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Muni Bond Funds: Comparing Different Tax Scenarios

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In late 2017, Congress passed the Tax Cuts and Jobs Act (TCJA) — the first major reform in decades of this country's exhaustive tax code.

While attracting headlines for cutting corporate rates and lowering the highest marginal federal tax bracket, the revisions include a less appealing feature for many high net-worth investors. Namely, this relates to the state and local tax (SALT) deductions that you receive and are capped at $10,000 a year.

Among the common types of taxes that many states impose are personal income tax, corporate income tax, sales tax and real property tax. This $10,000 cap can wind up raising tax obligations for many taxpayers, particularly high net-worth individuals in states with relatively high tax rates like California and New York. 

Investors in such states, however, can take advantage of passively managed bond funds that focus on municipal debt offerings. Commonly referred to as "muni bonds," this type of fixed-income is issued by states and local municipalities to help finance public projects like road repairs and water treatment plants. To enhance their allure to investors and to provide a lower cost of capital for the municipalities, interest income paid to investors is exempt from federal taxes and may also be exempt from state taxes, if issued within the state.

As we have stated many times before, the investor's expected return equals the cost of capital of the firm or in this case, the municipality. That cost of capital is a measure of the risk and, in the case of munis, the tax benefits offered to the buyers of those securities. 

In fact, owning Muni bond funds can help to avoid the Net Investment Income Tax (NIIT). Typically, interest income from such funds are exempt from the NIIT. These taxes are levied on individuals with adjusted gross income (AGI) of $200,000 and above ($250,000 for couples filing jointly and $125,000 for spouses filing separately). Still, any capital gains generated from selling muni bond funds are normally counted as part of the NIIT's income tax calculations.  

Given such nuances and differences in each taxpayer's unique financial situation, our investment committee warns that it's difficult to come up with broad conclusions about investing in muni bond funds. Simply put, determining whether a taxpayer will effectively benefit is going to be highly dependent on individual circumstances like income, mortgage interest, state and local taxes — as well as a careful comparison of the risks of the munis versus the risks of the taxable bonds.

To illustrate how a tax-related analysis of muni bond funds might impact various types of investors, we've developed a set of hypothetical scenarios for clients of different ages, state and local taxes paid and income levels. The tables below provide data for these scenarios on an individual filing basis as well as investors who are married and filing jointly. 

In each case, we compare the estimated total annual tax savings from using muni bonds versus using taxable bonds in taxable accounts. Note these hypothetical illustrations explore tax-adjusted outcomes for those living in California, a state with high-income taxes. Your analysis will vary if you are in a different state. The scenarios take into account California state and federal taxes. Annual income figures are referring to total taxable income. (We've also assumed that the total 2021 estimated pre-tax returns for the taxable bond and muni bond portfolios are the same.) 

Besides considering these different characteristics, we've also assumed different risk level index portfolios for each person based on age. For example, we've assumed our hypothetical 45-year-old client's Risk Capacity Survey indicates an IFA Index Portfolio 70 (70% stocks, 30% bonds). Of course, in actual implementation each investor's financial situation, tax situation and risk capacity are unique.

Here are the results of our estimates:

Married Filer - 45 yrs of age
  2021 Income Taxes 2021 Muni Bond Income Taxes  Difference
Index Portfolio IFA Index Portfolio 70 IFA CA Muni Index Portfolio 70 N/A
Annual Income $100,000 $98,200 $1,800
Portfolio Value  $300,000 $300,000 N/A
Mortgage Interest $14,000 $14,000 N/A
State & Local Income Tax $3,554 $3,410 $144
Federal Tax $8,739 $8,523 $216
Estimated Total Annual Tax Savings: $360
Married Filer - 55 yrs of age
  2021 Income Taxes 2021 Muni Bond Income Taxes  Difference
Index Portfolio IFA Index Portfolio 60 IFA CA Muni Index Portfolio 60 N/A
Annual Income $250,000 $245,200 $4,800
Portfolio Value  $600,000 $600,000 N/A
Mortgage Interest $25,000 $25,000 N/A
State & Local Income Tax $17,329 $16,883 $446
Federal Tax $40,179 $39,027 $1,152
Estimated Total Annual Tax Savings: $1,598
Married Filer - 65 yrs of age
  2021 Income Taxes 2021 Muni Bond Income Taxes  Difference
Index Portfolio IFA Index Portfolio 55 IFA CA Muni Index Portfolio 55 N/A
Annual Income $600,000 $582,000 $18,000
Portfolio Value  $2,000,000 $2,000,000 N/A
Mortgage Interest $40,000 $40,000 N/A
State & Local Income Tax $50,421 $48,567 $1,854
Federal Tax $157,179 $150,195 $6,984
Estimated Total Annual Tax Savings: $8,838

Here is data for three scenarios we've created for a set of hypothetical investors who file as single taxpayers:

Single Filer - 45 yrs of age
  2021 Income Taxes 2021 Muni Bond Income Taxes  Difference
Index Portfolio IFA Index Portfolio 70 IFA CA Muni Index Portfolio 70 N/A
Annual Income $100,000 $98,200 $1,800
Portfolio Value  $300,000 $300,000 N/A
Mortgage Interest $14,000 $14,000 N/A
State & Local Income Tax $6,340 $6,172 $168
Federal Tax $13,465 $13,106 $359
Estimated Total Annual Tax Savings: $527
Single Filer - 55 yrs of age
  2021 Income Taxes 2021 Muni Bond Income Taxes  Difference
Index Portfolio IFA Index Portfolio 60 IFA CA Muni Index Portfolio 60 N/A
Annual Income $250,000 $245,200 $4,800
Portfolio Value  $600,000 $600,000 N/A
Mortgage Interest $25,000 $25,000 N/A
State & Local Income Tax $20,290 $19,843 $447
Federal Tax $52,840 $50,978 $1,862
Estimated Total Annual Tax Savings: $2,309
Single Filer - 65 yrs of age
  2021 Income Taxes 2021 Muni Bond Income Taxes  Difference
Index Portfolio IFA Index Portfolio 55 IFA CA Muni Index Portfolio 55 N/A
Annual Income $600,000 $582,000 $18,000
Portfolio Value  $2,000,000 $2,000,000 N/A
Mortgage Interest $40,000 $40,000 N/A
State & Local Income Tax $59,428 $57,214 $2,214
Federal Tax $184,390 $177,046 $7,344
Estimated Total Annual Tax Savings: $9,558

How much tax-free muni bond funds versus taxable bond funds can alter your after-tax returns is highly dependant on each investor's particular tax situation.

In fact, our research gives us a high level of confidence that individual tax situations are the primary drivers for any long-term return differences between IFA muni and non-muni portfolios with similar risk characteristics. 

We strongly recommend you consult with an IFA wealth advisor and an experienced tax professional. Investors can also go to the "About Us" icon on IFA.com to review our wealth advisors' profiles and contact one of them about scheduling a meeting. The same can be done through the IFA App, which is available for Apple iOS and Android devices via the IFA App. This free App is available to download from both the Apple App Store and the Google Play Store for Android.

To help our clients understand the tax benefits of using muni bond funds in their IFA portfolios and address other important tax issues, our wealth advisors can also refer you to IFA Taxes, a division of Index Fund Advisors. 

IFA Taxes provides tax planning, accounting and tax return preparations for a fee. The Director of Taxes is John Dahlin, a certified public accountant (CPA). He doesn't charge on an hourly basis, preferring to set fees in advance based on the complexity of each individual situation. Introductory meetings are offered on a complimentary basis. To set up a conversation between you and your IFA wealth advisor about any tax benefits you might be able to receive from utilizing muni bonds in your portfolio, please feel free to contact Dahlin at: (888) 303-0765 or via email at: [email protected].


This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.This is intended to be informational in nature and should not be construed as tax advice. IFA Taxes is a division of Index Fund Advisors, Inc.

Certified Public Accountant (CPA) is a license to provide accounting services to the public awarded by states upon passing their respective course work requirements and the Uniform Certified Public Accounting Examination.