If you really want or need tax-exempt interest, Treasury bonds do not completely fill the bill. However, Treasury securities do provide some tax advantages over other types of taxable bonds. If you live in an area with high state or local income tax rates, such as Los Angeles, California, Treasury bonds will help with those tax bills. Interest from Treasuries is not exempt from federal income taxes.
Types of Treasury Securities
The U.S. Department of the Treasury sells debt securities with several names that define term lengths. Treasury bills have maturities of four to 52 weeks at issue. The terms for Treasury notes range from two to 10 years, and the official Treasury bond is issued with a 30-year term. The 10-year Treasury that acts as a benchmark for long-term interest rates is officially a note. However, in general use, the term "Treasury bonds" covers the full range of Treasury securities. Calling your 10-year Treasury note investments "Treasury bonds" will not get you sent to investment jargon jail.
Federal Interest Is Taxable
The interest you earn from Treasury security investments will be fully taxable on your federal income tax return. You will pay tax on the interest at your marginal – or highest – tax rate. The broker where you bought the bonds, or the Treasury if you bought direct, will send you a Form 1099-INT that lists the amount of interest you need to claim on your tax return.
State and Local Tax Savings
Interest earnings from Treasury bonds will be exempt from state and local income taxes. In the tax rules, the different levels of government do not tax interest paid by other government entities. As a result, the interest from municipal bonds issued by state and local governments is exempt from federal income tax, and the states do not tax federally paid interest. Interest paid by other federal agency bonds, such as Ginnie Mae mortgage securities, and not sold by the Treasury will be taxable at the state and local level.
Calculating Your After-Tax Yield
If you live in a state with high state or local income tax rates, the yield on a Treasury bond can be an attractive choice compared to other taxable bond options. Calculate a taxable equivalent yield for a Treasury bond by dividing the bond's yield by one minus your combined state and local income tax rate. For example, say the 10-year Treasury yields 5 percent and you pay 7 percent total state and local income taxes. Five divided by 0.93 – 1 minus 0.07 – equals 5.38 percent. A fully taxable bond would need to yield greater than 5.38 percent to provide a larger return than a 5 percent Treasury bond.