In the end, the American Taxpayer Relief Act did not eliminate the tax exemption for municipal bonds or modify it any way. In fact, the increase in the top marginal tax rate makes muni bonds more attractive versus taxable bonds. And the Medicare surtax on investment income, enacted in 2010 but effective in 2013, makes muni bonds more attractive still.
The only negative for municipals in the Act was the reinstatement of the so-called Pease limitation on itemized deductions, which in many cases will reduce the federal tax savings from deducting state taxes on out-of-state muni bond income.
The Pease limitation was created in 1990 but eliminated between 2010 and 2012. It does not affect the attractiveness of municipal bonds for taxpayers subject to the Alternative Minimum Tax, since the AMT itself takes away their ability to deduct state and local taxes.
The Pease limitation reduces most itemized deductions by 3% of the amount by which adjusted gross income (AGI) exceeds $300,000 for married couples and $250,000 for single taxpayers. There is a maximum reduction to itemized deductions of 80%.
For most taxpayers with itemized deductions, this represents an income tax surcharge equal to 3% of the taxpayer’s marginal tax rate. Thus, the effective tax rate increase for a taxpayer in the top tax bracket of 44.3% (the 39.6% top rate plus the 3.8% Medicare surtax on investment income and the 0.9% Medicare surtax on wages and self-employment income) would be about 1.3%.
While municipal bonds escaped the threat of taxation during this round of tax and budget negotiations, the issue will likely be resurrected when Congress moves to further reduce the federal budget deficit. While the tax law changes that went into effect in 2013 make municipals more attractive to investors, we expect the market impact to be limited until it becomes clearer what Congress will ultimately decide about the municipal bond exemption.
We believe taxing municipal bond income would be unwise. In our view, the municipal tax exemption is the most cost-effective, easy-to-implement way to subsidize infrastructure spending.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Michael Brooks is a Senior Portfolio Manager, Municipal Investments, at AllianceBernstein.