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Bonding with Taxes: General Tax Considerations for Muni Investors

Updated: Aug 29, 2023

Widely known in the investment world for their tax-exempt status, municipal bonds (Munis) offer an avenue to generate tax-efficient income and preserve capital. With the unique peculiarities and ever-changing nature of tax laws, it is worth a closer examination into the tax advantages and considerations generally applicable to municipal bond investors.



Tax-Exempt Income

The primary advantage of investing in municipal bonds is the tax-exempt status of the interest income. This benefit is based on state and local government’s desire to encourage investment in local communities. As a result, this tax-exempt status makes municipal bonds particularly attractive to investors in higher income tax brackets. Illustrated in the chart below, the tax-equivalent yield on municipal bonds offers a compelling yield advantage compared to other fixed income assets after adjusting for taxes.


Data from 4/28/2022. Tax Equivalent Yield (TEY) based on marginal federal tax rate of 37.0% & 3.8% ACA.


Interest income (coupon payments) earned from municipal bonds is generally exempt from federal income taxes. In addition, if you invest in Munis issued by your state of residence, the interest income may also be exempt from state income taxes. In simple terms: higher tax rates increase the benefits of owning tax-exempt Munis.


Taxable Munis

Not all municipal bonds are issued with the tax-exempt status, meaning that interest income will be subject to income taxes. After the Tax Reform Act of 1986, certain types of municipal issuers (depending on the purpose) were prohibited from issuing tax-exempt bonds. Over time, taxable Muni issuance grew, and they now make up approximately 15% of the total municipal bond market. Most recently, in 2017 following the Tax Cuts and Jobs Act, tax-exempt bonds were no longer allowed to be used to advance refund tax-exempt securities. While taxable Munis have grown in significance, the total size outstanding is a small fraction compared to the corporate bond market creating a unique liquidity premium that, at times, can offer additional yield and total return benefits.


Alternative Minimum Tax (AMT)

Investors who are subject to AMT may still have to pay taxes on their municipal bond income, even if it is exempt from regular federal income taxes. To avoid this, investors should consult with their tax professional and consider investing in Munis that are exempt from both regular federal income tax and AMT.


Capital Gains Taxes

If you sell your municipal bonds for a profit, you may be subject to capital gains taxes. These are short- or long-term, depending on the holding period of the security.


Bond Premiums and Discounts

If you purchase a municipal bond at a premium or a discount, the tax treatment of the income may differ. Buying a municipal bond above face value or at a premium allows the investor to amortize the premium over the life of the bond and deduct the amortization from interest income. All else equal, it is generally more tax-advantageous to buy a Muni at a premium or at par to avoid any tax surprises.


If you buy a bond at a discount, the price difference between the purchase price and the par value may be taxable as capital gains or ordinary income. The tax treatment depends on whether the bond is sold prior to maturity, called, or held to maturity and the steepness of the discount at purchase (the De Minimis Rule).


De Minimis Tax

The De Minimis Rule is applicable to municipal bonds purchased at a discount. The rule stipulates a price threshold under which the discount amortization is taxed as ordinary income instead of capital gains. This threshold is calculated as 0.25% price discount for each full year from the purchase date to maturity.


For example, the threshold for a bond maturing in 8 years is (100 – (0.25*8)) = 98.00. A purchase price below 98.00 would be affected by the De Minimis Tax.


As many investors’ income tax rates are higher than the capital gains rate, this unique rule is worth considering. Additionally, the De Minimis Rule can negatively affect a Muni’s liquidity by reducing the buyer demand for bonds trading below the threshold. At times, the illiquidity cliff associated with the de minimis threshold offers an attractive entry point even after considering the tax consequences.


Tax Equivalent Yield

When an investor is analyzing the yields offered by various fixed income securities, they must be careful to avoid comparing apples to oranges, that is, taxable yields to tax-exempt yields. The Tax Equivalent Yield is a useful tool for this purpose. It utilizes the investor’s marginal income tax rate to calculate the yield that a taxable security would need to equal the yield from a tax-exempt Muni.


Tax Equivalent Yield = Tax-Exempt Yield / (1 – Tax Rate)


The following table demonstrates the effect of a Colorado resident’s marginal tax rate on the Tax Equivalent Yield calculation for a Colorado Muni yielding 2.00%, 3.00% and 4.00%:


Investors can evaluate municipal bond opportunities more effectively by utilizing Tax Equivalent Yields to compare yields against US Treasuries or corporate bonds of similar maturities & credit ratings.


Legislative Risk

It’s important for Muni investors to understand the fundamental risk/reward nature of investing and note that while the tax advantages offered by Munis can be attractive, they also imply risks to federal & state legislative changes affecting tax codes. For example, the relative value of tax-exempt Munis may be adversely affected in a scenario where federal income tax rates were reduced. It's important to consult with a financial and/or tax professional before investing in municipal bonds to understand the potential risks and rewards of each investment.


Conclusion

The tax advantages of municipal bonds create a compelling case for their inclusion in taxable portfolios, particularly for investors in higher tax brackets. However, investors should be aware that not all municipals are fully tax-exempt and there are certain scenarios that may create unforeseen tax liabilities. This complexity can be a deterrent for some investors, but understanding the unique tax considerations can also be a helpful tool while seeking out attractive opportunities in the municipal market.


 

Sources:

Securities Industry and Financial Markets Association (SIFMA)

Not Always Tax-Free: 7 Municipal Bond Tax Traps, 2023; Charles Schwab

Overview of the Taxable Municipal Market, 2020; Fidelity Capital Markets

 

Disclosures:

This content has been prepared for informational purposes only and should not be considered as investment, tax, or legal advice. We recommend all investors to consult with a financial and/or tax advisor regarding their individual circumstances before taking investment decisions.


Investing in bonds exposes the investor to the risk of loss of principal. Lower and non-rated securities are more volatile and less liquid than investment grade bonds.


Please visit our website for a complete list of disclosures and risks: www.maustininvestments.com.

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