Why You May Wish to Amend Your 2023 State Income Tax Return
By John H. Robinson, Financial Planner (May 19, 2024)
The individual states and the federal government have long had a reciprocal agreement not to tax the interest paid to investors on each other’s debt obligations. For this reason, municipal bonds issued by all 50 states are generally not taxed by the federal government. Similarly, interest paid on treasury securities and certain government agencies (Federal Hom Loan Bank, Federal Farm Credit Bank, and Tennessee Valle Authority) is not taxed by the states. This mutual agreement helps lower the borrowing costs of each.
Investors who purchase treasuries (and/or the three agency securities listed above) will find that the interest is reported on IRS form 1099 INT as exempt at the state level. Interest paid on treasuries and the three special agency securities is also exempt when the securities are owned in mutual funds, but is not reported as exempt from state income tax on the IRS forms 1099-DIV that are issued by the funds. This is because the dividends paid by the fund throughout the year may also consist of interest and dividend income from securities that are not exempt.
So How do Bond Fund Investors Avoid Paying Tax on the Interest from Treasuries Held in the Fund Portfolio?
Since the interest on treasury securities owned in bond fund portfolios is not reported as exempt on the funds’ 1099-DIV, mutual funds that hold these securities typically issue Supplementary Tax Information that investors can then provide to their tax preparers. This document will show the percentage of the fund’s dividend income that is attributable to state tax-exempt government obligations. Taxpayers can then input this information into their tax preparation software to pass it along to their CPAs or other tax preparers to incorporate into their state income tax returns.
Communications Breakdowns Result in Overpayment of State Income Tax
There are three problems with the reporting of supplementary tax information described above. First, the information is not automatically sent to fund shareholders. Second, fund investors often do not know where to find this information. Third, CPAs and tax preparers do not necessarily know to ask for this information.
So How is this Information Relevant to Me?
Most readers of my content know that I completely eschew bond mutual funds (“Friends don’t Let Friends Buy Bond Funds”) and may therefore be wondering why I am writing about this problem. The answer is “money market funds.” Ever since interest rates began rising in early 2022, I have been encouraging clients to use treasury money market funds for safety and liquidity as an alternative to lower-yielding bank deposits.
As of this writing, Financial Planning Hawaii clients have more than 30 million dollars in the Schwab U.S. Treasury Money Fund. As per Schwab’s 2023 Supplementary Tax Information Report, 99.61% of the interest paid on this fund was exempt from state income tax. If you did not have this information to guide you or to give to your tax-preparer before filing your 2023 returns, you may very well have over-reported your taxable income.
Is It Worth Amending My State Income Tax Return?
If you live in a state with no income tax, such as Florida, New Hampshire, Texas, or Washington, there is nothing to amend. However, if you live in a high-tax state, such as Hawaii, California, New York, Oregon, or Vermont, it may be worth your while to amend. To illustrate by example, if you live in Hawaii, you earned $10,000 in treasury money market fund dividends in 2023, and you are in the 8% state marginal income tax bracket, you may have overpaid approximately $800 tax on your Hawaii tax bill. Call me parsimonious, but if I was the fellow in that example, I would be inclined to amend.
Summary
I am sure some readers may be thinking this tip would have been more helpful in January or February. The truth is that I did not pick up on this issue until I was reviewing my own tax return at the end of March. For more than a decade this information has not been actionable because interest rates were so low. 2023 was the first year in a very long time in which millions of American taxpayers reported significant taxable interest and dividends on their tax returns, so forgive me for being a bit rusty in passing along this reminder. For many Financial Planning Hawaii (and Fee-Only Planning Hawaii) clients, this information is still “better-late-than-never.”
Related Reading
Schwab 2023 Supplementary Tax Information
Fidelity Percentage of Income from U.S. Government Securities
Vanguard U.S. Government Obligations Income Information
States with the highest and lowest income tax rates (Turbo Tax)
John H. Robinson is the owner/founder of Financial Planning Hawaii and Fee-Only Planning Hawaii. He is also a co-founder of fintech software maker Nest Egg Guru.
