State Tax: Why Treasury Interest Can Beat a Higher CD Rate

Which of these are you?

• You live in a state with no income tax. There is nothing to adjust. Compare yields directly.
• You pay a mid-bracket state rate. Your marginal rate is set by your taxable income, not by the state's headline top rate. Use the bracket table below, not the top rate you read in the news.
• You want the exemption through a money market fund. Only part of a fund's dividends may qualify. Read the fund-limit section before you assume the whole yield is exempt.
• You itemize deductions and pay a lot of state and local tax. The federal deduction changes the size of the advantage. The deduction section shows how much.

The tax-equivalent yield formula

The tax-equivalent yield is the taxable yield you need to match an exempt yield: exempt yield divided by (1 - state rate). Because federal tax applies to both a Treasury and a CD, the federal layer cancels, and only the state and local layer decides the comparison.

Every rate in the worked examples below is hypothetical. State rates are from state revenue departments and are retrieved as stated in the sources.

The exemption itself is federal law. 31 U.S.C. § 3124(a) says that stocks and obligations of the United States Government are exempt from taxation by a State or political subdivision of a State. It excepts a nondiscriminatory franchise tax or another nonproperty tax imposed instead of a franchise tax on a corporation, and an estate or inheritance tax. So the exemption reaches income tax on individuals but not every tax a state can impose. IRS Publication 550 gives the same treatment for interest on U.S. obligations.

The CD wins here, even after state tax: 4.08% against 4.00%. The break-even state rate is 1 - (4.00 / 4.50) = 11.1%, and 9.3% is below it. On $100,000 for one year, the CD nets $4,081.50 after state tax and the Treasury pays $4,000.00, an $81.50 edge for the CD. A 0.50-point yield gap is large, and a mid-bracket state rate does not erase it.

The exemption is powerful when the yield gap is small and the state rate is high. It is weak when the gap is wide or the rate is low. The formula tells you which case you are in without a rule of thumb.

Your marginal rate, and why the top rate is the wrong number

Use your combined marginal state and local rate, the rate on your next dollar of interest, not the state's top rate. A top rate applies only above a stated income threshold. Below it, your rate is a lower bracket.

The table shows the tax-equivalent yield of a hypothetical 4.00% Treasury at a mid-bracket rate for each state, so you can see how much yield the exemption is worth for a saver in a typical bracket. The bracket thresholds come from each state's own schedule.

The New York row adds two separate taxes. The 2025 IT-201 instructions put New York State at 6% for a married-filing-jointly taxable income from $161,550 to $323,200, and the New York City resident schedule reaches 3.876% for taxable income over $90,000 in the same filing status: 6% + 3.876% = 9.876%. New York City is the only local income tax this chapter prices. If your city, county or school district adds its own income tax, add it too.

Now the top rates, which most savers never reach:

California's 13.3% is its 12.3% bracket, which starts at $742,953 of taxable income for a single filer, plus the 1% Behavioral Health Services Tax on taxable income over $1,000,000 (the tax formerly called the Mental Health Services Tax). New York's 10.9% bracket starts at $25,000,000 of income, and adding New York City's 3.876% gives 14.776%. New Jersey's 10.75% applies over $1,000,000. When a headline says a state taxes savings interest at 13.3% or 10.9%, that is the rate for a very small share of filers.

Finding your marginal rate

Your marginal rate is the rate printed next to your bracket in your state's schedule for your filing status and taxable income. It is not your average rate, which is total state tax divided by income, and it is not the state's top rate.

The California schedule for a single filer shows the mechanics. The 2025 Schedule X runs 1% up to $11,079, 2% to $26,264, 4% to $41,452, 6% to $57,542, 8% to $72,724, 9.3% to $371,479, 10.3% to $445,771, 11.3% to $742,953 and 12.3% above that. Interest on top of a $150,000 taxable income lands in the 9.3% bracket, so 9.3% is the rate to use. If the same interest would push you across a bracket line, only the part above the line is taxed at the higher rate, and a blended rate is the honest input.

Two habits keep the number honest. First, use taxable income after your state's deductions, not gross pay, because the schedules apply to taxable income. Second, price the interest itself: a $4,000 year of Treasury interest on top of a taxable income of $370,000 in California straddles the 9.3% and 10.3% lines, and the part above $371,479 is taxed at 10.3%. For most savers the interest does not cross a line and the single-rate shortcut is fine.

The same logic covers Treasury notes, bonds and inflation-protected securities, because the statute exempts obligations of the United States, not only bills. This chapter prices bills because they are the closest substitute for a CD.

The federal deduction caveat

The break-even formula above is exact when your state tax is deductible on your federal return. When it is not deductible, the exemption is worth more than the simple formula shows. Two things decide which case you are in: whether you itemize, and whether you are under the cap on state and local taxes.

The cap on this deduction changes by year, so the tax year matters. For 2025, IRS Publication 17 sets the overall limit on the deduction for state and local income, sales and property taxes at $40,000 ($20,000 if married filing separately), reduced when modified adjusted gross income exceeds $500,000 ($250,000 if married filing separately), and never below $10,000 ($5,000 if married filing separately). For 2026, IRS Publication 505 (2026) gives $40,400 ($20,200 if married filing separately), reduced when modified adjusted gross income exceeds $505,000 ($252,500 if married filing separately), with the same $10,000 ($5,000) floor. It applies only to filers who itemize. Check the current IRS publication for the year you are filing.

Write f for your federal marginal rate, t for your state rate, y for the CD yield and x for the Treasury yield. There are two cases.

• State tax deductible at the margin (you itemize and are under the cap). The state tax on your interest lowers your federal tax by f times that tax, so the CD keeps y(1 - f)(1 - t). The Treasury keeps x(1 - f). Both carry (1 - f), so the break-even state rate is 1 - x/y, the same formula as before.
• State tax not deductible at the margin (you take the standard deduction, or you are already at the cap). The CD keeps y(1 - f) - yt. The Treasury keeps x(1 - f). The break-even state rate becomes (1 - f)(1 - x/y), lower by the factor (1 - f).

Take the hypothetical 4.50% CD, a 4.23% Treasury, a 9.3% state rate and a 24% federal rate.

The steps: deductible CD = 4.50% x (1 - 0.24) x (1 - 0.093) = 3.10%; not deductible CD = 4.50% x (1 - 0.24) - 4.50% x 0.093 = 3.00%; Treasury = 4.23% x (1 - 0.24) = 3.21%; the second break-even = (1 - 0.24) x 6.00% = 4.56%.

The simple formula overstates the state rate you need if you cannot deduct state tax at the margin. A saver in Illinois at 4.95% sits below the 6.00% line and would pick the CD by the simple formula. If that saver cannot deduct the tax at the margin, the line is 4.56%, and 4.95% is above it: the Treasury wins by about 0.02 points. The federal rate here is a hypothetical 24%, so run your own.

Treasury money funds: the pass-through limit

A Treasury money market fund does not hand you the full exemption. Some states allow the subtraction for fund dividends only if the fund holds at least a stated share of its assets in U.S. obligations, and then only for the portion of the dividend traced to them.

Two states, both verified in their own guidance:

• California. The Franchise Tax Board's 2025 Schedule CA (540) instructions say that if a mutual fund has at least 50% of its assets invested in tax-exempt U.S. obligations and/or in California or its municipal obligations, that amount of dividend is exempt from California tax. The proportion that qualifies is shown on your annual statement or Form 1099-DIV, and funds that miss the 50% rule pass through no exemption.
• New York. The Department of Taxation and Finance's memo TSB-M-95(4)I says the subtraction applies only if the fund meets the 50% "U.S. Obligations" asset requirement under section 612(c)(1) of the Tax Law, and then only for the part of the dividend attributable to interest on obligations that are exempt from New York tax. The fund must send investors a written notice of the qualifying portion. That memo is dated January 29, 1996, so treat it as a description of the rule's structure and check the department's current guidance for details. It also lists interest on repurchase agreements as subject to New York tax, which matters because many Treasury funds hold repurchase agreements.

The after-state-tax yield of a fund when a share s of its dividends qualifies is y x (1 - t x (1 - s)). Take a hypothetical fund yielding 4.10% in California at 9.3%:

The difference between the first and last rows is $381.30 a year on $100,000, purely from how the holding is structured. The rates in the table are hypothetical, and fund yields are net of fees, so a fund and a bill are never yielding the same before-tax number in practice. The point is the mechanism.

Chapter 5 maps the fund types themselves, and chapter 14 covers holding bills directly.

A decision sequence

The federal side is not the only tax layer on cash. Timing of income is separate, and the CD-specific version is in CD interest and phantom income. For the mechanics of reporting Treasury interest on a return, use the Treasury interest tax checklist.

The calculator below models the same comparison with your own yields and rate.

Where this does not apply

The exemption is a rule about state and local tax on interest from U.S. obligations. It does not help in three cases:

• A state with no income tax. Texas has none, according to its Comptroller, so the exemption is worth nothing there.
• A tie on after-tax yield. When the two yields are close, liquidity, insurance limits and convenience should decide, not the last few basis points.
• Corporate holders. The statute excepts nondiscriminatory franchise taxes and taxes imposed instead of a franchise tax on corporations, so an entity that pays that kind of tax may not get the exemption.

Chapter 16 covers the other exempt option, tax-exempt municipal money market funds, which have their own state-by-state wrinkles.