(Bloomberg) -- There’s an easy way to hide from high taxes in states like New York and California that doesn’t involve packing up a moving van to Florida or Texas.
US municipal bonds are offering the highest yields in more than a decade after a record-breaking selloff this year. What makes them unique relative to other fixed-income securities like Treasuries, corporate bonds or even bank certificates of deposit is they usually pay interest that’s exempt from both state and federal taxes — a perk that can make a big difference.
Interest income from most bonds and ordinary dividends from stocks are taxed at the same rate as someone’s salary. That means for every $1,000 collected, New York state residents in the highest tax bracket could end up with as little as $483 after accounting for all taxes, while those in California may be left with as little as $459. With in-state munis, none of the interest earned would be taxed.
This discrepancy typically puts a lid on muni yields. But the Federal Reserve’s aggressive rate-hike campaign to counter widespread inflation has spared no corner of the bond market, including debt issued by state and local governments. Money managers and financial advisers say with a potential downturn around the corner, now’s the time to jump into the $4 trillion market, where the overwhelming majority of securities have historically never come close to default even in the worst economic conditions.
“We think the timing is never better,” said Peter Hayes, who oversees about $176 billion of municipals at BlackRock Inc. He said it’s an opportunistic time for retail investors to start buying before the market begins to turn around once the Fed pauses its interest-rate increases.
Muni bonds, which are available to buy on brokerages like Fidelity and Schwab and are also packaged into exchange-traded funds, are yet another route for retail traders who are looking for cash-like investments to ride out the volatility in stocks and other risky assets. US Series I savings bonds have been especially popular with their record yield of 9.62%. However, that’s estimated to drop to 6.47% as of Nov. 1 and the interest is federally taxable, though it’s exempt at the state and local level.
There’s also a yearly $10,000 cap on Series I bonds, whereas there’s no limit to owning munis. They’re especially beneficial for those in the top federal income tax bracket, which is currently 37% (plus a 3.8% Medicare tax).
In an extreme example, Anna Thompson Dodge, the widow of an automobile manufacturer who died in 1970, invested her entire fortune in muni bonds. That meant she never had to pay federal income tax on the reported $1.5 million a year that she received from the investments, the New York Times said in her obituary.
Even as part of a balanced portfolio, owning munis to save on taxes is a less life-altering option than moving to states that promote their lack of income tax like Texas or Florida, which U-Haul found were the most popular destinations for movers in 2021. An analysis of 2020 IRS data by the right-leaning Tax Foundation showed that wealthy taxpayers with income above $200,000 who moved between states also favored those two early on during the pandemic.
For Californians in the highest tax bracket, tax-exempt state debt can offer taxable-equivalent yields as high as 7.5%, said Joseph Gotelli, senior portfolio manager at American Century Investments. By comparison, the average annual stock market return is about 10%, according to SoFi. And that smooths out the rough patches: The S&P 500 has fallen by 22% this year.
California voters are considering a measure, Proposition 30, this November that would levy an additional tax of 1.75% on personal income above $2 million annually. The revenue would fund electric vehicle charging stations and wildfire prevention, among other uses.
“If Prop 30 were to pass and actually be implemented into legislation, the value of the tax-exemption would certainly increase” for those affected, Gotelli said.
Regardless, the extra income offered by munis is a “silver lining” to a tough year for markets, said Kathleen McNamara, senior municipal bond strategist at UBS Global Wealth Management. Judging by inflows to exchange-traded funds tracking munis, investors are starting to take notice.
BlackRock’s iShares National Muni Bond ETF (MUB) and the Vanguard Tax-Exempt Bond ETF (VTEB) have both already broken records for most yearly inflows, with $6.6 billion and $6.9 billion added, respectively.
Gordon Achtermann, financial planner at Your Best Path Financial Planning in Virginia, recommends munis to his high net worth clients to lessen their tax burden. Instead of buying individual bonds, he likes mutual funds such as Vanguard Tax-Exempt Bond Index Fund (VTEAX) or its ETF equivalent VTEB, which are often easier to purchase through brokerage accounts.
For his clients in taxable accounts, Harris Holzberg, chief investment officer at Holzberg Wealth Management, is looking to munis with near-pristine credit ratings, preferably in the state where his investors live.
“One of the tricks of muni bonds is to buy within your own state boundaries to get the double tax-free return,” he said.
To contact the authors of this story:
Amanda Albright in New York at [email protected]
Claire Ballentine in New York at [email protected]