as income when you sell or when the bond matures. If you do make the election, you accrue it annually. Most people don't make this election because it results in paying tax on income you haven't actually received yet. For your T-bills from Treasury Direct, just make sure your tax software properly excludes all the interest income (including the discount portion) from your state return!

This is exactly the comprehensive breakdown I was looking for! I've been struggling with this same issue and your point about adding up ALL Treasury income to ensure complete exclusion is really helpful. I have a mix of Treasury bonds, bills, and notes from different purchase dates, some at discount and some at premium, so tracking all the different income components has been confusing. Your approach of just making sure the total amount excluded matches all Treasury-derived income regardless of the specific category makes so much sense. One follow-up question - you mentioned this applies across multiple states. Have you encountered any states that DON'T follow this rule, or is the constitutional protection pretty universal? I'm moving from California to Texas next year and want to make sure I understand how this will work in different state tax environments. Also, do you happen to know if there are any special considerations for Treasury STRIPS or zero-coupon Treasury bonds? Those seem like they might be handled differently since all the income comes from the discount rather than periodic interest payments.

@Kristian Bishop - Great questions! Regarding state variations, the constitutional protection is indeed pretty universal, but states can differ in how they implement the exclusion on their forms. The good news about your move to Texas is that Texas has no state income tax, so you won t'have to worry about this issue at all once you relocate! For Treasury STRIPS and zero-coupon bonds, you re'right that they re'handled a bit differently. The interest "on" these securities is entirely from the discount since (they don t'pay periodic coupons ,)but it s'still considered interest income for tax purposes and should be fully exempt from state taxation. You ll'typically receive 1099-OID forms for these showing the annual accretion of the discount, and that entire amount should be excluded from your state return. The key principle remains the same - if the income is derived from a Treasury security, it gets the exemption regardless of whether it comes from periodic payments or discount accretion. STRIPS are actually backed by the same Treasury securities, just with the principal and interest components separated, so they maintain the same tax-exempt status at the state level. Your comprehensive approach of tracking all Treasury income is spot-on. With zero-coupon bonds and STRIPS, just make sure to include all the OID amounts in your total exclusion calculation along with any regular Treasury interest you might have from other holdings.

@Jamal Carter - Yes, I-bonds follow the same state tax exemption rules as other Treasury securities! Both the fixed rate portion and the inflation adjustment the (variable rate based on CPI are) exempt from state income tax since they re'both considered interest from a federal obligation. Regarding the tax deferral on I-bonds, you re'handling it correctly by waiting until redemption to report the income. When you do cash them in, the entire interest portion which (is the difference between what you paid and what you receive should) be excluded from your state return. The principal amount you originally paid isn t'taxable income anyway, so you d'only be concerned with excluding the interest/growth portion. Your approach of doing a comprehensive review is smart. For I-bonds specifically, when you redeem them, you ll'receive a 1099-INT showing the total interest earned over the life of the bond. That entire 1099-INT amount should be excluded from state taxation just like interest from any other Treasury security. One tip for I-bonds - keep good records of your purchase dates and amounts, because when you have multiple I-bonds purchased at different times, it can get confusing to track which ones you re'redeeming and how much interest each has accrued. But from a state tax perspective, it s'straightforward - all I-bond interest gets the same exemption as other Treasury interest.

Thank you for this professional perspective! Your point about Treasury-focused mutual funds is something I hadn't considered. I have some holdings in VGIT (Vanguard Intermediate-Term Treasury ETF) and receive K-1 distributions that I assume include Treasury interest, but I've been treating it like regular mutual fund income on my state return. Could you clarify how this typically works? Do the mutual fund companies usually break out the Treasury-sourced interest separately on their tax documents, or do I need to dig into the fund's annual reports to figure out what portion of my distributions should be exempt from state tax? Also, your point about estimated taxes is really valuable - I've definitely been overpaying my quarterly state estimated taxes because I was calculating based on all my investment income without accounting for the Treasury exemptions. That's probably costing me a significant cash flow disadvantage throughout the year. This whole discussion has made me realize I should probably review the last few years of returns to see if I've been overpaying state taxes on Treasury income. Is there a statute of limitations on how far back I can file amended returns to claim refunds for incorrectly paid state taxes on Treasury securities?