Municipal bonds have long been considered suitable for high net worth investors because their yields are generally excluded from federal income tax and, in some cases, state and local income tax. When choosing whether and how to invest in municipal bonds, you will need to consider your tax status, the after-tax returns of municipal bonds versus taxable issues, and the tax efficiency of investing in municipal bonds.
Consider your tax situation.
The maximum long-term capital gains tax remains at 15% for most Americans but increases to 20% for those with taxable income above $441,450 ($ 496,600 for joint filers). Also, a surtax on net investment income, which includes capital gains, results in a long-term capital gains tax percentage of 23.8% for high-income taxpayers.
Your financial advisor can help you compare the tax-free return for tax-exempt municipalities with that of taxable issues. Although income from corporate bonds is generally taxable, income from U.S. government bonds is exempt from government tax. If you are in a heavily taxed state or locality that also exempts interest income from locally issued municipal bonds (known as non-taxable double or triple exempt bonds), the calculation of the taxable equivalent yield for those issues will reflect the tax savings of state and local income.
Other tax considerations to consider before investing in municipal bonds include:
Capital gains on municipal bond investments are taxed as short or long-term capital gains, depending on the investment duration.
Income from private activity bonds must be declared taxable income if they are subject to the alternative minimum tax (AMT). These bonds are used to fund projects such as airport terminals or sports stadiums, which provide certain benefits to private companies and are identified as private asset bonds in their prospectuses.
Municipal bonds are generally not held in deferred retirement accounts, as the return on investment from these accounts is taxed as ordinary income upon retirement.
The tax efficiency of municipal bond investments
Individuals can invest directly in individual bonds, municipal bond mutual funds, or through a private account. Managed investments offer the benefits of professional management and greater diversification in the case of mutual funds. However, actively managed mutual funds can generate short and long-term taxable capital gains, outweighing some of the potential tax advantages of municipal bond investments.
Some funds may have accumulated capital losses in previous years, which can be carried forward and applied against future capital gains. A privately managed account combines the advantages of professional management with direct ownership of the underlying securities. An advantage of investing in municipal bonds through a privately managed account is the possible tax savings that may result from coordinating the recognition of losses in the securities portfolio to offset taxable gains on other investments you may have.
Suppose you have large unrealized gains in equity positions, for example. In that case, short-term losses on your municipal bond investments may offer you opportunities to realize some of the gains on your stocks. A private account manager may sell certain securities when prices are low, resulting in capital losses. The sale proceeds are then reinvested in various bond issues, and the losses can be used to offset gains on an equal number of listed stocks. Since long-term bonds tend to be more volatile than short-term bonds, an investor applying this strategy may fancy a portfolio that includes long-term bond issues.
Portfolio management approach
The prices of municipal bonds are sensitive to changes in interest rates and to supply and demand factors. Recent years' low-interest rate climate has made loans particularly attractive, both for new projects and for refinancing old debt.
Bond investors often suffer from higher interest rates because bond prices fall when interest rates rise, and they profit when interest rates fall. However, most long-term municipal bonds can be redeemed by the issuer before maturity at face value. An issuer is likely to buy back bonds at interest rates above the current market rate. The provisions relating to the bond return will specify the earliest date on which the bond can be claimed, which can be up to 10 years from the issue. If you are buying individual bonds worth more than their face value, it is important to determine whether the bond offers an attractive yield on the date of purchase rather than on its maturity.
Like other types of bonds, municipal bonds pose a credit risk. For example, a downturn in the economy typically creates larger price differentials between medium and high-quality municipal bonds, giving professional managers the ability to add potential returns through careful selection of bonds. High yield, variable-rate municipal bonds offer higher yields than bonds or general income bonds, but they also carry a higher risk of default. Combining multi-state investments and guaranteed bond investments are two strategies that can help reduce the credit risk of a municipal bond portfolio.
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