How to Claim Your State Income Tax Exemption — My Money Blog

As the brokerage 1099 forms for 2022 are coming out, here is a quick reminder for those in states with local income taxes. If you earned interest from a money market fund, a significant portion of this interest may have come from US Treasury bills and bonds, which are exempt from state and local income taxes. However, in order to claim this exemption, you’ll have to manually enter it on your tax return after digging up a few extra details.

Let’s take the default cash sweep option for Vanguard brokerage accounts, the Vanguard Federal Money Market Fund (VMFXX), which has an SEC yield of 4.29% as of 1/24/23. Vanguard has recently released the U.S. government obligations income information for 2022 [pdf] for all their funds, which states:

This tax update provides information to help you properly report your state and local tax liability on ordinary income distributions you received from your mutual fund investments in 2022. On the next page, you’ll find a list of Vanguard funds that earned a portion of their ordinary dividends from obligations of the U.S. government. Direct U.S. government obligations and certain U.S. government agency obligations are generally exempt from taxation in most states.*

To find the portion of Vanguard dividends that may be exempt from your state income tax, multiply the amount of “ordinary dividends” reported in Box 1a of your Form 1099-DIV by the percentage listed in the PDF. Note that on the IRS Form 1099-INT, there is a special Line 3 that includes “Interest on US Savings Bonds & Treasury obligations”. However, for the Vanguard funds, they report on 1099-DIV and not 1099-INT. My Vanguard 1099-INT was all zeros.

For the Vanguard Federal Money Market Fund, this percentage was 37.79% in 2022. Therefore, if you earned $1,000 in total interest from VMFXX in 2022, then $377.90 was exempt from state and local income taxes. If your marginal state income tax rate was 10%, that would be a ~$38 tax savings for every $1,000 in total interest.

Note that several other Vanguard funds have a significant percentage of dividends from US government obligations, including the popular Vanguard Target Retirement Income funds:

I don’t believe that TurboTax, H&R Block, and other tax software will do this automatically for you, as they won’t have the required information on their own. (I’m not sure if they ask about it in their interview process.) If you use an accountant, you should also double-check to make sure they use this information. Here is some information on how to enter this into TurboTax:

• When you are entering the 1099-DIV Box 1a, 1b, and 2a – click the “My form has info in other boxes (this is uncommon)” checkbox.
• Next, click on the option “A portion of these dividends is U.S. Government interest.”
• On the next screen enter the Government interest amount. This will be subtracted from your state return.

In the same way, municipal bond and money market funds will usually have their federally tax-exempt interest listed on the 1099-DIV, but they should also break down their interest down to the state-specific level elsewhere. This data was provided as part of my Vanguard 1099 forms. Your muni bond interest might be 100% exempt from federal income taxes, but it also may be partially exempt from your in-state income taxes. For example, dividends from the Vanguard Intermediate Tax-Exempt Fund was roughly 15% from New York, 10% from California, and 7% from Illinois.

[Image credit – Wikipedia]