Interest earned on all U.S. Treasury securities, including Treasury bills, is exempt from taxation at the state and local level but is fully taxable at the federal level. At the end of each tax year or early in the next (by Jan. 31), owners of Treasury bills should receive a Form 1099-INT from the Dept. of the Treasury. This form details how much interest was earned on government securities for the year; the info is also filed with the IRS.

key takeaways

  • Interest from Treasury bills (T-bills) is subject to federal income taxes but not state or local taxes.
  • The interest income received in a year is recorded on Form 1099-INT.
  • Investors can opt to have up to 50% of their Treasury bills' interest earnings automatically withheld.
  • If you live in a state with high local taxes, T-bills might be more advantageous than other short-term fixed instruments, like CDs.

Understanding Treasury Bills (T-Bills)

But first, a quick recap of the asset. Treasury bills—often referred to as T-bills—are short-term debt obligations that are fully backed by the faith and credit of the U.S. government. They are sold in denominations of $100 up to $5 million. T-bill maturity durations are all less than one calendar year. Common maturity durations are one month, three months (13 weeks) or six months (26 weeks).

Like all Treasury securities, T-bills are considered to be risk-free assets. The likelihood of the U.S. government defaulting on debt obligations is incredibly low, given its ability to tax and print money and, of course, the general strength and reputation of the U.S.

It was this reputation for safety that, during the 2007-08 financial crisis, caused investors to flock to Treasury securities as losses in stocks and other assets in their portfolios mounted. Those who had already invested heavily Treasury securities prior to the crisis did successfully safeguard their capital.

Tax Rate of Treasury Bills

The interest earned by a T-bill is taxable as investment income in the year the bill matures. It must be reported on your federal tax return, Form 1040, and is taxed at the investor's marginal tax rate.

Even if you don't receive a Form 1099-INT for some reason, you are responsible for reporting the interest income generated by your T-bills and paying taxes on that amount.

If you buy a T-bill at a discounted price and then sell it at a premium price, that profit might also be taxable as a capital gain.

The federal tax burden can be eased through automatic tax withholding. Investors who own Treasury bills can opt to have up to 50% of their interest earnings automatically withheld; the exact percentage can be specified through any retail securities site. The Treasury automatically transfers the withholdings to the U.S. Internal Revenue Service (IRS) and reports the amount that is withheld on the 1099-INT form.

Tax Advantages of T-Bills

Although T-bills don't pay the highest interest rate (the tradeoff for being so low-risk), their exemption from local taxes can give them an advantage over other short-term, fixed-income assets, such as certificates of deposits (CDs)—especially for investors living in high-income-tax states, such as California, Massachusetts, New York, and Oregon. CDs are fully taxable.

To compare the interest rate from a CD with the rate from a Treasury bill and see which works out better, tax-wise, you have to calculate the T-bill's state-taxable-equivalent yield. The equivalent yield is determined by dividing the Treasury bill by one minus your marginal tax rate.

As an example, say your state income tax rate is 8.82% (as it is in New York) and the 1-year Treasury bill you are looking at yields 1.48% (as it is as of Feb. 14, 2020). One minus 0.0882 (the 8.82% in decimal form) comes to 0.9118. Divide the 1.48% by 0.9118 to get a taxable equivalent yield of 1.62% percent. A CD must yield more than 1.62% to be a better deal than the Treasury bill.