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 increase in the maximum capital gains tax rate in late 2012 made municipal bonds more attractive to top earners. 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 $400,000 ($450,000 for joint filers). In addition, a new Medicare 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. What's more, municipal bonds' pre-tax yields historically have averaged approximately 31% below those available on Baa-rated corporate and 12% below government issues of the same maturities, making them an attractive investment for investors in the 25% tax bracket or above.1

Your financial advisor 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 bonds, known as private-activity bonds, must be reported as taxable income if you are subject to the alternative minimum tax. These bonds, which are used to finance projects such as sports stadiums or airport terminals that provide some benefits to private companies, are identified as private-activity bonds in their prospectuses.
  • Municipal bonds generally are not held in tax-deferred retirement accounts since 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.

As of December 31, 2013, 86% of municipal bond funds that have at least a five-year track record had tax-efficiency ratings of 95% or better, with the average tax-efficiency being 97.2%.2 In selecting a mutual fund investment, investors will want to consider the impact of capital gains taxes on the potentially higher pre-tax return that a fund's investment management policies may provide.3

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. 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% 15% 25% 33% 35% 39.6%

Tax-Exempt Yield Taxable-Equivalent Yields
2% 2.2% 2.4% 2.7% 2.8% 3.0% 3.1% 3.3%
3% 3.3% 3.5% 4.0% 4.2% 4.5% 4.6% 5.0%
4% 4.4% 4.7% 5.3% 5.6% 6.0% 6.2% 6.6%
5% 5.6% 5.9% 6.7% 6.9% 7.5% 7.7% 8.3%
6% 6.7% 7.1% 8.0% 8.3% 9.0% 9.2% 9.9%

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.

Value of $1,000 Municipal Bond Investment, 1983-2013
Enhancing after tax returns

Source: Standard & Poor's. Illustration based on the 12-month trailing yield and total returns of the Barclays Municipal Bond index, for the period from January 1, 1984, to December 31, 2013. Results assume reinvestment of dividends, interest, and other proceeds. Individuals cannot invest directly in any index. Index performance does not reflect the performance of any actual investment and does not take account of the costs associated with investing. Past performance does not guarantee future results. (CS000147)

Points to Remember

  1. Interest income from municipal bonds is usually exempt from federal income taxes and in some cases state and local income taxes. Capital gains are taxed as short- or long-term capital gains. Income from private-activity bonds is reported as taxable income if you are subject to the alternative minimum tax.
  2. The taxable-equivalent yield compares the yield on tax-exempt bonds with yields on taxable corporate or government bonds. The calculation of the taxable-equivalent yield is adjusted if you are comparing a municipal bond with a government bond -- which is free of state income taxes -- or for a locally issued municipal bond that is exempt from state taxes ("double tax exempt") or state and local taxes ("triple tax exempt").
  3. If you are investing in an actively managed municipal bond mutual fund, consider how taxes on short- and long-term capital gain distributions may affect your after-tax return.
  4. Privately managed accounts offer opportunities to coordinate the recognition of losses on a bond portfolio to offset gains elsewhere in your portfolio.
  5. Many municipal bonds are callable by the issuer prior to maturity. If you purchase a bond for more than face value that offers an above-market yield and the bond is called, you may lose some of the premium paid.
  6. Municipal bonds carry credit risks in addition to interest rate risk. The credit exposure of a bond portfolio may be reduced by diversifying among bonds issued by different states and by investing in insured bonds.
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1 Source: The Federal Reserve. Based on 20-year yields, yields of Baa-rated corporate bonds and General Obligation municipal yields over the 50-year period ended December 31, 2012.

2 Source: Standard & Poor's. Based on all funds tracked by Morningstar as of December 31, 2012, classified as domestic tax-exempt bond funds with a history of at least three years.

3 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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