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Tax Reform Shines Light on Muni Bond Funds

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The 2017 Tax Cuts and Jobs Act (TCJA) is the first major set of reforms to this country's tax codes in decades. While it's getting lots of headlines for cutting corporate rates and lowering the highest marginal federal tax bracket, the new law also features a less appealing feature for many high net-worth investors.

Starting with individual 2018 tax returns, the state and local taxes (SALT) you pay will be capped at $10,000 a year as a tax deduction against your income in calculating federal taxes. 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 is low for high net-worth individuals in states with high tax rates like California and New York. 

Muni bonds are issued to help finance public projects like road repairs and water treatment plants. To help enhance their allure to investors and to provide lower cost of capital for the municipalites, 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 offerred to the buyers of those securities. 

Investors in states with higher state tax rates, like California and New York, can take advantage of passively managed muni bond funds that focus on state issued municipal bonds. There are also other benefits in lowering income for investors, such as the possibility of avoiding the 3.8% Medicare surtax which is levied on the lesser of net investment income or the excess of modified adjusted gross income (MAGI) above $200,000 for individuals, $250,000 for couples filing jointly, and $125,000 for spouses filing separately.

It is 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, and a careful comparison of the risks of the munis versus the risks of the taxable bonds, like the term (duration) and default risks.

Presented below are charts comparing implementations of IFA Index Portfolios utilizing taxable bond funds of different maturities and muni bond funds. This comparison only applies to clients who hold bonds in their taxable accounts. If you have tax deferred and taxable accounts, it is best to hold the taxable bond funds in the tax deferred account and tax-managed equity funds in your taxable account. This is what we call the asset location strategy.

The scatter plots compare the historical return to standard deviation, which is a measure of risk that encompasses both the term and default risks of bonds. We looked at a 30-plus year period (January 1988-March 2018), based on available information for muni bond funds and muni bond indexes that IFA portfolio managers have determined would be appropriate to use in an implementation of IFA index portfolios. 

Although many scenarios exist across different muni funds offered for specific states, we've focused on two states with the highest individual state tax rates, New York and California. Also, we show results for national muni funds that provide investors with primarily federal tax savings and a much smaller allocation to individual states.

Let's start with California. To match the risk levels of the Intermediate CA muni bond portfolios, we created a taxable intermediate bond portfolio of similar average durations of 4.32 years. We are not offering this as an implementation to clients, but needed to create it for a fair comparison of the two portfolios. The red dots represent IFA California muni fund index portfolios with intermediate-term durations. The blue dots represent the taxable intermediate bond portfolios after federal and CA state tax, based on the highest marginal tax rates. Of course, not all investors will be taxed at this highest marginal tax rate, which bring the red and blue dots closer together. In fact, the effective tax rate is actually less than the marginal, but our access to after tax data is limited to only marginal tax rates. There are grayed out options in the legend that allow you to look at standard taxable bond IFA Index Portfolios with average maturites of 2.5 yrs, before and after tax and the taxable intermediate bond portfolios before taxes. Click around to get a good understanding of the differences.

As you can see, from index portfolios 30 to 90, the muni bond index portfolio implementations (red dots) had very slightly higher levels of risk and very slightly higher returns compared to the after-tax returns of a similar risk bond portfolio. Results may vary in different periods and the past performance does not guarantee the future performance. Because of the many complexities in applying the new tax law, we were not able to include the impact of the SALT cap on the after tax returns.

Since IFA Index Portfolios come with lower average maturities of 2.5 yrs, this is another clear indication of the importance of measuring risk along with returns. Based on all of the assumptions, the after-tax returns of the intermediate bond index portfolio are similar to the California muni index portfolio, indicating that the primary differences between the muni and standard IFA index portfolios are the differences in risk. But, as you will see below, there may be other advantages of the CA muni portfolio based on your individual situation. 

The same basic pattern existed for investors living in New York. Note that after-tax returns of the intermediate bond portfolio are similar to the New York muni index portfolio, indicating that the primary differences between the muni and standard IFA index portfolios are the differences in risk. 

The chart below looks at the impact of holding national muni bond index portfolios without any consideration of state taxes. Note that the after-tax returns of the intermediate bond index portfolio are very similar to the national muni portfolio. 

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 at different ages, state and local taxes paid and income levels. The tables below provide data for these people on an individual filing basis as well as clients 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 CA state and federal taxes. Annual income figures are referring to total taxable income. We have also assumed that the total 2018 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
  2018 Income Taxes 2018 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
  2018 Income Taxes 2018 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
  2018 Income Taxes 2018 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
  2018 Income Taxes 2018 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
  2018 Income Taxes 2018 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
  2018 Income Taxes 2018 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. To help our clients understand the tax benefits of using muni bond funds in their IFA portfolios and address other important tax issues, we refer you to IFA Taxes, LLC., an affiliate with common ownership of Index Fund Advisors. IFA Taxes provides tax planning, accounting and tax return preparations for a fee. The director of taxes is John Dahlin, CPA, and he has said that he will be happy to have a complimentary conversation with you and your IFA wealth advisor to discuss your individual situation and any tax benefits you might receive from utilizing muni bonds in your portfolio.