Municipal Bonds and Marginal Income Tax Rates

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Municipal Bond Investments and Marginal Income Tax Rates

Some investors hold municipal bonds in an attempt to reduce their tax burden. This article discusses the relationships between tax-exempt municipal bonds, marginal tax rates, and investment asset tax location.

An investor’s marginal tax rate is important, when making tax-related investment portfolio decisions. By combining your federal, state, and local marginal income tax rates, you can value the “tax shield” that you obtain from an incremental dollar of non-taxable bond investment income versus and incremental dollar of taxable bond income. The higher the combined marginal income tax rate, the higher the potential benefit from investments that yield non-taxable income.

Using state and federal marginal income tax rates, here are two examples with married couples filing joint tax returns who are California residents:

For an extra dollar of taxable income, Couple A would pay 34.55 cents in state and federal income taxes, while Couple B would pay 43.55 cents.

Both could avoid these taxes on an extra dollar of income, if they held a tax-exempt bond investment that was not taxed at both the federal and state income tax levels. California municipal bonds could shield them from these taxes and provide such savings. However, the question is whether the tax savings would be sufficient for one or both of these couples to warrant choosing tax exempt municipal bonds versus an alternative investment in taxable government or corporate fixed income bonds.

Because of investor bidding in real-time credit markets, the markets set differential investment yields on taxable versus tax-exempt assets.

The spread between these yields is influenced by bond investor supply and demand on an after-tax basis. Investors in higher marginal tax brackets have a greater incentive to own tax-exempt bonds. Those who benefit the most from tax avoidance tend to gravitate toward tax-exempt bonds and the opposite is true for those who do not.

To compare after-tax yields on taxable and tax-exempt investments, multiply the percentage yield on the taxable bond by one minus the marginal tax rate expressed as a decimal. Then, compare this result with the market yield on the tax-exempt bond. (Obviously, this comparison presumes that otherwise these taxable and tax-exempt bonds have similar maturities, likelihoods of default, and other provisions and characteristics.)

Clearly, the investor with the highest combined marginal tax rate has a stronger preference for holding tax-exempt municipal bonds. Investors in the highest total federal and state marginal income tax rate brackets get the most benefit, because the after-tax value to them could exceed significantly the actual market yield spread between taxable and tax-exempt bonds.

The lower one’s marginal income tax rates, then the lower ones potential tax shield benefit. At some point, municipal bond yields become disadvantageous for those who have lower marginal income tax rates, when compared to owning taxable fixed income investments. Whether or not to invest in a municipal bond versus taxable bond, of course, depends upon a variety of factors. These include one’s marginal tax rate, the spread at the time, the tax status of the account holding the asset, the concern for potential default, the duration, etc.

This analysis also demonstrates why municipal bonds should never be held in a tax-advantaged retirement account.

With a tax-advantaged retirement account, the current marginal tax rate on both taxable and tax-exempt bonds would be zero. Tax driven bond market supply and demand forces taxable yields upward or tax-exempt yields downward – whichever might be your perspective. Therefore, only taxable bonds should be held in tax-advantaged retirement accounts because of taxable bond yields would tend to be higher than tax-exempt yields on otherwise equivalent bonds.

There is a “sweet spot” for certain investors to hold municipal bonds

Given the factors discussed here regarding marginal income tax rates, bond market taxable versus tax-exempt yield spreads, and the optimal “tax location” decision, there is a “sweet spot” for certain investors to hold municipal bonds. Those who are more likely to benefit from municipal bonds have the following characteristics.

These investors tend to have an asset allocation that more heavily skewed toward bonds, and they tend to have far more assets in taxable rather than tax-advantaged accounts. Furthermore, they have relatively high current earned income. Investors with this profile, “fill up” their tax-advantaged accounts with taxable bonds. Next, their heavy allocation to fixed income assets then “spills over” into their taxable accounts. In this circumstance, their very high marginal income tax rates might make owning tax-exempt municipal bonds a more advantageous proposition. Nevertheless, an analysis should always be performed using current bond market yields and total marginal tax rates to confirm that tax-exempt municipal bond investments would be more advantageous, when these more tax-conscious investors file taxes in the spring related to the previous tax year.

Note that “tax location” is the tax optimization of one’s personal investment portfolio between taxable and tax-advantaged accounts, which include traditional and Roth tax-advantaged IRAs and defined contribution employer-sponsored retirement plans, such as 401k, 403b, 457, Simple, Keogh, and other retirement accounts. When you do tax location optimization, you do not simply apply the overall asset allocation percentages of your total investment portfolio to your taxable and tax-advantaged accounts.

Instead your taxable and tax-advantaged accounts hold different types of assets, which will achieve your overall asset allocation strategy targets when combined. With asset tax location optimization, you consciously invest certain assets in taxable versus tax-advantaged accounts to benefit from the differential tax characteristics of the major types of financial asset holdings, including cash, bond, and stocks. To better understand the tax issues related to asset allocation, investment asset tax location, and emergency cash management, go to: Asset Allocation Strategies.

Incidentally, you should pay attention to the asset tax location characteristics of your overall investment portfolio first, before you attempt to decide whether or not municipal bonds make sense in your particular situation. For example, if you have “room” in your tax-advantaged accounts for your total allocation to bonds, then this would obviate the need to even consider holding municipal bonds for your taxable accounts. You would invest in generally higher yielding bonds to be held in your tax-advantaged accounts instead. You can do some of this analysis on paper, but to develop a lifetime financial plan, you should use an automated retirement planning software tool that provides IRA retirement calculator, 401k retirement calculator, and other retirement tax calculator functions.

You need financial planning software with sophisticated income tax projection features to make a durable plan for your financial success

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