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In my years managing fixed income portfolios and working with financial advisors across the country, I have had the same conversation many times.
Consider an advisor in California, the kind I have met many of, managing a meaningful fixed income allocation for a high-net-worth client in the 37% bracket. The client holds a nationally diversified municipal bond ETF. The advisor presents the position in the annual review as tax-efficient income.
The client nods. Everyone moves on. Nobody has checked whether that income is actually tax-free.
Here is the problem. Municipal bond income is exempt from federal income tax under IRC Section 103(a). That part is true. But for clients in California, New York, New Jersey, Connecticut, or Massachusetts, the story does not end at the federal level. Most national muni bond funds hold bonds issued by municipalities across the country. Under the tax laws of most states, income from out-of-state bonds is not exempt from state and local taxes. The fund discloses this — in a state-by-state income breakdown buried in the annual report. Almost nobody reads it at the client level. Almost nobody adjusts the tax-equivalent yield calculation to account for it.
For that advisor's client in California, a fund with a stated yield of 4.52% produces a federal-level tax-equivalent yield of 7.17%. That is the number in the client's report. But once you factor in California's 9.3% state income tax applying to the out-of-state portion of the fund's income, the real number is lower. The client is not getting the full tax advantage they believe they are getting. They have never been told otherwise.
The Solution
I do not say this to criticize advisors. The assumption that muni equals tax-free is deeply embedded in how the asset class gets discussed and presented. But for high-net-worth clients in high-tax states, the gap between partially exempt and fully exempt is material enough to be worth a conversation.
At a 50% combined marginal rate, 200 basis points of after-tax yield difference on a $1million position is $20,000 a year. That compounds. Over time, it matters.
The question I always get asked at that point is: Is there a way to eliminate the state tax entirely? The answer is yes, and it has been federal law since 1917.
Under 48 U.S.C. Section 745, the statute reads in full:
All bonds issued by the Government of Puerto Rico, or by its authority, shall be exempt from taxation by the Government of the United States, or by the Government of Puerto Rico or of any political or municipal subdivision thereof, or by any State, Territory, or possession, or by any county, municipality, or other municipal subdivision of any State, Territory, or possession of the United States, or by the District of Columbia.
48 U.S.C. § 745. (1917, March 2). Tax exempt bonds. United States Code, Title 48, Chapter 4. https://www.law.cornell.edu/uscode/text/48/745
Every word in that statute matters. Not some states. Not residents of Puerto Rico. Any State. Any county. Any municipality. Every U.S. investor, regardless of where they live, is fully exempt at every level of taxation on income from bonds issued by the Government of Puerto Rico. Federal, state and local. No exceptions written into the statute. No residency requirement.
This is not a planning technique or an aggressive structure. It is a statutory exemption that has been on the books for over a century and has been consistently upheld.
For comparison, a California resident holding California municipal bonds pays no California state tax on that income. But a California resident holding New York municipal bonds does pay California state tax on that income. Bonds issued under 48 U.S.C. Section 745 are the only category that eliminates state and local taxation for every investor in every state simultaneously. No other municipal bond structure does that.
The audit I would encourage every advisor to run before the next client review in a high-tax state takes less than one hour. Pull the fund's most recent annual report and find the state-by-state income breakdown. It shows what percentage of the fund's distributions came from bonds issued in each state. Apply the client's actual combined marginal rate, not just the federal rate, to the portion that is subject to state tax. Then compare what you have been presenting with what the position is actually worth to that client on an after-tax basis.
In my experience, for most high-net-worth clients in California, New York, New Jersey, Connecticut, and Massachusetts holding nationally diversified muni bond funds, that number is lower than what appears in the review — sometimes meaningfully lower. And when you show the client the corrected number, and then show them what full triple exemption would look like at their combined rate, the conversation changes.
It is not a difficult conversation. It is just one that almost never gets started.
Ignacio Canto, CFA is the president, founder, and portfolio manager of X-Square Capital, an investment management firm based in Puerto Rico. X-Square Capital manages ZTAX (NYSE Arca: ZTAX), a municipal income ETF. This article is for educational purposes only and does not constitute investment advice. Individual tax situations vary. Investors should consult a qualified tax advisor. [email protected]
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.