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In late 2021 and early 2022, I sold our core bond holdings in our taxable account and invested the proceeds in I-Bonds as part of a strategy to build an income bridge to allow me to defer taking my SS. This provided the stability of a known inflation-adjusted income stream that had yielded an average of 6.6% per year until we began redemptions this past year. Given what occurred with bond funds in 2022 (and almost double-digit I-Bond interest for a brief time), you might think I was a genius….. but it was just the dumb luck of timing.
Now I am preparing to pay taxes on the I-bond interest as I do my 2024 tax returns. I know, given that I-Bonds are U.S. government obligations, I will pay income tax to the federal government, but not to my state and local government. But why? Can anybody help me understand why the federal government gets “their fair share”, but my state and local governments get stiffed and appear to be the ones providing the subsidy? Is there some history behind this rationale?
Marjorie has it right and basically so do all the others. As a Purchasing Officer for the Federal Judiciary I had a card that stated that on anything I purchased that no taxes would be owed or paid.
https://law.justia.com/constitution/us/article-6/08-federal-exemption-from-state-taxation.html
Bill, I thought a simple explanation might do, as I indicated below, but the above is a link to the whole enchilada.
The benefit is two fold. You do not pay state and local taxes as the bond purchaser. The debt issuer is able to raise capital at a lower cost. There is a cost savings and benefit for local taxpayers to maintain and build local infrastructure.
However, the IRS will penalize the issuer if they “invest” the bond proceeds – that is earn gains from interest arbitrage. That was not an issue for a long time with bank account interest rates so low. Now I have to actively monitor my bond proceed cash holdings. I work as a municipal CFO.
There has been some recent chatter by federal legislatures about removing the tax free exemption for municipal bonds. If that were to happen, it would have a big negative impact on your local taxes.
Great question! Didn’t realize until now that the answer would go back two centuries. The Supreme Court determined in the early 1800’s that the Constitution restricts states from interfering with federal institutions, such as national banks : https://en.m.wikipedia.org/wiki/McCulloch_v._Maryland
Taxation of interest earned on federal instruments of debt would interfere with federal powers.
Bill, A simple explanation is that income from federal securities is beyond the reach of states taxing power.
A better simple answer is that US Treasury issued I bonds provide a competitive alternative to tax free issued municipal bonds.
Thank you Peter, but your comments don’t address Bills question.
Bill’s question, “I will pay income tax to the federal government, but not to my state and local government. But why? ”
To encourage investors, particularly in high state income tax rates, to purchase their debt and not municipal debt which is also tax free.
Equally, muni bond interest isn’t taxed by the feds.