The Tax Cuts and Jobs Act has increased the tax burden for high-income individuals and residents of high-tax states in one key way. Starting this year, the federal income tax deduction on state and local income taxes, or SALT, is capped at $10,000, regardless of income.
Previously, taxpayers could deduct the state income taxes, property taxes, and sales taxes they paid from their federal tax bill. This unlimited deduction, which may be subject to other IRS adjustments, had the largest impact on high-income individuals.
Residents of states with high income tax and property tax rates will be hardest hit, particularly those who live in:
- New York
- New Jersey
Municipal bonds show their appeal
Many investors are taking a fresh look at municipal bonds as a source of tax-advantaged income. The yields on municipals are free from federal and, in some cases, state and local income taxes.
Residents of high-tax states have been driving demand for municipal bonds as they seek to reduce their tax bills. But municipals are a compelling fixed income investment for reasons beyond their tax benefits. Municipal bonds offer competitive yields and typically lower volatility than taxable bonds with similar credit ratings and maturities.
The tax-free advantage of municipal bonds can make a meaningful difference in an investor’s overall return, particularly if an individual is in a high tax bracket.
Take a look at the chart below. This illustration shows the hypothetical tax equivalent yield necessary on a taxable bond for an individual in the 37% marginal federal tax bracket.
For example, the taxable equivalent yield on a 4% municipal bond is 6.62%. A corporate bond would have to deliver a much higher pre-tax yield than a municipal in order to yield that same 4% after taxes.
* The taxable equivalent yield measures what an investor would have to earn (yield) on a taxable (or fully taxable) investment in order to match the yield provided by a tax-exempt municipal bond. The taxable equivalent yield is only one factor that should be considered when purchasing a security, and is meant to be used only as a general guideline.
This chart is hypothetical and for illustrative purposes only. Actual results will vary. Income is subject to State and local taxes for non-(State) residents. Some income may be subject to the Federal Alternative Minimum Tax. Capital gains, if any, are taxable.
Municipal bonds that are not subject to state or local taxation may offer even more attractive rates of income than those that are merely federal tax-free. And the incremental yield advantage of municipals, compounded over time, can have a significant impact on one’s portfolio.
A favorable environment for municipals
The municipal market is highly liquid and transparent. Nearly $442 billion in new municipal securities, on average, were issued in each of the last 10 years, and roughly 39,000 municipal trades occur each day.1
Although some municipalities are facing budget pressures, the strong economy and job market are positive factors likely to increase tax collections. And the demand for municipal projects is growing. The American Society of Civil Engineers estimates that repairing and improving U.S. infrastructure will require expenditures of $4.6 trillion by 2025.2
While some municipal securities have experienced defaults, most notably those in Puerto Rico, default rates remain low relative to corporate bonds over the past four-plus decades:3
Investment-grade municipal bonds: 0.18%
Investment-grade corporate bonds: 1.74%
The advantages of professional management
Dreyfus offers an extensive selection of national and state-specific municipal bond funds as well as a municipal bond separate account offering.
Experienced portfolio managers conduct in-depth proprietary credit research. By gaining an understanding of individual issuers, they seek to avoid the risk of credit downgrades and defaults while taking advantage of upgraded issues. These skilled professionals can help navigate the complexities of the municipal market on behalf of their shareholders.
Enhance the tax-efficiency of your portfolio
It is critical to consider taxes when making investment decisions. Please contact me to schedule a portfolio review in light of the new tax law. I’ll recommend strategies you can pursue in order to minimize your taxable income and make your investments as efficient as possible.