A major benefit of municipal bonds, or “munis,” is that the interest they pay is generally exempt from federal income taxes. They’re also generally exempt from state income taxes if the issuer is from your home state. That may seem like a compelling argument for sticking with in-state munis. However, many muni investors may benefit by diversifying outside of their home state, even if it results in a higher state tax bill.
We’ve identified five factors when it could make sense to consider munis from other states. After considering all five, we think that muni investors in all states, with the exception of two high-tax states—California or New York—could benefit from investing in a national, not state-specific, portfolio of muni bonds.
1. You live in a state with low or no state income tax.
If you live in a state with low or no state income tax, then you will likely benefit from diversifying your muni portfolio with munis from issuers outside of your home state.
The map below shows the maximum marginal income tax rate by state for married taxpayers filing jointly.
Investors in states with low or no state income tax could benefit from out-of-state munis.
Source: Tax Foundation, as of 3/5/2018. Note: The top marginal tax rate is 4.997% for Ohio and 5.499% in North Carolina. Indiana, Massachusetts, Michigan and Pennsylvania have a flat income tax. Tennessee and New Hampshire only tax interest and dividend income.
For investors in states with no state income taxes, like Florida or Texas, there’s no state tax benefit from staying within your home state. For investors in California, on the other hand, the benefit can be large because the state tax rate is the highest in the country—13.3% for the top bracket. Therefore it may make more sense if you’re in a high-income-tax state to buy bonds issued in your home state, all else being equal.
2. Federal tax reform caused your tax rate to increase.
Changes to federal taxes will have a different impact on state taxes depending on which state you are in. Some states use your federal income and federal deductions to determine your state tax, whereas other states, like California, begin with your federal income but then apply state-specific changes to arrive at your state taxable income.
However, the recently enacted federal tax reform eliminated many popular federal tax deductions and therefore has the potential to increase federal income taxes for residents of high-tax states like California and New York.
Prior to tax reform, the state and local tax deduction, commonly known as SALT, allowed taxpayers to reduce the amount of income subject to federal income taxes by the amount of state and local taxes paid. Now, filers who itemize their deductions can only deduct up to $10,000 in a combination of property tax, income tax and sales tax. Approximately one third of New York and California tax filers took the state and local tax deduction in 20151 and the average state and local tax deduction for many counties in these states was above the new $10,000 cap, as shown in the table below. Generally, the effect for some residents in these areas is that more of their income will be taxable, but at lower rates, under the new tax code. The net effect is that the amount of federal taxes they pay may increase.
The areas with the highest SALT deductions are in New York City and the San Francisco Bay area.
Source: Tax Foundation using 2014 tax data as of 4/27/2017
For investors negatively affected by federal tax reform, they may benefit by sticking to only in-state munis and saving on state taxes paid to help lower their overall tax burden.
3. You could earn a higher yield, even without state tax breaks.
Some out-of-state muni bonds offer higher yields than in-state munis, even after accounting for any state income taxes.
It depends on where you look, though. The table below shows the yield investors in certain states would have to earn on out-of-state munis compared with the yield on an index of munis from their home state to make up for the lack of state income tax breaks. This assumes the investors are in their home states’ highest marginal state tax bracket. The difference in yield is expressed in basis points (hundredths of a percentage point). Note that Florida, Texas and Washington don’t have state income taxes, so there’s no spread.
Investors in various states would have to earn higher yields on out-of-state munis to make up for a lack of state income tax breaks.
Source: Bloomberg, as of April 27, 2018 and the Tax Foundation for state tax rates, as of March 5, 2018. States selected at the top 10 based on market value in the Bloomberg Barclays Municipal Bond Index. Difference in yields may be due to different credit qualities, call features, or other factors.
For example, the yield on an index of 10-year California general obligation bonds is currently is 2.66%. A married couple in the highest marginal state tax bracket (which, in California, is 13.3%) would have to earn a yield of at least 3.07%—or 41 basis points more—on a bond from outside of California to achieve the same after-tax yield as the in-state bond. It may be possible to achieve this higher yield if you invest in a bond from a state like Illinois, New Jersey or Pennsylvania, for example. Of course, higher yields generally also mean higher risks, so investors should keep that in mind.
4. Economic conditions in your home state are deteriorating.
The muni market is large, with many issuers—there are approximately $3.6 trillion of muni bonds outstanding,2 with roughly 11,300 different issuers rated by Moody’s Investors Service3—and the credit quality of each state and issuer are affected by different economic conditions or sources of revenue. Although historically it’s been rare for municipalities to not pay interest or principal payments on time, it does occasionally occur. If the conditions in your home state, or regions of your home state, aren’t favorable, other states’ bonds might be more appealing. Investors in Illinois, for example, should consider diversifying outside of Illinois because of the state’s deteriorating financial condition and also because most Illinois municipal bonds are subject to Illinois state income taxes.
It may also make sense for investors living in states where municipalities share similar political, geographic and economic risks to diversify into other states to reduce these risks. Credit quality is generally stronger in areas with steadily increasing populations, skilled workforces and diverse economies.
5. You live in a state with few choices.
We recommend holding at least 10 different bonds from issuers with dissimilar credit characteristics, to create sufficient diversification in a portfolio of individual bonds. This could be difficult if your home state has a relatively small number of issuers with similar risks, but easier to achieve in a larger states such as California, New York and Texas with many issuers. In fact, bonds from California, New York, and Texas account for approximately 40% of all issuers in the Bloomberg Barclays Municipal Bond Index.4 But in-state diversification is difficult for smaller states—as the chart shows, many states have fewer than 100 issuers.
The number of Moody’s-rated issuers by state
Source: Moody’s as of 3/12/18
Summing it all up
Considering all five factors, we generally suggest investors in all states other than New York and California consider munis outside of their home state. Investors in higher tax brackets in California and New York may benefit by investing in an all in-state portfolio because of high state income tax rates and access to many different issuers with different credit risks.
Although there are many different highly rated issuers in Texas, for example, investors don’t benefit by sticking to only bonds issued by issuers in Texas because the state does not have a state income tax.
As always, your individual situation may vary. So choose a single-state muni or nationally diversified portfolio of munis based on your needs and situation. For additional help in selecting an appropriate solution for your needs, contact your local Schwab fixed income representative.
1 Source: Tax Policy Center, as of 10/12/2017
2 Source: Bloomberg, as of 4/27/2018
3 Source: Moody’s as of 3/12/2018
4 Source: Bloomberg Barclays, as of 4/27/2018