If you are concerned about the potential for negative effects of health care reform – higher interest rates, inflation, regulatory costs, higher tax burden, it will mostly likely hurt the stock market. As such, a potential beneficiary of reform may be tax-free municipal bonds.
TAX BURDEN WILL INCREASE
Upper-income individuals face significantly higher tax rates in the coming years, including new levies on unearned income from interest, dividends and capital gains to help pay for health care reform. Beginning in 2013, individuals earning more than $200,000 and couples earning more than $250,000 will pay the 3.8% Medicare tax on investment income. That would be on top of the rate increases slated to take effect next year with the phase-out of the Bush tax cuts. The top bracket on ordinary income will rise to 39.6% from the current 35%. Dividends, which have enjoyed a top tax rate of just 15%, would revert to being taxed as ordinary income. The capital-gains tax rate, also 15% currently, will rise to 20%.
Ultimately, what this means is that with a 39.6% top tax bracket and the 3.8% Medicare tax, the top-bracket investors will be paying a rate on interest income of 43.4%, or nearly 25% more than the current 35% rate. Upper-income investors will face a 23.8% tax rate on dividends and capital gains starting 2013, versus 15% currently. That will result in a 59% tax hike on these forms of investment income for those in the top brackets. For an investor taxed at the top rate of 43.4%, slated to take effect in 2013, a 5% long-term, tax-free municipal bond will be equivalent to earning 8.8% on a taxable debt security.
OPPORTUNITY AMONG THE OBSTACLES
From a taxpayer standpoint, the picture may not be ideal. However, as an investor, the changing tax climate provides opportunity. Even now, before the tax increases are instituted, tax-free municipals are priced attractively, offering compelling yields versus their taxable counterparts, particularly further out on the yield curve. For this reason, investors have been active buyers in the past year or so. Clearly, rising tax rates provide yet another incentive for tax-free buyers, as holders of tax-free municipals will likely be rewarded in principal appreciation as the demand for tax-free bonds increase.