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During 2020, a tiny set of taxpayers managed to have it all: lots of income and no tax liability — and the chief way many accomplished it was with an investment vehicle that’s grown in allure since then, according to experts.

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Amid more than 160 million tax returns filed during a year upended by a pandemic, just over 9,300 tax returns had at least $200,000 in income but no federal income-tax liability after various credits, write-offs and exemptions, according to the Internal Revenue Service.

That’s a microscopic speck in a flood of tax returns. But zoom in and it’s clear to see that tax-exempt interest income from state and local government bonds played a key role in the financial feat.

The exclusion of interest income from municipal bonds was the primary way that 30% of this small sliver of taxpayers managed to wind up with no income-tax liability, according to a recent IRS report on high-income tax returns. It was a secondary reason for another 11% of the returns at issue.

State and local governments issue municipal bonds to help fund big public projects, like roads and infrastructure. The interest income is generally exempt from federal income taxes and may also skip state and local taxes depending on where someone lives and the state the bonds come from. To be sure, bond investors who sell would face capital-gains taxes.

Behind tax-exempt interest, the deduction for medical and dental expenses was the chief reason for eliminating tax in almost 21% of high-net worth returns during 2020. The write-off for cash donations to charity — temporarily made extra generous in response to COVID-19 — came in third. It was the main explanation for 15% of the returns with no tax liability but lots of income.

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The IRS has been issuing the report for decades tracking trends with high-income tax returns of at least $200,000 and examining the reasons when there’s no income-tax bill. Tax-exempt interest has long been the top explanation when high-income returns have loads of income and ultimately no tax obligation, the agency’s reports show.

The lean into tax-exempt interest is an “extremely prevalent” strategy for wealthy households, said Lance Dobler, a market leader with TIAA Private Asset Management. “It’s the go-to source.”

But Dobler and others are quick to note that “munis” may not make sense for many other people, who can score better yield on bonds that are subject to tax.

That’s worth remembering at a time when investors are focused on the yields in fixed income and cash.

Investors pouring money into bonds

After the Federal Reserve sent its benchmark interest rate to a two-decade high, the question now is when the central bank will cut its rate — and what that could mean for portfolios built on stocks, bonds and cash.

Investors who want to grab yields now are pouring money into bonds, according to experts.

Investors can buy municipal bonds directly, or they can put money in municipal bond mutual funds and ETFs. Here’s one peek at demand. There was $759.6 billion in municipal-bond mutual funds by the end of January, a nearly 15% decline from the totals in the funds at the March 2022 start of the Fed’s rate-hiking cycle, according to data from the Investment Company Institute.

Meanwhile, municipal bond ETFs had $123 billion in assets through January, up nearly 46% from March 2022, according to the association that represents regulated investment funds like mutual funds and ETFs.

The IRS report comes in a presidential election year, where taxes could be a flashpoint. The winner has a chance to remake massive parts of the tax code, with Trump-era tax cuts for individuals sunsetting at the end of 2025.

Municipal-bond interest income is generally tax-exempt, but the IRS could take a cut of some municipal-bond interest if someone’s subject to the Alternative Minimum Tax.

The AMT is the parallel tax code built to tax rich households that would face a lower bill under the ordinary code. The same Trump tax cuts pushed the AMT’s exemption rules higher through 2025, shrinking the number of people subject to the tax for now.

An investment vehicle with tax benefits ‘that are more beneficial to high-net-worth individuals’

Long ago, federal lawmakers decided to exclude municipal-bond interest income from tax to entice bond buyers and reduce the borrowing costs for state and local governments, said Erica York, senior economist at the Tax Foundation, a right-leaning think tank. “It’s not fair and it’s not a really efficient way to get at what the goal of the policy is,” York said.

The federal government already has grants for state government projects, but York said it’d be best for direct grants to be the sole avenue “rather than running this subsidy though the tax code that’s captured by high-income taxpayers.”

Municipal bonds are “not necessarily a loophole that high-net worth individuals are using,” said Cooper Howard, director of fixed-income strategy at the Schwab Center for Financial Research. It’s just that municipal bonds are an “investment vehicle that has tax benefits that are more beneficial to high net-worth individuals,” he said.

Municipal bonds “have long been an investment option, but I think they have gained more attention and more attraction.” Affluent baby-boomer investors looking for low-risk places to protect wealth, rising yields and temporary limits on other tax deductions help explain the focus, he said.

So, does the IRS report reveal a playbook for other investors who want to minimize tax and boost income? Perhaps, but experts say they’ll need to understand the complexities behind these types of bonds — and also make enough money for the tax strategy to make sense.

Municipal bond investments hinge on determining tax-equivalent yield

The municipal bond market is valued at $4 trillion, but it’s just one piece of a much larger bond market that also includes corporate debt and Treasurys.

The interest income on Treasury debt is taxed federally, but not by state and local governments, while the interest from corporate bonds is taxed at the state and federal level. The upside is municipal bond interest can skip federal tax, and generally can skip state taxes if it’s for an in-state bond.

But there’s a typically lower return, given the tax advantages, York said.

That’s why municipal bond investments hinge on determining tax-equivalent yield, Howard and Dobler said. It boils to this question, Dobler said: “What would the yield need be on a taxable bond to get a better return on income?”

Higher-earning households face higher combined federal and state tax rates, so a taxable bond needs to generate more income to beat tax-exempt income.

After hitting a nearly 15-year high in October, the effective yield on investment-grade corporate bonds was last pegged near 5.3%, according to the ICE BofA US Corporate Index. As of Wednesday, there was a 3.39% yield to worst on municipal bonds, according to the Bloomberg municipal bond index. (Yield to worst is the minimum yield a bond is expected to produce, assuming no default.)

Yields on municipal and corporate bonds tend to follow the yield direction on Treasurys. The two-year Treasury note BX:TMUBMUSD02Y on Friday had a 4.48% yield, while the 10-year BX:TMUBMUSD10Y had a 4.08% yield, while falling for three straight weeks, according to Dow Jones Market Data.

There’s a range of calculators (like here and here) where would-be investors can determine tax-equivalent yields.

The dividing line depends on the going rates for taxable and tax-exempt yields, which can change, Howard noted. But for now, people in the 32% tax bracket are generally where municipal bonds start making more sense than taxable corporate bonds, Howard said.

The 32% bracket is the third-steepest marginal rate, behind the 35% rate and the top rate of 37%.

“Muni bonds mostly make sense for individuals and families in the higher tax brackets, as the after-tax returns of taxable bonds are considerably higher than those of muni bonds,” said George Gagliardi, a financial advisor at Coromandel Wealth Management in Lexington, Mass.

His clients need to be in the 32% bracket before he starts considering these types of investments for them, he said.

For Gagliardi, the question should be about maximizing return and not shrinking tax liability at all costs.

“It is the ‘after-tax’ return that matters, not avoiding taxes,” he said.

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