The tax code might change, but not the role of muni bonds

A general election without a debate about taxes has yet to materialize. But the results of this year could lead to a significant change for individuals. The Tax Cut and Jobs Act (TCJA), which went into effect in 2018, cut the tax bill for most individual taxpayers by reducing rates and adjusting the thresholds for various tax brackets. Notably, the highest bracket was reduced from 39.6% to 37%. The Act also altered deductions, credits and the reach of the Alternative Minimum Tax.

But the TCJA is set to expire on Dec. 31, 2025. It could be extended, modified or simply allowed to sunset. Which path it follows will be largely determined by the results of November's general election. It stands the best chance of extension if the Republicans take the presidency and both houses of Congress. If the Democrats sweep, it likely will either lapse or survive in diminished form. Under a split government, its future will depend upon the parties' ability to negotiate. If they cannot successfully come to an agreement-and that is an iffy proposition-the Act will almost certainly lapse, leading to many implications for municipal bond investors.

For one, the exemption of income and total return of most muni bonds from federal taxations would become more valuable as tax rates increase. Under current conditions, investors in the 37% marginal bracket get the same return from a municipal bond earning 3.15% as the after-tax equivalent of a taxable bond earning 5%. If that bracket reverted to 39.6%, the muni security would need to earn only 3.02%. (Neither capital gains nor corporate tax rates would be affected.)

But because some municipal bonds are subject to the Alternative Minimum Tax (AMT), the expiration of the TCJA could be costly to many taxpayers. At present, about 200,000 meet the criteria for the AMT, but as many as 7 million could join them. These taxpayers would be more likely to invest in municipal bonds, so AMT muni bonds could fall out of favor in a post-TCJA environment. But AMT bonds make up only about 5% of the muni universe, so the impact would not be widespread despite spreads widening this year as a reflection of the heightened risk.

Another key provision of the TCJA is the cap on the deduction of state and local taxes (SALT) at $10,000 for both single filers and married couples. This made in-state municipal bonds more attractive in high-tax states, as some investors shifted allocations to avoid paying no-longer-deductible state taxes on investments. Expiration of the cap may have a small positive effect on state and local credit, however. If SALT once again become fully deductible, states and local governments might face less resistance from constituents when they seek to raise taxes. Key word here is "might."

What about the coming Federal Reserve easing cycle? While it certainly can affect fixed-income returns, it does not have much bearing on the tax advantage of municipal bonds.

All of this might seem like a distant issue, but investors should consider-even prepare for-potential changes to the tax code.