Municipal Bond Swap in a High-Tax Bracket
Robert and Linda, married filing jointly, have $420,000 of taxable income, placing them in the 32% federal bracket and a 6.5% state bracket. They are 67 and 65 and want income from $600,000 of cash from a maturing CD. Their adviser proposes an in-state municipal bond fund with a 3.10% SEC yield, average duration of 7.2 years, and 4.5% annual turnover. The fund holds 12% private activity bonds subject to the alternative minimum tax (AMT). Their CPA says they paid AMT two years ago but is unsure about this year. The alternative is a corporate bond fund yielding 5.40% with a duration of 6.8 years. Both funds have similar credit quality (AA average). Robert and Linda want to minimize taxes but also need reliable income. They have no other municipal holdings and a $1.2 million portfolio.
1. Calculate the tax-equivalent yield of the municipal fund and the after-tax yield of the corporate fund. Which is superior on a pure after-tax yield basis?
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Combined marginal rate = 32% federal + 6.5% state = 38.5%. TEY of muni = 3.10% / (1 - 0.385) = 3.10 / 0.615 = 5.04%. After-tax yield of corporate = 5.40% x (1 - 0.385) = 3.32%. The corporate fund's after-tax yield exceeds the muni's 3.10% by 22 bp. The break-even tax rate is 1 - (3.10/5.40) = 42.6%; the clients are below that. So on pure yield, corporate wins. The state tax exemption is already included in the calculation; AMT could reduce the muni yield further, making corporate even more attractive. The recommendation should not be muni solely for tax reasons unless the CPA confirms a higher marginal rate or AMT is not an issue.
2. Evaluate the AMT exposure and suitability of the muni fund. What additional information or adjustments would you require?
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AMT is a parallel tax system; private activity bond interest is added back to AMT income. If the clients paid AMT two years ago, they may again. The fund's 12% AMT exposure means 12% of the 3.10% yield, or 0.372%, could be taxable at 26-28% if AMT applies. That reduces the muni's effective yield by roughly 0.10%. I would request the CPA's AMT projection for the current year before recommending the fund. If AMT is likely, either avoid the fund or use a non-AMT municipal fund. Also check the fund's expense ratio and turnover: 4.5% turnover is low, so tax efficiency is decent. Suitability also depends on credit quality and duration; AA average is fine, but a 7.2-year duration means price risk if rates rise. Given they need income and are retired, a ladder of individual munis or a shorter-duration fund may be better than a 7.2-year fund.
3. Discuss the duration and credit risk trade-off between the two funds and recommend an allocation.
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The muni fund has 7.2-year duration vs 6.8 for corporate; a 100 bp rise would cost about 7.2% vs 6.8% in price, so the muni has slightly more rate risk. Credit quality is similar at AA, but municipal credit can be idiosyncratic (e.g., pension liabilities, revenue bonds). The corporate fund may have call risk and sector concentration. For a $600,000 income allocation, I would not put all in either. A blend, say 50% corporate and 50% non-AMT muni, diversifies tax and credit exposures. But the yield math favors corporate, so a 60/40 corporate/muni split may be reasonable. Reassess after the CPA's AMT determination. Also consider a municipal ladder if they want held-to-maturity income and lower fund fees.