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Should I Sell My Out-of-State Muni Bonds?

A reader writes in, asking:

“After retiring, my husband and I moved to a less expensive part of the country. But our portfolio still includes municipal bonds from the state we used to live in. I understand that we will now have to pay state income taxes on the interest from these out of state bonds. We’re in the 25% tax bracket. Would you suggest holding the bonds or selling them?”

There’s nothing necessarily bad about owning municipal bonds from another state. In fact, for many investors, it makes perfect sense to own a portfolio of muni bonds from around the country for diversification’s sake.

So the question here is primarily about whether or not the tax savings from switching to in-state bonds would outweigh the costs of making the switch. A few of the factors that would impact the decision would include:

  • Does the state in which you currently live exempt in-state municipal bonds from state income taxes?
  • What is your marginal tax rate for state income taxes (that is, what state income tax bracket are you in)?
  • Are the municipal bonds you currently own held individually, or is it a state-specific muni bond fund that you own?
  • How does your cost basis in the bonds (or bond fund) compare to their current market value?

How Much Savings Could You Achieve By Switching?

If you current state of residence does not exempt in-state bonds from state income taxes, there’s no tax savings to be had from selling the bonds and buying new ones. (That said, depending on the cost of switching, it might make sense to do so simply to get some additional diversification among borrowers.)

Assuming that in-state bonds are exempt from state income taxes, the amount of savings per year is going to be the difference between the after-tax yield on your current bonds and the after-tax yield on in state-bonds of a similar duration and credit quality. Naturally, the higher your state income tax rate, the greater the annual savings from switching.

If the currently-owned bonds are individual bonds, switching to in-state bonds would only result in tax savings for the years between now and the time the currently-held bonds would mature. In contrast, if it’s a bond fund that you own, it will never mature (because the fund will continue to buy more bonds over time), and the savings would be for an indefinite period.

What is the Cost of Switching?

The costs of switching from out-of-state bonds to in-state bonds would consist of:

  • Capital gains taxes (if any), and
  • Brokerage-related costs.

The lower your cost basis in the bonds relative to the bonds’ current market value, and the higher your tax rate on capital gains, the more expensive it would be to sell your existing bond holdings, making it less likely to make sense to switch.

With regard to brokerage costs, in addition to considering any commissions you would have to pay to sell your current bonds or bond fund, you would want to consider the cost of buying new bonds. For example, if there is no low-cost bond fund that owns bonds from your current state of residence, you would have to put together a portfolio on your own, which is more work and sometimes more costly due to having to pay high markups on the bonds.

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