Some of the effects of the recent tax reform remain to be seen. However, one thing is for sure. It has generated a lot of volatility in the municipal bond market (munis). Consider this – December 2017 saw the greatest issuance of municipal bonds in history, while January 2018 was the worst January since 1981 for the municipal bond market. It remains to be seen whether the tax reform will have an overall positive or negative effect.
Municipal bonds have traditionally attracted investors looking for stability; they yield a fixed rate of return, and interest income from munis is typically tax-exempt. When compared with other taxable investments, such as Treasuries, the overall yield (because there are no taxes) can be higher for a municipal bond. For example, assuming April 2018 rates, a $1 million investment in munis would return $24,000 in one year. At the same time, a $1 million investment in Treasuries (assuming a 37% income tax bracket) would return only $18,270.
While munis may be exempt from taxes, they are not exempt from risks. These risks can include:
- Interest rate risks: If interest rates continue to go up (as the FED has promised in 2018 with plans to continue to raise rates in 2020), the value of bonds will decrease; with the most pronounced effect on bonds with a longer term maturity.
- Domicile risks: If you move to a different state, you may owe income taxes on the municipal bonds you hold from your (now out-of-state) bonds. However, selling your bonds means incurring transaction costs.
- Liquidity risks: You may find that if you want to get out of your bond, market conditions have shifted. Munis could be less attractive, or investors may simply not be selling. On top of that, the tax reform limited issuers’ ability to refinance bonds (ie. buy back bonds to take advantage of lower interest rates), which may eventually reduce the supply of municipal bonds. The result may be an inability for you to buy or sell bonds at your preferred price and timing.
- Retirement risk: If your tax bracket drops in retirement, municipal bonds may lose some of their tax-exempt appeal. More importantly, interest from municipal bonds contributes to your taxable ‘provisional income’ in retirement. If your provisional income is greater than $44K (for joint filers), then up to 85% of your your social security benefits could be taxed.
- Estate tax risk: If you make it through the municipal bond maze, and manage to hold onto your bonds until death, they become subject to estate taxes. Assuming you die after 2026, the estate exemption limit will be around $11 million (for couples). If your estate exceeds the exemption limit, a $1 million municipal bond could taxed at 40%, cutting the investment down to a disappointing $600,000 for your loved ones.
A Better Way
May we suggest another way to preserve your wealth, avoid the municipal bond market risks, and pivot around estate taxes? Instead of buying munis, you could use the same money to buy an immediate annuity.
Case in Point
Let’s use the same example of $1 million invested in municipal bonds. Your annual return would be $24,000, and for a large estate, the $1 million would be reduced to $600,000 (as we stated above) for your heirs.
Compare that to investing the $1 million in an immediate annuity. Depending on your age (the older you are the more you get), your income could be more like $50,000 per year. For this to make sense, you would then create in irrevocable trust within which to buy an insurance policy (thus removing it from your taxable estate and ensuring that your heirs receive the benefits free of estate taxes). This is because unless you make special arrangements, an immediate annuity dies when you do; no estate, no return of your principal, nothing. It’s over. You need the life insurance policy to take care of ensuring your wealth can also be transferred to the next generation. However, you have some options as to how to accomplish this.
Scenario 1: You take the funds from the immediate annuity. You choose to live off of $37,000 per year, and invest the remaining $13,000 in a $600,000 life insurance policy. This allows you to receive more income (vs. the muni) in your lifetime, and your children still receive the same inheritance.
Scenario 2: You take the immediate annuity, but choose to live off of less and invest the remainder in a bigger life insurance policy. If you receive an annual payout of $24,000 (the same amount that you would have gotten from munis), your children could then receive a $1 million death benefit, almost double what they would have gotten had you left the money in a municipal bond.
In either scenario, you disinherit the IRS and increase your wealth!
The team at Axia Global has the estate planning experience to provide valuable insight, ideas and solutions to you or your affluent clients. It is our goal to make a measurable difference in your financial life. Give us a call today at 626-795-9590.
Note: the statements above should not be considered financial, legal or tax advice, but ideas for careful consideration with your trusted financial advisors and lawyers. For current tax or legal advice, please consult with an accountant or an attorney.
About Axia Global
For decades, Michael Roney – Founder of Axia Global, has worked alongside top financial and legal professionals to craft profitable solutions for even the most complex wealth preservation and estate planning cases. Together, the team at Axia Global has nearly a century years of combined experience in the financial services sector.