How to avoid taxes on taxable bonds

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bondcurious
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How to avoid taxes on taxable bonds

Post by bondcurious »

I'm in charge on selecting investments for a relative who lives in a state with fairly high income tax. This relative is late in life, and expected to live for less than 20 years. Her financial situation is strong, and she wants most of her investments to be inherited by her beneficiaries.

We've determined that putting a sizable portion of her investable assets into fixed income will be appropriate. Because her annual income is somewhat high due to pension, etc., we've decided that municipal bonds likely make the most sense, as opposed to treasuries or corporates.

When looking at the municipal bond offerings, it became apparent than zero-coupon municipal bonds offer the best taxation situation, because any muni that makes periodic interest payments has to pay state/local income tax on those interest payments. Whereas a zero-coupon bond realizes its full profit from price appreciation at the time of maturity. Since she expects to live less than 20 years, I expect any muni that matures after that (e.g. 2045) to benefit from the cost basis step up.

For example, purchasing XYZ zero-coupon muni today for 44.60; XYZ price is 88.20 when relative passes in 2042; XYZ is redeemed by her beneficiary for 100 in 2045. In that case I would expect only 100 - 88.20 = 11.80 to be subject to state/local income tax instead of 100 - 44.60 = 55.40.

Here's the rub. Municipal bonds are subject to the "de minimis" rule, which dictates that if the bond price is below a certain number (the de minimis cutoff), the gains from price appreciation are classified as ordinary income instead of capital gains. If she were to buy a zero-coupon muni priced below the de minimis cutoff and outlive the bond, the entire gain would be classified as ordinary income. As far as I can gather, this means the profit would become subject to federal income tax at the ordinary income rate instead of being completely exempt from federal income tax.

Using the example above, if she were still alive in 2045, she would have to record ordinary income of 100 - 44.60 = 55.40 in 2045. The question I have is what would happen if she passed in 2042 as in the example above. Would her beneficiary only have to record ordinary income on 100 - 88.20 = 11.80, or would the full 55.40 be counted as ordinary income? Or something else altogether?

I've tried extensively to find an authoritative document that describes the tax treatment of a muni bond purchased below the de minimis cutoff whose owner passes prior to maturity. I haven't been able to find one and I'm not comfortable purchasing munis below the de minimis when I don't have clarity on the tax treatment. If anyone here can refer me to an authoritative document it would be much appreciated. And I welcome any other thoughts or suggestions on how best to help my relative with her fixed income selection.
Geologist
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Re: How to avoid taxes on taxable bonds

Post by Geologist »

Ignoring market fluctuations and secondary purchases to start, the increase in value of zero-coupon municipal bonds over their life is not "price appreciation" (=capital gains) but accumulated interest. This is effectively paid out at maturity.

If you buy municipal bonds for your state (or local area), then they should be exempt from those income taxes too.
Longdog
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Re: How to avoid taxes on taxable bonds

Post by Longdog »

There is not a cost basis step-up on zero coupon municipal bonds. The accumulation is treated as muni bond interest, which would likely then be attributed to the estate of the decedent - federally tax free and if issued in the state of residence prior to their passing, would also be state tax free. If you want to avoid state taxation on municipal bonds, whether they are zero coupon or not, you should purchase muni bonds issued in that state.

Similarly, although you did not ask this explicitly but you might have considered because it seems like a similar thought process, there is not a cost basis step-up on savings bonds, which defer taxation on their interest over the years.
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Re: How to avoid taxes on taxable bonds

Post by retired@50 »

bondcurious wrote: Tue Jul 09, 2024 12:32 am I'm in charge on selecting investments for a relative who lives in a state with fairly high income tax.
Welcome to the forum.

Which state?

Regards,
"All of us would be better investors if we just made fewer decisions." - Daniel Kahneman
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grabiner
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Re: How to avoid taxes on taxable bonds

Post by grabiner »

If the state has a low-cost muni fund (Vanguard has these for CA, MA, NJ, NY, and PA), that could be the best investment. If not, the cost of an in-state muni fund is likely to be more than the tax savings, so you should use either a national muni fund or a Treasury fund, or individual munis from the state.

Also, you say that "she wants most of her investments to be inherited by her beneficiaries." This is a reason to prefer stock for taxable investments, and bonds in an IRA if she has one. The reason is that the tax cost on stock will be very low. If she buys a US stock fund with a 2% yield, all qualified dividends, and pays 25% combined US and state tax, that is 0.5% per year as long as she lives. Capital gains would be taxed at 25%. but she won't have them if she leaves the stock to her heirs.

She may still need bonds in her taxable accounts if her tax-sheltered accounts aren't large enough.
Last edited by grabiner on Tue Jul 09, 2024 8:08 am, edited 1 time in total.
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Re: How to avoid taxes on taxable bonds

Post by grabiner »

bondcurious wrote: Tue Jul 09, 2024 12:32 am Here's the rub. Municipal bonds are subject to the "de minimis" rule, which dictates that if the bond price is below a certain number (the de minimis cutoff), the gains from price appreciation are classified as ordinary income instead of capital gains. If she were to buy a zero-coupon muni priced below the de minimis cutoff and outlive the bond, the entire gain would be classified as ordinary income. As far as I can gather, this means the profit would become subject to federal income tax at the ordinary income rate instead of being completely exempt from federal income tax.
While this rule does not apply to zero-coupon bonds, it is an important issue with low-coupon bonds. If a muni was issued with a 2% coupon but now has a 4% yield because it is as a discount, this means that the bond price will increase by 2% annualized so that it returns to par value at maturity. That 2% will be federal taxable income, and will increase the basis of the bond, so that there is no capital gain when the bond matures.
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bondcurious
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Re: How to avoid taxes on taxable bonds

Post by bondcurious »

grabiner wrote: Tue Jul 09, 2024 8:08 am
bondcurious wrote: Tue Jul 09, 2024 12:32 am Here's the rub. Municipal bonds are subject to the "de minimis" rule, which dictates that if the bond price is below a certain number (the de minimis cutoff), the gains from price appreciation are classified as ordinary income instead of capital gains. If she were to buy a zero-coupon muni priced below the de minimis cutoff and outlive the bond, the entire gain would be classified as ordinary income. As far as I can gather, this means the profit would become subject to federal income tax at the ordinary income rate instead of being completely exempt from federal income tax.
While this rule does not apply to zero-coupon bonds, it is an important issue with low-coupon bonds. If a muni was issued with a 2% coupon but now has a 4% yield because it is as a discount, this means that the bond price will increase by 2% annualized so that it returns to par value at maturity. That 2% will be federal taxable income, and will increase the basis of the bond, so that there is no capital gain when the bond matures.
On the brokerage website, each zero-coupon bond I look at says language of the following sort:
"The municipal security you’re attempting to purchase may have a "market discount" (meaning, a purchase price that is below its stated redemption price at maturity). Municipal securities purchased at a price with a non-de minimis amount of market discount can have different tax implications (e.g., ordinary income tax rather than capital gains tax) when they are sold, redeemed, or held to maturity. The accretion of the discount associated with this municipal security will generally be taxed as ordinary income if purchased at a price at or below $41.162."

That number comes from CUSIP 65830VAR1, which is currently selling for a price of $35.322, well under the cutoff.
cas
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Re: How to avoid taxes on taxable bonds

Post by cas »

bondcurious wrote: Tue Jul 09, 2024 12:32 am
I've tried extensively to find an authoritative document that describes the tax treatment of a muni bond purchased below the de minimis cutoff whose owner passes prior to maturity. I haven't been able to find one and I'm not comfortable purchasing munis below the de minimis when I don't have clarity on the tax treatment. If anyone here can refer me to an authoritative document it would be much appreciated. And I welcome any other thoughts or suggestions on how best to help my relative with her fixed income selection.
I agree that it is very frustrating that there is no place where the IRS lays out how to deal with all the potential moving parts of a marketable bond upon death. (And this applies to marketable bonds of all sorts, not just marketable muni bonds.) My guess on why this is the case is that, in the big picture, the vast majority of marketable bonds are owned by entities that can not die (e.g. mutual funds, banks, pension funds, governments, etc.) and that - in the big picture of all the people in the US population who die in a given year - it is pretty rare for a decedent to have owned any sort of individual bond in a taxable account.

(By contrast, the IRS does have quite a lot of detailed discussion on how to handle the *non-marketable* US Savings Bonds (which *are* primarily owned by individual taxpayers who are capable of dying) when the owner dies. However, since marketable bonds and the non-marketable US Savings Bonds have significant differences and are dealt with in different parts of the tax code, there is only so far you can extrapolate from what the IRS says about US Savings Bonds.)

There have been several discussions on bogleheads over the last year from people trying to settle estates, running into this situation, and also running into the circumstance that various big brokerages seem to be flailing on figuring out the cost basis of various sorts of marketable bonds after death. However, no one in those discussions has had any particular sort of professional expertise, and we do a lot of amateur flailing around various IRS documents and regulations, so those discussions are about as far from authoritative as you can get.

However, if you want to read my personal summary of the current state of discussion, which includes some links for further reading (e.g. in IRS Publication 559 "Survivors, Executors and Administrators"), as well as links to some of the previous Bogleheads' discussions mentioned above, you can find it here: What happens to treasury notes when I die? (Yes, I realize that is about Treasuries and not muni bonds, but a lot of same concepts apply.)

One source I didn't link in that post is this one: Strategies for Minimizing the Impact of Income in Respect of a Decedent. (This is not specifically about bonds, but about the concept of "income in respect of a decedent." (IRD) And a lot of the previous bogleheads discussion is whether all those various moving parts of a marketable bond are/are not IRD. However, since you asked for authoritative sources, that is an article from a professional CPA organization that contains a lot of references to specific sections of the tax code that you can look up. (But note that the article says right up front that the situation is based on "regulations and ***commentary over the years***". It seems to be that combination of vague-ish regulation + "commentary over the years" that is leading to the "lack of authoritative source" that you have discovered.)

(I will note that Bogleheads expert poster bsteiner (estates and trusts attorney) replied to my post further down in that linked thread. His advice was that it would be necessary to go to an estates and trusts attorney (BTW, $1000/hr in my moderate cost of living area a couple of years ago) and have their specialized software value the bonds. However, I went and read the FAQ of the software he mentioned, and while it is true that that software will determine the *fair market value* (for Form 706 (Estate Tax Return) purposes) of a marketable bond, that is a different value than the stepped-up/down *cost basis* of that bond when "income in respect of a decedent" (IRD) gets involved.*** And I don't see any evidence in the available documentation/FAQ that the software gets into providing the cost basis adjusted for any IRD. Maybe it does. Maybe it doesn't.

My personal response to all this was to swear off having any individual bonds in taxable accounts for myself or elderly relatives over a certain age/state of health. I settled an estate a couple of years ago, and I know that the extra complexity is the absolute last thing that the survivors in my family will need at a trying time. (By contrast, determining the fair market value and stepped up/down cost basis of mutual fund shares after death is straightforward and simple.)
Chardo
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Re: How to avoid taxes on taxable bonds

Post by Chardo »

Aren't the periodic interest payments on a municipal bond tax-free? Isn't that the point of munis?
Chardo
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Re: How to avoid taxes on taxable bonds

Post by Chardo »

What about MYGA? Interest is tax deferred, no current taxation. Principal and interest are guaranteed, generally more than munis pay. Designated beneficiaries make estate settlement easy.
Harmanic
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Re: How to avoid taxes on taxable bonds

Post by Harmanic »

If you buy Berkshire stock, it pays no dividends and has a huge allocation to bonds. And you get a step up on death.

Technically, treasury bills, not bonds, but close enough.
The question isn't at what age I want to retire, it's at what income. | - George Foreman
rossington
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Re: How to avoid taxes on taxable bonds

Post by rossington »

bondcurious wrote: Tue Jul 09, 2024 1:17 pm
grabiner wrote: Tue Jul 09, 2024 8:08 am
bondcurious wrote: Tue Jul 09, 2024 12:32 am Here's the rub. Municipal bonds are subject to the "de minimis" rule, which dictates that if the bond price is below a certain number (the de minimis cutoff), the gains from price appreciation are classified as ordinary income instead of capital gains. If she were to buy a zero-coupon muni priced below the de minimis cutoff and outlive the bond, the entire gain would be classified as ordinary income. As far as I can gather, this means the profit would become subject to federal income tax at the ordinary income rate instead of being completely exempt from federal income tax.
While this rule does not apply to zero-coupon bonds, it is an important issue with low-coupon bonds. If a muni was issued with a 2% coupon but now has a 4% yield because it is as a discount, this means that the bond price will increase by 2% annualized so that it returns to par value at maturity. That 2% will be federal taxable income, and will increase the basis of the bond, so that there is no capital gain when the bond matures.
On the brokerage website, each zero-coupon bond I look at says language of the following sort:
"The municipal security you’re attempting to purchase may have a "market discount" (meaning, a purchase price that is below its stated redemption price at maturity). Municipal securities purchased at a price with a non-de minimis amount of market discount can have different tax implications (e.g., ordinary income tax rather than capital gains tax) when they are sold, redeemed, or held to maturity. The accretion of the discount associated with this municipal security will generally be taxed as ordinary income if purchased at a price at or below $41.162."

That number comes from CUSIP 65830VAR1, which is currently selling for a price of $35.322, well under the cutoff.
Hello OP,
This whole idea may ultimately be
to complex for all concerned now and in the future. You should check on the muni funds or treasury funds as mentioned above instead. Also VUSXX even though it is a MM fund currently pays a good rate, is @80% exempt from state tax and liquid. I don’t know much about the MYGA’s but that is something to consider also.
"Success is going from failure to failure without loss of enthusiasm." Winston Churchill.
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