June 9, 2011

Indiana to Tax Out of State Municipal Bonds Beginning in 2012

On May 10th, 2011, Indiana Governor, Mitch Daniels signed two tax bills, one bill includes a provision to tax municipal bond interest from bonds issued from states other than Indiana.

Ind. Code § 6-3-1-3.5(a)(33) as added by L. 2011, P.L. 172, §53, eff. 01/01/2012. "Adjusted gross income" defined adds back to your Indiana income the amount excluded from federal gross income under Section 103 of the Internal Revenue Code interest received on an obligation of a state other than Indiana, or a political subdivision of such a state, that is acquired by the taxpayer after December 31, 2011.

Certain municipal bond interest is generally not taxable for federal income tax purposes and as the law now stands will continue to be tax free for federal purposes. Under prior Indiana law, Indiana considered all municipal bond interest (whether an out of state bond or not) tax free for federal purposes to be tax free on your Indiana income tax return. Many states have always taxed out of state bonds, now Indiana joins that list. An example would be if an Indiana resident owns an Illinois municipal bond and an Indiana municipal bond, the interest from both bonds would have been free from Indiana income taxes. Now, if an Indiana resident buys an Illinois municipal bond after December 31, 2011 the interest received will be taxable on the Indiana income tax return. Your existing out of state municipal bonds are grandfathered.

The current Indiana adjusted gross income tax rate is 3.4% plus a county tax rate that depends on your county of residence as of January 1st each year. The county rate can be in excess of 2%. For a Morgan County, Indiana resident the total state and county rate would be 6.12%. $10,000 of out of state municipal bond interest that was previously tax free would have a state tax burden of $612.

What does this potentially mean to the Indiana municipal bond investor? First, we should see an increase in the demand for Indiana municipal bonds from Indiana residents. The impact all things being equal (i.e., credit quality, etc.) should be to drive yields on Indiana bonds down, resulting in appreciation of existing Indiana Bonds. However, given Indiana’s low income tax rates as compared to states with much higher rates the impact of this additional demand may not be significant. So don’t throw your out of state bond purchase decisions out with the bath water, without some careful analysis. Non-Indiana municipal bonds provide geographical diversification, it’s not only how much of your income you keep on after-tax basis, return of principal matters for the municipal bond investor.

From a tax return preparation perspective, your Indiana return will now be a little more complicated due to the add back of municipal bond interest, municipal bond interest will be separated between Indiana and non-Indiana interest. Municipal bond mutual fund investors will have to dig into the details of the tax reporting to determine how much of any of the income is attributable to Indiana bonds.

This is probably a good time to review your municipal bond portfolios. Not only as a result of this law change, but due to other risks and opportunities associated with municipal bonds in general.

Call risk, credit risk and interest rate risk in your portfolio should be strongly considered in this analysis. With potentially rising tax rates looking into 2012 and 2013 ( as part of the healthcare bill there will be an additional 3.8% surtax on investment income for some taxpayers beginning in 2013) and our country’s aging demographics, more households will be looking to invest more for income, resulting in more demand for income producing investments such as bonds. Being pro-active by actively managing your bond holdings for income and total return, much like you manage your stock portfolio makes a lot of sense in this tax and economic environment. The days of buying bonds, putting them away in safe keeping and clipping the coupons until your bonds mature or are called, are in the past.

Give us a call to schedule a portfolio review.

Martin James, CPA/PFS
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