The new administration seems firmly committed to slashing individual tax rates. That’s good, but it raises the issue of whether it still makes sense to invest in municipal bonds.
These securities typically have some favorable tax-related attributes. Interest income from muni bonds is usually exempt from federal taxes and in many cases from state income taxes, also.
Whether you own some of these securities or not, there are some things you need to know.
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How they work. Such bonds typically have a lower yield than taxable bonds of an equivalent quality and duration. But when the two types of security are compared on an after-tax basis the muni bonds often look more attractive, especially if you are in a high tax bracket.
“For higher earners or higher net worth individuals they are definitely more beneficial,” says Jeff Carbone, managing partner at Cornerstone Financial Partners? in Charlotte, North Carolina.
That’s because income tax eats into the return of taxable bonds more when the individual is in the higher tax bracket. For example, if you pay a top rate of tax of 39.6 percent, then a muni bond yielding 3 percent would be equivalent to almost 5 percent before tax. Yet for someone in the 20 percent tax bracket, the taxable bond equivalent would be a yield of 3.75 percent.
The higher percentage of income tax you pay, the more attractive these muni bonds look. But with personal tax rates likely to drop, should you bother?
For many people, the answer is no. That’s because many people have their all investments held either in 401(k) plans or IRA accounts. Those products already give you the benefit of deferring your income taxes to a later date. There is no additional tax benefit to holding muni bonds within such a product.
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Administrators of 401(k) plans should be keenly aware of this so they likely won’t provide a muni-bond investment choice for you. If you find muni bonds held in either type of account, it is probably time to dump them.
If you do have investments that are outside 401(k)s and IRAs, then congratulations! You’ve obviously been saving, and better still, these tax-free bond investments may still make sense. However, there are some things you need to know.
Some good news. “At today’s market prices you benefit from owning a muni bond over a corporate bond even if you only have a 20 percent tax rate,” says David Hammer, head of municipal bond portfolio management at Pimco.
Given where municipal bonds are trading now, the yield on the muni will be higher than that of the after-tax yield of an equivalent taxable bond if your tax rate is 20 percent or higher. If you pay a lower tax rate, the muni makes little sense right now.
Higher rates, volatility ahead. Investors need to prepare themselves for a bumpy ride. A Pimco report says municipal bonds will be more volatile in 2017.
The price of munis, like all bonds, move in the opposite direction to interest rates. If interest rates go up (or are expected to do so) then muni prices will fall.
Likewise, the uncertainty over exactly what policies the new White House administration will or will not introduce will tend to make the bond market more volatile as well. Investors hate uncertainty.
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Not all muni bonds are created equal. “There are lots of muni bonds; some are safer than others,” says Jim Kee, president and chief economist for South Texas Money Management of San Antonio.
Some municipalities aren’t as creditworthy as other ones. You may recall the recent fiscal crisis in Puerto Rico that caused some anxiety for muni investors. Even in a state which has good credit, not all bonds are created equal. Some have more risk than others.
The long of the short of the multitude of different bonds is that if you are going to invest in single securities then you need to do research on the credit quality of the bond.
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Trump’s Tax Reforms May Be Another Reason to Avoid Municipal Bonds originally appeared on usnews.com
