Bond Investing - Tax-Efficient Bond Investing for High-Net-Worth Individuals

Plante Moran writes: ​Investing in bonds has produced some nerve-racking moments over the past several years because of global financial crises and other macroeconomic events. Monetary policies used by central banks around the world to maintain low interest rates have led many experts to forecast tepid returns for many types of bonds over the next few years. Couple this potentially low-return environment with 2013 tax rate increases, and it quickly becomes apparent that maximizing the after-tax yield of one’s bond holdings will require diligence and an understanding of the impact that taxes can have on bond returns.

While bonds come in all shapes and sizes, they can generally be grouped into one of two tax classifications: tax-exempt and taxable. Tax-exempt bonds are obligations of state or local governments, the District of Columbia, and any possession of the United States. Interest payments on these bonds are excluded from a taxpayer’s federal gross income and typically offer lower yields than their taxable counterparts. On an after-tax basis, these bonds can be an attractive option for investors.

For example, a taxpayer in the 39.6% federal tax bracket has the option of purchasing two bonds with identical maturities. One is a taxable bond yielding 4%, while the second is a tax-exempt bond yielding 3%. Based on the information provided, the tax-exempt bond has a greater after-tax yield (3%) than the taxable bond alternative (4% - (4% × 39.6%), or 2.416%).

It would seem on the surface that comparing the after-tax yields of taxable versus tax-exempt bonds would be a fairly straightforward algebraic exercise … but is it? Consider this sample of complicating tax considerations:

• State taxes. Tax-exempt bond interest may escape federal income tax, but many states that assess an income tax require residents to include interest from most tax-exempt bonds in their state gross income. Further complicating matters is that many U.S. bonds, such as Treasury and savings bonds, are exempt from state income taxes but not federal income taxes.
• Alternative Minimum Tax (AMT). Certain tax-exempt bonds, such as private activity bonds (PABs), aren’t exempt from the AMT. If the AMT is an issue, PABs may not be a tax-efficient avenue to pursue.
• Pease limitation and personal exemption phaseouts. These tax traps limit the deductions and exemptions that high-income taxpayers may claim on their federal income tax returns. Some states have their own versions of these limitations. Investing in taxable bonds increases the likelihood that these limitations will apply.
• Net Investment Income Tax (NIIT). This is an additional 3.8% federal tax on certain investment income of high-income taxpayers. Interest from taxable bonds is considered investment income for NIIT purposes, while tax-exempt bond interest is not.

As with many personal finance matters, evaluating the tax and non-tax aspects of bond investing can be more nuanced than it initially appears.