The first major reform in decades of U.S. tax codes — the Tax Cuts and Jobs Act (TCJA) — ushered in a new era of lower tax rates for many business owners. Passed by Congress in late 2017, the act also cut individual taxes at the highest marginal federal bracket. 

The revisions, however, do include a less appealing feature for many high net-worth investors. Namely, this relates to the state and local tax (SALT) deductions that you receive and are capped at $10,000 a year. 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 can wind up raising tax obligations for many taxpayers, particularly high net-worth individuals in states with relatively high tax rates like California and New York. 

Investors in such states, however, can take advantage of passively managed portfolios of bond funds focused on municipal debt offerings. Commonly referred to as "muni bonds," this type of fixed-income is issued by states and local municipalities to help finance public projects like road repairs and water treatment plants. To enhance their allure to investors and to provide a lower cost of capital for the municipalities, 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 offered to the buyers of those securities. 

Owning muni bond funds can help taxpayers to avoid the Net Investment Income Tax (NIIT). Typically, interest income from such funds are exempt from the NIIT. These taxes are levied on individuals with adjusted gross income (AGI) of $200,000 and above ($250,000 for couples filing jointly and $125,000 for spouses filing separately). Still, any capital gains generated from selling muni bond funds are normally counted as part of the NIIT's income tax calculations.  

Since its enactment, lawmakers in Washington, D.C., have debated increasing — or even stripping — the act's SALT caps. Unless Congress takes action, it's also worth noting that key provisions of the TCJA are set to sunset by the end of 2025. 

Given such nuances and differences in each taxpayer's unique financial situation, our investment committee warns that it's 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 — as well as a careful comparison of the risks of the munis versus the risks of the taxable bonds.

To illustrate how a tax-related analysis of muni bond funds might impact various types of investors IFA Taxes has developed a set of hypothetical scenarios for clients of different ages and income levels in various states. The tables below provide data for these scenarios on an individual filing basis as well as investors who are married and filing jointly. 

In each case, we compare the estimated total annual tax savings from using IFA portfolios with muni bonds versus those with 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 California state, local and federal taxes. Also, annual income figures are referring to total taxable income. (We've also assumed that the total 2023 estimated pre-tax returns for the taxable bond and muni bond portfolios are the same.) 

Besides considering these different characteristics, we've included different levels of portfolio risk. For example, we've assumed a hypothetical 45-year-old client's Risk Capacity Survey indicates an IFA Index Portfolio 70 (70% stocks, 30% bonds). Likewise, the IFA Portfolio 60 (60% stocks, 40% bonds) was selected for a 55-year-old theoretical taxpayer. Then, someone aged 65 in such a scenario was put into the more conservative IFA Index Portfolio 55 (55% stocks, 45% bonds). 

Of course, in actual implementation each investor's financial situation, tax situation and risk capacity are unique situations that need to be reviewed on an individual basis. Here are three tables showing results of our estimates for hypothetical investors filing as married taxpayers:

In the next three tables, we show data for a set of hypothetical investors filing as single taxpayers:

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 experienced tax professional. For those looking for such support, IFA Taxes works with individuals and business owners on a fee-only basis. Lisa Rimke, who serves as IFA's Director of Taxes, is a certified public accountant (CPA). She doesn't charge on an hourly basis, instead setting fees in advance based on the complexity of each individual situation. Introductory meetings are offered on a complimentary basis. To set up a conversation about possible tax benefits you might be able to receive from utilizing muni bonds in your portfolio, please feel free to contact Rimke at: (888) 302-0765 or via email at: [email protected].

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.This is intended to be informational in nature and should not be construed as tax advice. IFA Taxes is a division of Index Fund Advisors, Inc.

Certified Public Accountant (CPA) is a license to provide accounting services to the public awarded by states upon passing their respective course work requirements and the Uniform Certified Public Accounting Examination.