With our annual settlement with the IRS having come and gone, you may be breathing a sigh of relief for the first time in a few weeks. However, if line 61 (total tax) on your 1040 was a bit more than you anticipated this year, now’s probably as good a time as any to be thinking strategically about your investment assets and next year’s tax bill. One of the few ways Americans can generate tax free income and potentially lower overall tax liability at the same time is by investing in tax-free municipal bonds, either individually or by means of a pooled product.
The income tax has made liars out of more Americans than golf.
While all investors can benefit from the diversification and tax benefit of munis, those in higher tax brackets stand to gain the most by utilizing them. For example, if we have two investors that generated $10,000 of taxable corporate bond interest in 2013, with “Investor A” in the 15% bracket and “Investor B” in the 33% bracket, A pays $1500 to the IRS while B pays $3300. If both investors rotate their exposure from corporates over to munis the following year, their respective tax liability on that income vanishes and their overall taxable income drops. Thus it would behoove “Investor B” more than Investor A to shelter as much investment income as possible.
By decreasing income by rotating taxable investments over to municipals, you can decrease your overall adjusted gross income (AGI). Depending on the amount of investment income you shelter, you could potentially move yourself to a lower tax bracket or keep yourself from a higher one, depending on where you currently sit, and where you think you will be next year. Keep in mind, however, that municipal debt, in general, given its tax advantaged nature, possesses lower coupon rates than corporates with similar maturity dates.
To wit, you might be able to find an investment grade corporate note with a 4.5% yield to maturity in 10 years, but may only get 3.5% if you look at a 10-year municipal. Still, if you are in the 33% bracket, your after-tax yield on the 4.5% security is only 3%, so you come out ahead by investing in the municipal. The after-tax benefit for our investor in the 15% tax bracket is less pronounced, so it may still make sense to invest in the taxable security.
Just like investment in corporate debt, one faces default and price fluctuation risk when putting money in municipals. Bankruptcies in Harrisburg, PA and Detroit have brought to the forefront the fiscal crisis that is facing many cities, states, and municipalities around the country. Fortunately, for the time being, these bankruptcies have been few and far between. Also, some municipal debt may carry insurance, although given the plight of many of the insurers since the days of the fiscal crisis, their strength and claims paying ability has come into question.
For investors in cities and states with high tax rates, it may make sense to buy municipal debt positioned where you live. This could provide you with double or triple tax-free income. Since I live in Pennsylvania, if I buy a general obligation municipal bond issued by any city in the Commonwealth, like Philadelphia, Pittsburgh, Allentown, or Scranton, not only do I not pay federal tax on the interest, but I also save an extra 3% (PA tax rate) by investing in those cities.
If I go out of state for my municipal offering, I won’t pay federal tax, but I will pay 3% of the interest to Pennsylvania. So consideration of the total taxes of where you live is an important aspect as to which specific issues you purchase.
Outside of individual bonds, there are a variety of ETFs, CEFs and mutual funds that are dedicated to the municipal bond space. While I think most investors with the asset base to build an individual bond portfolio should do so, pooled products may be an appropriate solution for many. While I’m somewhat inclined to recommend closed-end funds because of the higher yields and discounts at which they can be purchased at, most muni. CEFs come with high leverage and long durations, which could present severe risk in a rising rate environment. So they should be considered and purchased perhaps judiciously and sparingly.
On the ETF side, there are a variety of plain and defined maturity ETFs available from iShares, Guggenheim, and other managers. The problem with those is that after the fee is paid, there isn’t a lot of yield left over for investors, providing little in the way of overall value in my view.
Municipals provide for a unique, tax-free income source. While the benefit is greatest for those in the higher tax brackets, they may be appropriate for just about any kind of bond investor. So if your tax bill was surprisingly high this year, consider municipals as a way to keep more money in your pocket and less in Uncle Sam’s come this time next year.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.