Enhancing after-tax returns with municipal bonds

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Municipal bonds have long been considered well-suited for high-net-worth investors because their income returns are generally free from federal income taxes and, in some cases, state and local income taxes. In choosing whether and how to invest in municipal issues, you will want to consider your tax situation, the after-tax returns of municipal bonds compared with taxable issues, and the tax efficiency of managed municipal bond investments.

Consider your tax situation

The maximum tax on long-term capital gains remains at 15% for most Americans, but rises to 20% for those with taxable incomes of over $492,300 ($553,850 for joint filers) In addition, a surtax on net investment income, which includes capital gains, results in an overall top long-term capital gains tax rate of 23.8% for high-income taxpayers.
Your tax professional can assist you in comparing the after-tax yield on tax-exempt municipals with that of taxable issues. The accompanying table shows the taxable-equivalent yield for different yields and federal income tax brackets. These figures provide a general reference, but may not be applicable to your situation. While income from corporate bonds is generally fully taxable, income from U.S. government bonds is exempt from state income taxes. If you are in a high-tax state or locality that also exempts interest income from locally issued municipal bonds (known as double or triple tax-exempt bonds), the calculation of taxable-equivalent yield for those issues must be adjusted to reflect the state and local income tax savings.
Other tax considerations you should be aware of before investing in municipal bonds include:
  • Capital gains on municipal bond investments are taxable as short- or long-term capital gains, depending on how long you have held the investment
  • Income from certain private-activity bonds must be reported as taxable income if you are subject to the alternative minimum tax. These bonds are used to finance projects such as sports stadiums or airport terminals that provide some benefits to private companies, and are identified as private-activity bonds in their prospectuses.
  • It may not be federal tax-efficient to hold municipal bonds in tax-deferred accounts, because the investment returns in these accounts are taxed as ordinary income upon withdrawal

The tax efficiency of managed municipal bond investments

Individuals may invest directly in individual bonds, in municipal bond mutual funds, or through a privately managed account. Managed investments offer the advantages of professional management and, in the case of mutual funds, greater diversification. However, actively managed mutual funds may generate taxable short- and long-term capital gains, offsetting some of the potential tax advantages of municipal bond investing.
Some funds may have accrued capital losses in previous years that can be carried forward and applied against future capital gains. A privately managed account combines the benefits of professional management and direct ownership of the underlying securities. One advantage of investing in municipal bonds through a privately managed account is the potential tax savings that can result from coordinating the recognition of losses in the bond portfolio to offset taxable gains on other investments that you may have.
If you have large, unrealized gains in stock positions, for example, short-term losses on your municipal bond investments may offer opportunities to realize some of the gains on your stock holdings. Using a technique known as "tax loss harvesting," a private account manager may sell some bonds when prices are depressed, resulting in realized capital losses. The proceeds of the sale are then reinvested in different bond issues, and the losses may be used to offset realized gains on an equal amount of appreciated stock. However, the proceeds cannot be used to purchase substantially similar securities, or the wash sale rules may operate to disallow the loss. Because longer-term bonds tend to be more volatile than shorter-term issues, an investor using this strategy may prefer a portfolio that includes long-term bond issues.

Taxable vs. tax-free yield

Tax bracket
10% 12% 22% 24% 32% 35% 37%
Tax-Exempt yield Taxable-Equivalent yields
2% 2.2% 2.3% 2.6% 2.6% 2.9% 3.1% 3.2%
3% 3.3% 3.4% 3.8% 3.9% 4.4% 4.6% 4.8%
4% 4.4% 4.5% 5.1% 5.3% 5.9% 6.2% 6.3%
5% 5.6% 5.7% 6.4% 6.6% 7.4% 7.7% 7.9%
6% 6.7% 6.8% 7.7% 7.9% 8.8% 9.2% 9.5%

Portfolio management strategies

Municipal bond prices are sensitive to changes in interest rates and to demand and supply factors. The low-interest-rate climate of the past few years made borrowing especially attractive, both for new projects and for refinancing older debt.
Bond investors are generally hurt by higher interest rates, as bond prices fall when interest rates rise, and benefit when interest rates fall. However, most long-term municipal bonds are callable by the issuer prior to their maturity date at face value. An issuer is likely to call bonds that carry interest rates above the current market rate. The bond's call provisions will specify the earliest date that the bond may be called, which may be as soon as 10 years after the issue date. If you purchase individual bonds for more than their face value, it's important to consider whether the bond offers an attractive yield to the call date, rather than maturity.
Like other types of bonds, municipal bonds carry credit risks. For example, a slowing economy generally creates wider price spreads between high- and medium-quality municipal bonds, offering professional managers opportunities to potentially add incremental returns through careful security selection. High-yield and variable-rate municipal issues offer higher yields than general obligation or revenue bonds but also pose greater risk of default. Combining investments from several states and investing in insured bonds are two strategies that can help reduce the credit risk of a municipal bond portfolio.

Next steps

Important Note on Bond Funds: Return of principal is not guaranteed. Bond funds have the same interest rate, inflation, and credit risks that are associated with the underlying bonds owned by the fund. Generally, the value of bond funds rises when prevailing interest rates fall and falls when interest rates rise. There are ongoing fees and expenses associated with owning shares of bond funds.

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The material was authored by a third party, DST Retirement Solutions, LLC, an SS&C company ("SS&C"), not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circumstances and, if necessary, seek professional advice.

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