What do municipal bonds and 529 plans have in common?

The Supreme Court is considering an appeal to Kentucky versus Davis, a lawsuit that could have an impact on the state tax treatment of both municipal bonds and some state 529 plans.

As described in this article from the Wall Street Journal (also available here as an excerpt from the Albany Times Union, if you don’t have access to the WSJ site), the case is a lawsuit in which the plaintiffs argued that it is unlawful for a state to provide a tax exemption for its own bonds while not providing the same exemption for out-of-state municipal bonds.  Kentucky’s Supreme Court let stand a ruling which said that giving different tax treatment to out-of-state bonds is a violation of the Constitution.  A ruling from the US Supreme Court is expected sometime this summer.

Current speculation leans toward expecting that the court will overrule Kentucky’s court, or at least that is what bond fund managers are hoping.  A change in the tax treatment of these bonds would undoubtedly roil the muni bond market for a while before things settled down.  There’s also speculation that given the current unease about disruptions in the financial markets and their effect on the economy, if the Court were to uphold the decision, Congress would step in to prevent a fresh upheaval.

If the rules were to change, there are two possible scenarios.  On the one hand, states could decide to exempt all municipal bonds, including those from other states; on the other, they could eliminate the exemption entirely.  One could imagine that if the law did change, different states might respond differently, and this would add to the confusion.

If a state eliminated the exemption for all municipal bonds, the probable effect would be that its municipalities would have to pay higher interest rates in order to attract investors to buy their bonds.  Presumably the federal tax exemption for many municipal bonds would remain, so the rates would not need to increase all the way up to the level of corporate bond yields.  Still, state bonds would move closer in character to corporate bonds, where yields are taxed at both the state and federal levels.  This seems unlikely, as increasing the borrowing costs of cities, towns and municipal agencies would be a politically unpopular move for any state legislature.

Alternatively, if a state were to exempt all municipal bonds from state taxation, this would keep existing holders of its bonds happy but would also eliminate the “home-court” advantage that state municipal bonds presently have.  Presently, one state need not offer as high an interest rate as another because the state tax breaks favor in-state bond investments.  If multiple states responded differently to a change in the rules, this would really alter the muni market.  If all (or the vast majority of) states responded by exempting the interest on all municipal bonds, muni bond investors might have the best of all possible worlds; such a situation would put the states in competition with each other for the attraction of bond investments.  One can also imagine some states being issuers of high-quality, low-interest-rate bonds, while less creditworthy states find that their debt has become the municipal equivalent of junk bonds.

For people who currently have a large chunk of their invested funds in muni bonds in order to avoid income taxation altogether (this is a strategy sometimes used by individuals in high tax brackets who want current income from their investments), the elimination of state tax breaks for muni bond income would be an annoyance, at a minimum.  Managers of single-state muni bond funds could also be greatly affected.  Managers of multi-state funds would be less troubled, as investors in these funds are necessarily not so sensitive to state tax breaks, but the makeup of these funds could shift significantly if states responded differently to a change in the law.

The reason that Kentucky versus Davis might have an impact on state 529 plans (if the Kentucky Supreme Court’s ruling were upheld) is that several states now offer preferential tax treatment for contributions made by in-state residents to their own state’s 529 plan.  If the Court rules that states cannot give preferential tax treatment to its own obligations, it’s likely that this would also be applied to preferential tax treatment for 529 plan contributions.

A change in the rules would require states to reassess their tax laws: do they give tax breaks to all 529 plan contributions, or to none?  State legislatures would be forced to choose between giving up revenue and supporting the higher education of its citizens generally (without being able to simultaneously favor in-state plans) versus keeping the income tax revenue that would be lost by continuing the tax incentives.  Since special treatment for in-state plan contributions is not given by all states currently, a change in this area would almost certainly produce varied responses.  States that don’t currently offer a tax break would probably do nothing (especially since many states already find their budgets squeezed).  States that currently provide favorable treatment for in-state plans would have little incentive to expand those tax breaks to out-of-state plans and probably many of them would simply permit the breaks to be overturned.

All of this, of course, is sheer speculation, as the US Supreme Court has not yet ruled on Kentucky versus Davis.  But it’s a good idea for municipal bond investors and owners of 529 plans to at least consider how their strategies would be affected by a change in the current law in case it comes to pass.  If there is a change as a result of this case, we can certainly expect dislocations for a time in the municipal bond markets, unless Congress manages to move surprisingly quickly in response to such a ruling.  Confused markets present opportunities for those who can see through the confusion.

The simplest outcome would be for the court to reverse the Kentucky ruling, which is why muni bond managers are hoping for a reversal.  Time will tell.

About the author

Thomas Fisher, CFP®

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