Even during the low-interest-rate environment of recent years, there were some potential new municipal bond investing opportunities, such as possible higher after-tax yields from private activity bonds (PABs) (see “Recent Developments for Municipal Bond Investors,” JofA, Sept. 1, 2020). Subsequently, municipal bonds have resurged as an asset class, but there is concern about the pending but politically uncertain expiration after Dec. 31, 2025, of many provisions of the law known as the Tax Cuts and Jobs Act (TCJA), P. L. 115-97. Because of these events, now may be an appropriate time for advisers and clients to once again consider and evaluate strategies to optimally employ these tax-advantaged bonds within investment portfolios.

Municipal bonds are used to raise money for local and state projects such as building roads, schools, water systems, and libraries, as well as to fund day-to-day governmental expenses. Generally, interest paid on the bonds is exempt from federal income tax and, in many cases, state and local taxes if the investor resides in the state where the bond is issued. Often, states tax interest derived from out-of-state bonds. In addition, on disposition of the bonds, gain or loss is taxable.

This article focuses on the tax implications applicable to municipal bond investments of expiring provisions of the TCJA. It also briefly addresses other tax and nontax issues of potential concern to municipal bond investors.

BRACKET CHANGES

The value of a tax-advantaged investment such as municipal bonds depends partly on the investor’s tax bracket. In 2026, when many TCJA provisions sunset, the top individual marginal income tax rate is scheduled to increase from its current rate of 37% to the pre-TCJA rate of 39.6%. But the larger impact for many taxpayers may be the reversion in tax brackets. For example, in 2018, following the enactment of the TCJA, a married couple filing jointly who had taxable income of $300,000 in both 2017 and 2018 would have seen their marginal tax rate drop from 33% to 24%. The expiration of TCJA provisions, though, would reverse that benefit, resulting in a marginal tax rate increase of 9 percentage points.

The change in marginal rates may, however, vary widely depending upon a taxpayer’s individual situation. For example, if the couple had taxable income of $450,000 in both years, the marginal tax rate would not have changed in 2018 from the 2017 rate of 35% (ignoring, in both cases, the 3.8% tax on net investment income). These examples illustrate that, for municipal bond investments, the impact of the scheduled reversion in brackets will depend upon a taxpayer’s level of income.

DEDUCTING STATE AND LOCAL TAXES ON BOND INTEREST

The TCJA sunset would affect the taxation of municipal bond investments in other ways as well. For one thing, the current cap on state and local taxes (SALT cap) may serve as a disincentive for many taxpayers to diversify, often viewed as a means of reducing portfolio risk, through investments in out-of-state bonds. This may occur where a taxpayer’s resident state excludes municipal bond interest on in-state bonds but taxes interest generated from those that are out of state. The sunset of the SALT cap would make it easier for investors to deduct state and local tax payments on bond interest and thus incentivize them to diversify their holdings.

Further, under the TCJA provisions, many taxpayers have claimed the standard deduction, giving them no tax benefit from the payment of state and local taxes. Post-sunset, after the reduction in the standard deduction, they may find it advantageous to itemize and deduct state and local tax payments on municipal bond interest.

Clients should be made aware, however, that the post-sunset benefits from being able to deduct taxes on bond interest may be mitigated or even eliminated by the alternative minimum tax (AMT) and/or the reemergence of the overall limitation imposed on itemized deductions for higher-income taxpayers.

Potential trade-offs

Trade-offs exist between striving for higher after-tax income versus assembling a widely diversified portfolio to lower investment risk. These may vary significantly depending upon a taxpayer’s individual situation, particularly how their state of residence taxes municipal bond interest.

Example 1 (post-TCJA sunset): A is a resident of California, which excludes in-state municipal bond interest and taxes out-of-state municipal bond interest. He is subject to a federal marginal tax rate of 33%, the tax on net investment income of 3.8%, and California state income taxes at a rate of 9.3%. He is not subject to the AMT or the limitation on itemized deductions. He earns $10,000 in municipal bond interest from a mutual fund.

Scenario 1: All the income is derived from either California and/or a qualifying territory (e.g., Puerto Rico) and therefore is exempt from California tax. Net tax: $0.

Scenario 2: $1,000 (10%) of the income is derived from California and/or a qualifying territory, and $9,000 (90%) is from out-of-state bonds (taxable to California), as shown in the table “Tax Results for Scenario 2 of Example 1,” below.

In the second scenario, where 90% of the interest income derives from municipal bonds from outside California, the taxpayer must pay a substantial amount of net tax, making it costly to achieve portfolio diversification. A quandary for the investor in deciding whether to pay for diversification is that there is no well-established means for quantitatively evaluating the extent, if any, of the diversification benefit.

Other considerations

In comparing the two scenarios in Example 1, the federal tax on net investment income for municipal bonds, zero, is not a factor. But this additional tax may help determine whether to invest in tax-exempt or taxable investments.

Also, yield spreads between muni bonds and taxable government and corporate bonds can vary greatly, and, from time to time, these spreads can make investing in tax-free bonds less appealing or even detrimental.

A challenge in evaluating yield spreads and making after-tax comparisons is that even when taxable and nontaxable bonds have the same rating from the same company, levels of risk may not be equivalent. For example, the cumulative default rate, 20-year time horizon during the period 1970–2022 is 0.00% for AAA-rated municipal bonds but 0.73% for AAA-rated global corporate bonds (Moody’s, “U.S. Municipal Bond Defaults and Recoveries,” 1970–2022).

Low-tax states

For comparison with the California example, consider a municipal bond investor in a state that has no income tax.

Example 2 (post-TCJA sunset): B is a resident of Alaska, one of the seven states that do not levy a state income tax. Because there is no disincentive to investing in out-of-state bonds, B can diversify her municipal bond portfolio without incurring any additional tax costs.

Similarly, for residents of the five states (Illinois, Iowa, Oklahoma, Utah, and Wisconsin) that tax both in-state and out-of-state municipal bond interest, there is also no disincentive to investing in out-of-state bonds (i.e., both in-state and out-of-state bonds are subject to the same tax rate). Municipal bond interest from territories (e.g., Puerto Rico and Guam), however, is tax-exempt in these and all states and therefore provides limited diversification opportunities for single-state funds.

RISK OF DEFAULT

Although municipal bonds rarely default, investors should keep in mind this risk. A prime example is Puerto Rico’s bankruptcy process, which largely concluded with a March 2022 federal court ruling that reduced Puerto Rico’s debt by approximately 80%. Puerto Rico had accumulated bond debt that, according to Moody’s, exceeded 15 times the median debt of the 50 states (see Walsh, “The Bonds That Broke Puerto Rico,” The New York Times, June 30, 2015; see also Hammer, Zhang, and Russo, “Recent Developments for Municipal Bond Investors,” JofA, Sept. 1, 2020).

Bonds with a higher default risk tend to pay higher interest. In 2015, one tax-exempt Maryland mutual fund actually held more Puerto Rico bonds than Maryland bonds and, as a result, generated higher returns than would be expected using only Maryland bonds. Similar incentives may exist currently for single-state fund managers to invest in Puerto Rico bonds because investment returns over the last one-, three-, and five-year periods have well exceeded their benchmark. The outsized bond returns from Puerto Rico and possibly other territories, when held in sufficient quantity by a single-state tax-exempt fund, can at times significantly increase total performance. The converse, however, is also true because substantial declines in Puerto Rico bonds’ returns can significantly decrease performance. Therefore, clients should be reminded to evaluate a single state tax-exempt fund’s holdings to ensure they are consistent with their expectations.

AMT CONSEQUENCES

Returning to the topic of the TCJA’s sunset, some municipal bond investors will be affected by planned changes to the AMT. According to projections of the Tax Policy Center, the number of taxpayers subject to the AMT dropped from more than 5 million in 2017 to about 200,000 in 2018. However, absent new legislation, the number of taxpayers subject to the AMT is expected to surpass its previous levels, rising in 2026 to 7.6 million taxpayers and in 2032 to 9. 7 million. This increase will largely be driven by the reversion from the existing provisions, as enacted by the TCJA, to what was in effect under prior law. An unamended expiration of the TCJA would result in taxpayers’ exemption being reduced to the pre-TCJA statutory amount ($50,600 for unmarried taxpayers and $78,750 for a joint return) plus an inflation adjustment from 2011 (the 2017 amounts were $54,300 and $84,500, respectively). For comparison, the 2024 exemption amounts for single and married taxpayers filing jointly are $85,700 and $133,300, respectively.

Perhaps threatening an even more drastic effect is the pending change in the beginning AMT exemption phaseout levels: a reduction to the statutory levels of $112,500 for single taxpayers and $150,000 for married taxpayers filing jointly, plus inflation adjustments from 2011 (in 2017, they were $120,700 and $160,900, respectively). In 2024, the phaseout for single taxpayers begins at $609,350 and for married couples filing jointly, $1,218,700.

A consequence of the AMT reversions is that AMT adjustment and preference items that are addbacks, such as state and local taxes (e.g., in-state taxes on out-of-state bonds) and PAB interest, will become increasingly likely to generate liabilities for the AMT.

Private activity bond interest

Broadly speaking, PABs are tax-advantaged municipal bonds issued by a state or local government on behalf of a private entity engaged in a project that has some public benefit, such as construction of affordable housing. Generally, because PAB interest is an AMT preference item that must be added back to income, these bonds are in demand by a smaller pool of buyers than other municipal bonds. After the TCJA sunset, they may potentially be subject to a further decline in demand as a much greater pool of investors becomes subject to the AMT. While the exact impact of such a change, if any, on investment return is uncertain, broad economic supply/demand principles would suggest that if demand for PABs declines, the price of such bonds would also decline. Accordingly, taxpayers may find it beneficial to consider how a reversion to pre-TCJA AMT provisions would affect their investments.

Example 3: C, a taxpayer subject to a high marginal tax rate, determines, pursuant to a 2026 tax projection, that if he were to invest in municipal bonds yielding $10,000 in PAB interest, he would still not be subject to the AMT. C’s cost of purchasing the bonds theoretically would be expected to fall, assuming other market conditions are unchanged, as demand for PABs would be expected to fall with the looming expiration of the TCJA.

Clients considering this strategy should be reminded, however, that acting on the assumption that market conditions, which include political considerations, will remain unchanged and/or match projections leaves them subject to these risks, which are not readily quantified.

OTHER MUNICIPAL BOND TRENDS

ETF expenses are generally lower than for mutual funds

According to Morningstar, the average net expenses for municipal bond mutual funds was 0. 79%, versus 0.34% for municipal bond exchange-traded funds (ETFs) (Morningstar, as of Sept. 30, 2023) . However, the universe of municipal bond mutual funds is much larger: 1,678 in Morningstar’s Muni Fund Category, versus 83 for its ETF category. The adviser’s role in presenting this information, unless they are a registered investment adviser or registered representative, should generally be to provide a broad overview and not include specific recommendations regarding the purchase of particular bonds, ETFs, or funds.

Separately managed accounts continue to emerge as a challenger to mutual funds and ETFs

Separately managed accounts, a growing form of municipal bond investment, provide opportunities for professional customizable management but typically require significant minimum investments, often around $250,000 (see “Fast-Growing Force in Muni Market Is Upending Mutual Funds’ Grip,” Bloomberg.com, Jan. 12, 2024). In these accounts the investor owns the individual bonds rather than owning a fractional share of the entire portfolio, and, as a result, tax reporting can potentially change dramatically.

Exposure to cyberattacks and increases in climate change may pose growing, albeit hard-to-measure, risks

In consideration of potential cyberattacks, governing agencies may bolster their software technology (see “A Hidden Risk in the Municipal Bond Market: Hackers,” Wall Street Journal, Dec. 7, 2023) and, in consideration of potential climate-related risks (e.g., floods), increase spending for physical infrastructure (e.g., flood barricades). For investors, a broad strategy of achieving risk reduction through diversification may apply here as well (e.g., avoid holding a preponderance of bonds within contiguous geographical areas deemed subject to a high risk of major flood damage).

INFORMED DECISION-MAKING FOR THE UNCERTAIN FUTURE

Whether provisions of the TCJA will expire, be amended, or perhaps even be made permanent is, at this point, unknown. Municipal bond investors should carefully evaluate their specific situation in light of this uncertainty, as well as the evolving municipal bond marketplace (e.g., growth of ETFs and separately managed accounts) and, in some cases, issues specific to their state of residence (level of territorial holdings of single-state tax-exempt funds). This will help them make informed decisions to manage risk and achieve higher after-tax income.