Are you missing the tax deduction for U.S. obligation interest?
Hopefully by now you’ve heard that interest rates have increased substantially in the last couple of years. With this change, many investors with sizeable amounts in their taxable (non-IRA) accounts have been utilizing high-yield savings accounts, money market funds, CDs, and U.S. Treasuries to capitalize on these higher rates.
With this higher income comes more taxes. But there is a deduction that I’ve seen missed a number of times, resulting in unnecessarily higher taxes: the deduction for U.S. obligation interest.
What is U.S. obligation Interest?
U.S. Obligation interest comes from interest earned on bonds, notes, bills, certificates, savings bonds, and other debt of the U.S. government. This can come either from directly held notes or indirectly via mutual funds or exchange-traded funds (ETFs).
Some custodians report U.S. obligation interest on their Form 1099 provided to clients. Others do not, so it’s up to the investor and/or their tax preparer to calculate this number.
Why does U.S. obligation interest matter?
If you live in Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington or Wyoming, it doesn’t. That’s because these states do not have a state income tax.
But for everyone else subject to state income tax, U.S. obligation interest is not taxable at the state level*.
What kind of savings potential is this for me?
This all depends on the size of your assets, state income tax rate, and how much of your taxable investments contain U.S. obligation interest. If you live in North Dakota and have $100 of U.S. obligation interest, you might save $3 in taxes. But if you live in California and have $100,000 of U.S. obligation interest, that could save you $13,300 if you’re subject to their top bracket.
If my custodian doesn’t report U.S. obligation interest, how can I calculate it?
Typically, interest on U.S. savings bonds and treasury obligations are reported in Box 3 of your Form 1099-INT. U.S. obligation interest derived from mutual funds or ETFs is usually displayed in a supplemental section toward the end of your Form 1099 Composite if your custodian provides this information. If you don’t see it, you’ll need to look up each mutual fund and ETF position you own to see what percentage is U.S. obligation interest, if any. Most fund companies will list all the funds that qualify on a summary sheet. A simple search for “Vanguard US obligations 2022,” using the applicable fund company and year, should provide what you need.
Once you have the percentage by fund, you then need to multiply it by the dividends received by each fund for that tax year using the dividend details from Form 1099. Then total up all of your U.S. obligation interest and report it on your state tax return as a deduction/subtraction depending on the state.
What mutual funds and ETFs contain U.S. obligation interest?
As mentioned above, you’ll need to look up each fund you own that holds at least some portion of bonds. This includes some money market funds, as well as many U.S. bond funds. Here are some examples from 2022 and their percentage of U.S. obligation interest:
- Vanguard Total Bond Market Index (VBTLX or BND) – 34.75%
- iShares Core US Aggregate Bond ETF (AGG) – 30.46%
- Fidelity US Bond Index (FXNAX) – 30.95%
- Vanguard Short-Term Bond Index (VBIRX or BSV) – 57.36%
- PIMCO Income (PIMIX) – 10.37%
- American Funds Bond Fund of America (ABNDX) – 41.56%
- Vanguard Short-Term Investment-Grade (VFSTX) – 7.86%
Taxes are complicated. But being aware of some of the nuances, such as the deduction for U.S. obligation interest income, can be financially rewarding.
As always, tax laws and interpretations can change. Consult with your tax professional regarding your specific financial situation to ensure you’re maximizing your deductions and staying compliant.
*Note that California, Connecticut, and New York require that at least 50% of the fund’s assets consist of U.S. government obligations to be eligible for the deduction.
About the Author
Michael T. Powers, CPA, PFS, CFP® (Mike), is a flat fee-only financial planner based in Richmond, VA serving clients virtually nationwide. He has been fortunate enough to help hundreds of people successfully retire over his career. As a CPA, being tax efficient in financial decisions is always on his mind.
Photo by Annie Spratt on Unsplash.
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