Stock market volatility has some investors thinking about putting some money into bonds, which historically have offered relatively stable prices. One key decision facing bond market investors is whether to choose regular, taxable bonds or tax-exempt municipal bonds. (This discussion concerns investments in taxable accounts because tax-exempt municipals and muni funds typically don’t belong in a tax-favored retirement account.)
Taxable bonds generally offer higher yields than tax-exempt bonds. On the other hand, the after-tax return from munis may be higher after investors pay tax on taxable bond interest. Thus, the appeal of municipal bonds increases as investors’ tax rates move up.
Lower rates, tougher calls
The Tax Cuts and Jobs Act of 2017 (TCJA) reduced tax rates for many taxpayers, which could make municipal bonds less attractive.
Example 1: Assume, hypothetically, that a taxable bond fund yields 4%, and a muni fund with similar characteristics (default risk, interest rate risk) yields 3%. Al Brown, in a top 37% tax bracket, would net 2.52%, after paying 1.48% (37% of 4%) in tax. Carl Davis, in a 12% bracket, would net 3.52%, after paying 0.48% (12% of 4%) in tax.
Therefore, high-bracket taxpayers could get a substantial increase in after-tax yield from a muni fund, whereas those in lower brackets might profit by choosing taxable issues. Those in between, perhaps in the 22% or 24% bracket, might find scant difference in after-tax yield between taxable and tax-exempt bonds.
State of the art
The numbers provided previously use federal income tax rates to find the after-tax yield. Many investors, though, would also pay state and even local income tax on interest from taxable bonds. That leads to a further calculation.
Example 2: Suppose Al Brown from example 1 has $100,000 invested in a taxable bond fund yielding 4%. Therefore, he collects $4,000 a year in taxable interest income. As mentioned, Al is in the 37% tax bracket, so his federal income tax on that interest income would be $1,480. Assume Al also owes 8% in state income tax, or $320 on his $4,000 of interest income, for a total tax bill of $1,800, which would leave him with $2,200 of net interest income after state and local income tax.
In prior years, Al might have been able to deduct the state income tax paid on his bond interest income. Multiplying the $320 of state income tax by the 37% saved by a federal income tax gives him a tax savings around $118, raising his net payout from his taxable bond fund to $2,318.
However, Al may not be able to deduct that $320 of state income tax paid under the TCJA. That could be the case if he takes the standard deduction, rather than itemize deductions such as taxes paid. Even if Al itemizes deductions, the $10,000 cap on state and local tax deductions may keep him from getting any tax benefit from the tax paid on his bond interest, keeping his after-tax income at $2,200, or 2.2% on his $100,000 investment.
The TCJA provides cross-currents for bond investors. Lower stated tax rates make municipal issues less appealing, but the possible absence of a deduction for taxes paid effectively raises the tax rate, which favors munis.
High bracket investors traditionally favor tax-exempt bonds, and that will continue to be the case. In high tax states, the new law may increase the lure of home state munis and funds specializing in such bonds because the payouts usually avoid state and local income tax.
Low bracket investors may find better yields, after tax, from taxable bonds. Those in the middle — investors with roughly $40,000 to $160,000 in taxable income, or $80,000 to $320,000 on a joint return — may find the choice between taxable and municipal issues a close one. Our office can help you work through the numbers when you’re planning an investment in bonds, including the possible impact of the 3.8% surtax on net investment income, which may be owed by high-income taxpayers.