Tax-free municipal bonds recorded a good year (in our opinion) in 2012, despite policy uncertainty and concerns about the financial stability of municipalities. Demand for the bonds was strong, in part due to improvement in state and local government finances and the perception that taxes would be going up. The President’s reelection last November increased demand, as concern rose that taxes would likely be hiked in 2013. Prices on municipal bonds rose immediately after election day. The American Taxpayer Relief Act of 2012 was approved on January 1st as part of a deal to fix the fiscal cliff. Unfortunately, the future of the tax exemption for municipal bonds was not addressed. Will municipal bonds continue to perform well in 2013?
The President recently announced his 2014 budget, calling for a balance of spending cuts and increased revenue to reduce the deficit. The proposal calls for eliminating tax loopholes and some popular deductions to increase revenue. One popular deduction is the tax break America’s highest earners now receive from municipal bonds. President Obama has advanced the idea twice, first in a jobs bill in 2011 and again in his 2013 budget proposal. Could the third time be a charm?
The National Commission on Fiscal Responsibility and Reform suggested taxing all municipal bond interest. Other experts have proposed taking the exemption away from new municipal bonds or capping the amount of tax-exempt bonds issued each year. President Obama’s proposal would not “grandfather” existing bonds, but would apply to all of the $3.7 trillion worth of municipal bonds outstanding. Households with incomes over a certain threshold would only be allowed to reduce their tax liabilities to 28 percent of income, from the current 39.6%. Tax-exempt interest payments on municipal bonds would be part of the limitation.
Tax-free municipal bonds may still be a valuable part of an overall tax strategy, but the role they play could be limited. Tax policy seems to constantly be changing, and your strategy will likely need to change with it.