Tax Exempt Bond Funds - Considerations after Tax Reform

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Scooter57
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Tax Exempt Bond Funds - Considerations after Tax Reform

Post by Scooter57 » Fri Jan 12, 2018 4:40 pm

I haven't seen any recent discussions here about whether there are new issues to consider when buying tax exempt bond funds now that tax reform has passed, though the recent rise in the Vanguard Muni Money Market Fund has come up for discussion.

Quick math shows me that the tax-equivalent yield of munis for investors in the new 35% bracket are much better than they used to be. But knowing that this means they must carry more risk, I'm trying to understand what is going on.

Are there reasons to think that tax reform may change investor behavior in ways that makes muni bonds a) riskier or b) harder to sell?

Do rising levels of government debt at all levels of government post more of a threat?

Does the knowledge that Congress and the President appear to be hostile to states not identified with the ruling party cast a pall?

Are municipalities likely to face more bankruptcies as a result of the loss of deductibility of state and local taxes?

I know there is no free lunch, so when I see much better rates than I used to in the muni fund universe, I have to wonder what I'm missing.

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Phineas J. Whoopee
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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by Phineas J. Whoopee » Fri Jan 12, 2018 7:29 pm

Surely bond dealers also read the news, and adjust their bid and ask prices, which is the same as adjusting their bid and ask yields, in accordance with their interpretations of what has happened. No doubt more and more analysis will discover more and more implications.
PJW

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grabiner
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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by grabiner » Fri Jan 12, 2018 10:40 pm

Logically, yields should rise slightly when tax rates fall. If an investor in a 25% tax bracket is willing to buy a muni yielding 2.25% rather than a taxable bond yielding 3%, he must believe that the muni is no riskier, since the two bonds have the same after-tax return. When he drops to the 22% tax bracket, the break-even yield becomes 2.34%.

The new tax laws also make in-state munis slightly more attractive for investors who are choosing whether to hold bonds in taxable or tax-deferred accounts. Previously, if this investor paid 8% state tax, his marginal tax rate on qualified dividends was 21%, but it is now 23% if he is over the SALT deduction limit or doesn't itemize deductions. Meanwhile, he pays the same zero tax on munis from his own state (but 8% rather than 6% on out-of-state munis, so there is no advantage for them).
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Scooter57
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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by Scooter57 » Sat Jan 13, 2018 4:15 pm

David,

Thanks! That makes a lot of sense.

The other thing that strikes me is that there is more incentive now to move taxable income to tax-exempt bonds for people who are nearing 157K in taxable income because of that sharp 8% surge in the tax rate that kicks in at that level, from 24% to 32%. The older brackets were more gradual.

jebmke
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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by jebmke » Sat Jan 13, 2018 5:16 pm

Scooter57 wrote:
Sat Jan 13, 2018 4:15 pm
David,

Thanks! That makes a lot of sense.

The other thing that strikes me is that there is more incentive now to move taxable income to tax-exempt bonds for people who are nearing 157K in taxable income because of that sharp 8% surge in the tax rate that kicks in at that level, from 24% to 32%. The older brackets were more gradual.
One also has to be alert to the hidden marginal rates (27%) that occur below the 24% bracket for people with significant dividend and capital gain income.
When you discover that you are riding a dead horse, the best strategy is to dismount.

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House Blend
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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by House Blend » Sun Jan 14, 2018 8:12 am

jebmke wrote:
Sat Jan 13, 2018 5:16 pm
Scooter57 wrote:
Sat Jan 13, 2018 4:15 pm
David,

Thanks! That makes a lot of sense.

The other thing that strikes me is that there is more incentive now to move taxable income to tax-exempt bonds for people who are nearing 157K in taxable income because of that sharp 8% surge in the tax rate that kicks in at that level, from 24% to 32%. The older brackets were more gradual.
One also has to be alert to the hidden marginal rates (27%) that occur below the 24% bracket for people with significant dividend and capital gain income.
And in contradiction to what Scooter57 wrote, if one has significant div and cap gain income, there is no 8% spike as you approach $157K in (Single) Taxable Income. One needs to subtract off the div and net LTCG first and compare that to $157K.

So a Single with $160K in Taxable Income, including $20K in qualified dividends, should evaluate the question of munis-in-taxable vs. nominals-in-tax-advantaged from the perspective of the 24% bracket. In this scenario, replacing the $20K of QDI with tax-exempt interest has no effect on the marginal tax rate. It's 24% either way.

Wagnerjb
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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by Wagnerjb » Sun Jan 14, 2018 12:01 pm

jebmke wrote:
Sat Jan 13, 2018 5:16 pm
One also has to be alert to the hidden marginal rates (27%) that occur below the 24% bracket for people with significant dividend and capital gain income.
Can you kindly elaborate on how the 27% marginal rate comes about? I expect minimal dividends and no cap gains for 2018, but I hope to convert to a Roth to the top of the 24% bracket. I would like to understand this effect even if I may not be subject to it.

Thanks!
Andy

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grabiner
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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by grabiner » Sun Jan 14, 2018 12:51 pm

Wagnerjb wrote:
Sun Jan 14, 2018 12:01 pm
jebmke wrote:
Sat Jan 13, 2018 5:16 pm
One also has to be alert to the hidden marginal rates (27%) that occur below the 24% bracket for people with significant dividend and capital gain income.
Can you kindly elaborate on how the 27% marginal rate comes about? I expect minimal dividends and no cap gains for 2018, but I hope to convert to a Roth to the top of the 24% bracket. I would like to understand this effect even if I may not be subject to it.
If your total income is in the 22% tax bracket, but your income without the long-term gains and qualified dividends would be in the 12% bracket, then you are not paying 22% on any of your income. You are paying 10% and 12% on your regular income, and 15% on the capital gains that are over the top of the 22% bracket.

If you earn another $1000 in ordinary income, this income is taxed at 12%, but it also pushes $1000 of qualified dividends from the 12% bracket (no tax) to the 22% bracket (15% tax). Your tax increases by $120+150=270, a 27% marginal tax rate. (This could also happen under the 2017 tax law, with the 15% and 25% brackets, creating a marginal tax rate of 30%).

The 27% marginal tax rate lasts until you fill up the 12% bracket with ordinary income. After that, you are paying 15% tax on all your qualified dividends, so an additional $1000 of ordinary income is taxed only at the 22% rate applying to ordinary income.
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Scooter57
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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by Scooter57 » Sun Jan 14, 2018 1:01 pm

Houseblend,

Because stock dividends and capital gains are treated separately by the tax code, they aren't relevant to this discussion. But bond or CD income would be, making this of particular interest to retirees with taxable assets and a preferance for fixed income: For example, a retiree who has sold a profitable business at retirement. Or older adults who have received taxable inheritances.

It's worth mentioning, too, that as rates slowly rise back to a more traditional range the amount of fully taxable fixed income interest earned by a retiree may go up significantly, which would increase the value of a tax-exempt fund for taxable fixed interest.

NYCwriter
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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by NYCwriter » Sun Jan 14, 2018 6:34 pm

Thanks to David for providing a clear explanation.

I'm in this group, as my current job (10 years) pays much less than my previous career, and I added a small inheritance some years ago that pushed up my taxable portfolio. In addition to shoveling as much as I can into my 403b and 457b pretax and maxing out my post-tax Roth annually, I hold a NY Muni Bond fund as my primary taxable portfolio bond fund. I debated whether it was worth it in my tax bracket, but I consider it a long-term hold and expect to continue living in NYC.

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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by gilgamesh » Sun Jan 14, 2018 7:37 pm

Delete

masteraleph
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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by masteraleph » Sun Jan 14, 2018 7:49 pm

One (minor) clarification:

The capital gains rates were not updated in the new tax bill. What that means is that the 22% bracket starts at $38,700/$77,400 single/MFJ for 2018, but the 15% rate on capital gains actually starts at $38,600/$77,200- not the hugest difference, but something to keep track of. The 20% capital gains rate starts at $425,800/$479,000, but for income, that falls in the middle of the 35% bracket, which is $200,000-$500,000 for single and $400,000-$600,000 for MFJ. So you might run into some odd discrepancies if you're assuming that the 15% LTCG rate starts where the 22% bracket starts, and if you have LTCG/Qualified Dividend income and your income is in the mid $400k range, make sure to keep an eye on things to keep from being surprised by the capital gains bracket change.

Wagnerjb
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Re: Tax Exempt Bond Funds - Considerations after Tax Reform

Post by Wagnerjb » Sun Jan 14, 2018 8:51 pm

grabiner wrote:
Sun Jan 14, 2018 12:51 pm
Wagnerjb wrote:
Sun Jan 14, 2018 12:01 pm
jebmke wrote:
Sat Jan 13, 2018 5:16 pm
One also has to be alert to the hidden marginal rates (27%) that occur below the 24% bracket for people with significant dividend and capital gain income.
Can you kindly elaborate on how the 27% marginal rate comes about? I expect minimal dividends and no cap gains for 2018, but I hope to convert to a Roth to the top of the 24% bracket. I would like to understand this effect even if I may not be subject to it.
If your total income is in the 22% tax bracket, but your income without the long-term gains and qualified dividends would be in the 12% bracket, then you are not paying 22% on any of your income. You are paying 10% and 12% on your regular income, and 15% on the capital gains that are over the top of the 22% bracket.

If you earn another $1000 in ordinary income, this income is taxed at 12%, but it also pushes $1000 of qualified dividends from the 12% bracket (no tax) to the 22% bracket (15% tax). Your tax increases by $120+150=270, a 27% marginal tax rate. (This could also happen under the 2017 tax law, with the 15% and 25% brackets, creating a marginal tax rate of 30%).

The 27% marginal tax rate lasts until you fill up the 12% bracket with ordinary income. After that, you are paying 15% tax on all your qualified dividends, so an additional $1000 of ordinary income is taxed only at the 22% rate applying to ordinary income.
Thanks David. I am quite familiar with the 30% marginal bracket in the 2017 tax law.

I probably misinterpreted the post by Jebmke. He mentioned the 27% marginal rate as "below the 24% bracket", when it sounds like it is at the bottom of the 22% bracket. That is about $250,000 away from where I thought it was. :D

Thanks again.
Andy

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