Tax season is upon us. Many Americans across the country are preparing their income tax returns to help fund the government’s operations. While taxes are a necessary evil, Americans are always looking for ways to reduce their total tax liability. Tax rates are near historic lows, and from a long term perspective, the risk of them going higher certainly exists. Given the tax exempt nature of municipal bonds, making them part of your portfolio will help reduce your total tax liability in comparison to taxable securities.
Government spending is not going anywhere. Looking at the top three line items at the federal level, the U.S. is financing wars, healthcare expenses are spinning out of control, and social services liabilities are only likely to increase. Military spending is too popular, overhauling healthcare has not been successful enough, and too many Americans are dependent on social services. These budget gaps need to be corrected to balance the budget. Without significant reductions to these programs, the probability of an increase in taxes is among the more feasible ways to balance the budget once the economy becomes healthier.
California is in a similar situation. The top expenses of the state include K-12 education, higher education, social services, and corrections and rehabilitation. While reform is possible to make each of these expenses more efficient and more productive, reductions have faced strong opposition. Cuts are being made, and Governor Jerry Brown has threatened further cuts to California’s education system if the temporary state income tax increases are not extended. With California’s appetite for government services, higher taxes could be looming in the future.
Whether taxes stay the same, increase, or decrease, the value of a tax-free fixed income investment is determined by calculating the tax-equivalent yield (TEY). TEY defines what yield would be required in a taxable security to obtain the same after-tax return of a tax-free security. TEY is determined by the following formula:
Under today’s tax formula, a Californian in the top tax bracket is subject to a 35% federal income tax rate and a 9.55% state income tax rate. Using those assumptions, if a Californian in the top tax bracket buys a tax-free California municipal bond yielding 5%, the TEY of the bond would be 9.02%! That means the investor would need to find a fixed income security of similar credit quality yielding 9.02% to have the same after tax yield. Now imagine if income tax rates were to return to 1980 levels, with the top federal income tax rate at 70% and the top state income tax rate at 10.3%, according to The Tax Foundation. The same investor buying the same security yielding 5% would realize a TEY of 25.38%! While taxes are not likely to return to those levels, municipal bonds provide very strong TEYs!
Trying to project the direction of tax rates is merely speculation, but understanding the value of tax-free income is essential. If taxes increase, tax-free income becomes more valuable. In the current municipal bond environment, many municipal bonds continue to trade at higher yields than comparably rated taxable Treasury bonds. As long as that anomaly exists, municipal bonds present an excellent value for a wider array of investors, including lower tax bracket investors. States are not permitted to run the deficits that the federal government currently runs, and municipal bonds often have specific streams of revenue securing them. If you want to earn tax-free income, contact your Alamo Capital representative today.
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This report is prepared for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument or service. Market prices and other data may be obtained from outside sources and is not warranted as to completeness or accuracy. Any comments, statements and/or recommendations made herein are subject to change without notice, and may not necessarily reflect those of Alamo Capital. Alamo Capital has no affiliation with any political party. Investing involves risk. Consult with a Financial Professional for additional information to determine the suitability of this or any other financial product or issue as it relates to your particular situation.