The 50% Threshold That May Quietly Eliminate an AGG State Tax Break in California, New York, and Connecticut

California, New York, and Connecticut each use a strict cutoff to decide whether AGG holders owe state income tax on Treasury interest, and AGG’s current mix suggests many investors may be on the wrong side of that line.

Most retirees know Treasury interest is usually exempt from state income tax. If you own Treasury notes directly, that is generally true. But if you hold Treasuries through the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG) and live in California, New York, or Connecticut, that benefit can disappear. Those three states each apply a 50% asset test to fund dividends, and the latest available data suggests AGG is below that mark.

A Small Fee Masks a Larger Tax Cost

AGG markets itself on low cost. Its prospectus lists gross and net expense ratios of 0.03%, which is barely noticeable. For some investors, though, the real cost shows up on a state tax return, and no factsheet highlights it.

AGG pays monthly distributions. The most recent was $0.334142 per share, and the ex-dividend date was October 1. The 10-year Treasury yielded 4.99% on October 27, underscoring how much of that income comes from government bonds. There is little room for unnecessary tax drag, either. Over the five years through late October, AGG’s dividend-adjusted price declined 1.34%.

Three States Use the Same 50% Test

Each state allows a fund to pass U.S. government interest through tax-free only if it meets a quarterly asset requirement:

• California: Under Cal. Rev. & Tax. Code § 17145(a), a fund may pay exempt-interest dividends only if at least 50% of the value of its total assets consists of obligations whose interest would be exempt from state tax for an individual. The test is applied at the close of each quarter of the fund’s taxable year.
• New York: N.Y. Tax Law § 612(c)(1) permits shareholders to subtract fund dividends designated as interest from U.S. obligations only if at least 50% of the fund’s total assets are U.S. obligations at the close of each quarter. The fund must also provide written notice of that amount to shareholders within sixty days after its taxable year ends.
• Connecticut: Conn. Gen. Stat. § 12-718 allows a fund to pay exempt dividends only if at least 50% of its total assets, measured at each quarter-end, are obligations that federal law prohibits Connecticut from taxing.

These are hard thresholds. If a fund falls short, its government interest loses pass-through treatment, and residents of these states pay state tax on that income as ordinary dividends.

Where AGG Stands

On the latest reading, iShares showed Treasuries at 46.76% of AGG’s market value. Mortgage-backed pass-throughs made up another 22.83%. For state tax purposes, agency mortgage bonds generally do not count as U.S. obligations, so they do not help AGG reach the 50% requirement. That leaves the Treasury allocation as the key figure to watch.

There is an important limitation, however. This is a single-day sector snapshot, while the law looks at holdings at each quarter-end, and AGG’s composition changes as its index rebalances. Based on that reading, AGG appeared to be below the threshold. Whether it passed or failed in each quarter will be reflected in the fund’s year-end tax reporting.

Who Pays and Who Does Not

The impact falls on California, New York, and Connecticut residents holding AGG in taxable brokerage accounts. Holding AGG in an IRA or 401(k) avoids the issue, because distributions in those accounts are not taxed by the state when paid. Many other states allow the Treasury portion to pass through regardless of the 50% rule. The same fund can therefore produce a different after-tax yield depending on where an investor lives.

Treasury-Only Funds Can Close the Gap

Investors seeking the state break on government interest can look at funds invested entirely in Treasuries. In its portfolio filing as of late July, the iShares U.S. Treasury Bond ETF (CBOE:GOVT) listed debt holdings issued by the United States, along with only small short-term cash positions. The Vanguard Intermediate-Term Treasury ETF (NASDAQ:VGIT) offers a similar government-only exposure. But switching comes with trade-offs: you give up AGG’s corporate bonds and mortgage securities, along with the extra yield and diversification they can provide, and Treasury funds still move with interest rates.

What to Review Before Filing

Before tax filing, check AGG’s year-end tax information. Look for the share of income from U.S. government obligations and whether the fund satisfied the quarterly 50% test. If you live in one of these three states and own AGG, the key question is whether state tax on the Treasury interest still leaves a 0.03% fee the cheapest way to hold a core bond allocation.