For a smaller tax bill in 2021, consider municipal bonds

By Brian Erickson, Vice President, Fixed Income Research and Strategy

Key Points

  • Municipal bonds can provide tax-free income while preserving capital.
  • Changes in the tax law make municipal bonds more attractive to investors who were previously subject to the alternative minimum tax or deducted state income taxes.
  • Taxable municipal bonds can offer diversification for a bond portfolio.1

As tax time approaches, we know tax efficiency is top of mind for many investors with non-qualified (i.e., non-retirement) accounts. Paying taxes on capital gains or investment income can spark a search for tax-efficient investment options.

After funding your retirement accounts, you could consider tax-exempt municipal bonds for non-qualified accounts. They offer a tax-friendly solution if you’re in the middle to high marginal income tax brackets with non-qualified accounts.

Favorable tax treatment for municipal bonds

The interest paid on most municipal bonds is exempt from federal income tax, including the 3.8% net investment income tax (if applicable), and if you invest in a bond that a municipality within your state issues, it may be exempt from state income tax as well.

If your state has low tax rates or no income tax, a nationally diversified municipal bond allocation may be a good option for you. Interest on municipal bonds issued within your state of residence may be exempt from state income tax.  This tax treatment can offer a sizable advantage compared to taxable bonds, particularly for those in higher marginal income tax brackets or who are residents in states with high-income tax rates.

If your state income tax is high, you may consider municipal bonds from your home state for some of your municipal exposure, striking a balance between concentration risk with tax efficiency. In this way, the sensitivity to tax impacts can help lessen your tax bill every April. It’s a good idea to work with your Ameriprise advisor to determine the specific allocation based on your circumstances.

Gains from sales or dispositions of municipal bonds are subject to both federal and state income taxes, but gains can be limited with a buy-and-hold investment strategy. 

High-quality municipal bonds can help preserve capital

The tax-advantaged status of municipal bonds can offer attractive after-tax income while preserving capital. According to Moody’s Investor Services, 92% of Moody’s rated municipals were A-rated or better at the end of 2018, occupying the middle to upper ratings of investment-grade bonds.2 This suggests the average municipal bond investment is backed by a strong capacity to repay obligations.

Types of municipal bonds:

  • City, county or state obligations: Full faith and credit (general obligation), limited obligation and appropriation-backed
  • Essential service providers: water, sewer and transportation systems
  • Public schools, colleges and hospitals

Tax reform and the municipal bond market

The Tax Cuts and Jobs Act of 2017 (TCJA) made several major tax code changes that impacted the municipal bond market. First, the TCJA limited the federal income tax deduction from state and local income taxes, which increased the federal tax burden on state-taxable investments for many taxpayers. The TCJA also increased the standard deduction, making it harder for middle-income taxpayers to deduct any state taxes as an itemized deduction. These changes made tax-exempt municipal bonds more attractive.

The TCJA also reduced the number of filers subject to alternative minimum tax (AMT) by 96% (according to Tax Policy Center estimates), opening for many more investors a segment of the municipal bond market that is subject to the AMT, private activity bonds. This segment represents just 5% of the outstanding municipal market, according to Bloomberg. It may offer relatively more income than similar non-AMT bonds and provide a source of diversification.3

Lastly, the TCJA eliminated the tax-exemption of certain new municipal issues (advanced refunding bonds), leading to a growing supply of taxable municipal bonds. Though taxable munis lack a tax benefit, they do offer diversification for high-quality government bond allocations in both qualified and non-qualified accounts.

Understand your situation

Municipal bonds can ease the squeeze of investment income taxes, while supporting communities. Consult your tax professional to determine your personal tax situation. Your Ameriprise advisor will provide you with personalized advice based on your goals and needs and will determine whether municipal bonds are appropriate for your long-term investment portfolio.