Changes in tax rates, tax reform, tax exemptions, etc. are ever-present conversations in the news these days. The consensus appears that some type of tax reform for both individuals and corporations is on the table. Municipal bonds are a big draw for investors looking for income exempt from federal taxes and your tax-free investor clients may be worried about the impact cuts may have on their tax-free income.
Many investors fear that muni bonds will lose value if income tax rates are reduced. The belief is that reduced tax rates will lower the attractiveness and thus the demand for tax-exempt bonds.
We’ve put together a list of reasons why your clients might want to keep calm and carry on with their tax-free allocations. There is no correlation between municipal bond prices and changes in income tax rates. If tax rates for individuals drop by several percentage points, as proposed by the Trump administration, municipal bonds will not necessarily cheapen relative to corporate and treasury bonds.
Many municipal investors are not in the highest marginal tax bracket. The average tax rate of holders of municipal bonds is in the 25%-28% range – much lower than the highest tax bracket at 39.6%. The current proposal to lower the highest rate to 33% may cause some adjustment in muni pricing; however, many investors will continue to reap the after-tax benefit over taxable bonds.
Lowering the corporate tax rate could have an impact on demand for munis. However, corporations, like banks and insurance companies, only own about 20%-25% of municipal bonds.
Better conversations. Better outcomes.
Helping you engage in better conversations that drive better outcomes is at the very heart of who we are at BMO Global Asset Management. We help you tackle the tough tax reform questions as part of our Better conversations. Better outcomes. podcast series.
To help your clients determine the impact of any reductions in income tax rates, calculate the tax equivalent yield to show the tax-adjusted returns on their muni bonds. The formula for the calculation is:
Tax free yield ÷ (1 – tax rate) = Tax equivalent yield
Here’s an example of using the formula — for a client with a tax rate of 25%, we want to know the taxable equivalent yield of a municipal bond paying 3%:
With this example, your client would need a taxable bond with a yield of 4% to get the same return as a muni bond.
For more information and a cheat sheet of taxable equivalent yields, download the full PDF below.