While tax season may be over for the nearly 140 million Americans who filed their returns by April 15, a…
While tax season may be over for the nearly 140 million Americans who filed their returns by April 15, a proposed congressional measure addressing municipal-bond interest may put the squeeze on many individuals’ tax strategies going forward.
The House Ways and Means Committee is currently considering some 200 different measures to generate tax revenue for the federal government as part of the budget approval process. Tucked away on page 9 out of 50, there is a proposal to repeal the tax-exempt status of state and local bonds, which would retain an estimated $114 billion in tax revenue over the next 10 years.
Asset manager Nuveen pegs the federal government’s annual cost for municipals’ tax exemption at around $40 billion annually, or $400 billion over the next decade. On the flip side, if the current proposal becomes law, the Public Finance Network projects the repeal would raise borrowing costs by more than $823 billion for many state and local governments over the next 10 years. Higher borrowing costs could be passed along in the form of a tax increase of more than $6,500 per American household and business over the same time period.
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Here’s what you need to know about the move to alter municipal bonds’ tax-exempt status:
— How popular are municipal bonds?
— Why do investors like municipal bonds?
— Shifting bond strategies.
— Opposition to muni bond legislation.
— Potential grandfathering of tax-exempt status.
How Popular Are Municipal Bonds?
For context, there were more than $4.2 trillion outstanding municipal bonds in the market by the end of 2024, according to data from the Securities Industry and Financial Markets Association, or SIFMA. The Municipal Securities Rulemaking Board, or MSRB, established by Congress in 1975, estimates that individual investors are “by far the largest holders of municipal bonds, holding nearly 66% of outstanding securities, 45% directly and approximately 21% through mutual funds.”
Why Do Investors Like Municipal Bonds?
Municipal bonds appeal to many investors because of their low default rates and reliable, tax-exempt income. And nearly 50,000 state and local governments rely on bond issuances to fund projects and essential services, according to MSRB.
According to data from Moody’s Investors Service and AllianceBernstein, the 10-year cumulative default rate for investment-grade municipal bonds has been 0.1% since 1970. By comparison, investment-grade corporate bonds over that same period have had a default rate of 2.2%. The secret sauce for municipal bonds is their steady cash flow from sources that often require voters’ approval, such as tax revenue, and fees from public utilities, toll roads and airports.
Shifting Bond Strategies
Therein lies the rub: Despite municipal bonds’ popular appeal among individual investors and viability among state and local governments, the Congressional Budget Office estimates there’s a $1.9 trillion budget deficit for fiscal year 2025 that needs attention.
In a sense, this challenge is a lot like playing mahjong: The tiles keep shifting, the strategy evolves and just when you think you’ve got the perfect hand, you must adapt all over again. The key is staying calm, reading the table and knowing that even a discarded tile can lead to your next big win.
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Opposition to Muni Bond Legislation
Recently, several congressional members on both sides of the aisle have read the room and advocated to retain municipal bonds’ tax-exempt status. An April 4 letter signed by 25 members of Congress asked Jason Smith, House Ways and Means Committee chairman, to preserve the tax-exempt status of municipal bonds, with the letter noting that “(s)ince 1913, tax-exempt municipal bonds have worked to help overcome the financial shortfalls of federal infrastructure spending and to address the needs of our communities, from our largest metropolitan cities to our small rural towns across our country.” MacKay Municipal Managers, which is entrusted with about $82 billion in assets under management, estimates there is currently a $3.7 trillion deficit in America’s infrastructure investment.
Potential Grandfathering of Tax-Exempt Status
“We believe that Congress will preserve the core municipal bond exemption to avoid increasing costs for state and local governments and to preserve the benefit for retail investors,” says Frances Lewis, director of research for MacKay Municipal Managers. If the proposal somehow progresses in Congress, Lewis maintains existing municipal bonds will likely be grandfathered into legislation, which could potentially boost valuations on investors’ municipal holdings.
Benefits of Holding Muni Bonds
For now, keen investors will look to the reasons they own municipal bonds for the long run, anyway. Stability and reliable income may come to mind for many. Others might point to the projected return for municipals over the coming decade, which currently stands at 3.87%, according to Nuveen. That’s a compelling estimate for, say, a couple who file a joint tax return and have an effective tax rate of 25%; essentially, they’d need to shop for a taxable bond or certificate of deposit that would pay roughly 5.16% over the next decade to eclipse a municipal bond return of 3.87% in that time frame.
Since the Federal Reserve is inclined to lower rates, rather than raise them, in the coming years, that could benefit existing municipal-bond investors even further over time, especially if Congress either grandfathers them in any new repeal legislation or scraps the repeal altogether this year.
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Municipal Bonds’ Tax-Exempt Status at a Crossroads originally appeared on usnews.com