When a Muni’s Tax Efficiency Doesn’t Mean Better After-Tax Returns

Given that goal and a rosier outlook for investment-grade corporates than munis,  Schroders it looking to minimize exposure to municipal bonds in its funds and separately management accounts by selling munis and buying corporates while also taking into account any capital gains.

"There's no point as a fund manager building the perfect portfolio if a client is paying capital gains taxes," says Chorlton. "You need to manage capital gains."

One popular strategy to manage capital gains is to offset those gains with taxable losses, which can be "harvested" throughout the year as needed. The key is to harvest the loss and realize the gain without negatively impacting a portfolio, says Chorlton.

That often involves buying another asset to replace the one that was sold for a profit, which can be hard to do in the bond market, says Chorlton, noting the difficulty in finding a similar credit with a similar coupon and maturity.

"Most of the time [in fixed income] it's not about finding a replacement but managing the cost of the transaction," says Chorlton. "You don't want to try to do it when everyone else is doing it. If you realize a gain in December, the chance of finding an offset is very limited."

Investors also need to be aware of the IRS Wash Sale Rule when trying to replace an asset that has been sold for a loss to offset a capital gain. Under the rule an investor cannot buy a substantially equal security within 30 days – before or after – of that sale.

Here are some other tax issues that muni investors need to be aware of:

• Income from municipal bonds used to finance stadiums, airports and other capital projects for "private activity" issuers could be subject to the Alternative Minimum Tax (AMT). Investors who are subject to the AMT will be taxed at 28% on that municipal bond income rather than nothing.

• Municipal bonds bought at a discount and sold at a profit can be required to pay their higher income tax rate rather than capital gains rate on those gains if the bond was bought at a discount of more than 0.25% for each year until maturity. For example, an investor who bought a 10-year muni bond with a face value of 100 at less than 97.5 (100 – [0.25 × 10 years]), he or she would have to pay ordinary income tax on any capital gain.

– Related on ThinkAdvisor:

• 5 Key Questions on Taxation of Mutual Fund Dividends
• Andy Friedman's 8 Tips to Cut Taxes for Clients Before Congress Acts
• IRS: Top12 Tax Scams for 2016