A Supreme Court Case Physician Families Will Want to Watch Closely

Everybody knows that doctors pay way more than their fair share of taxes, and most will go out of their way to trim their tax bill. One of the more popular and traditional ways to reduce investment-related taxes is to own municipal bonds issued in the state where you live. Before I tell you why this investment strategy might not be such a good idea in the months ahead, let me tell you why it seemed like such a great idea up until now.

A municipal bond (also called a "muni") is an I.O.U. that is created when a municipality - city, state, county, parish, etc. - borrows money from the public to do something like build a school or a bridge. Like other bonds, these bonds are evidence of the municipality's indebtedness.

Physicians in high tax brackets often flock to munis because the interest on most (but not all) municipal bonds is free from federal taxes. And when you buy a municipal bond that's issued in your home state (for example, if you live in California and you own a California-issued municipal bond), then the income from that bond is ordinarily exempt from state income taxes. That's why these single-state munis are often called "double tax-free" bonds.

So it seems like double tax-free single-state munis are a good investment, right?

Maybe not for long.

Only the rule of law prevents municipal bond interest from being taxed, and laws can be changed.

In fact, the United Stated Supreme Court may wind up altering this bit of law when they review Case No. 06-666, Kentucky v. Davis this term. In that case, a married couple (the Davis's) have successfully argued that Kentucky state's policy of taxing interest on out-of-state bonds while exempting taxes on interest on their own debt violates a clause in the Kentucky Constitution.

On Monday, November 5, 2007, the Supreme Court will rule on whether the legal opinion stands. If it does, the interest on certain munis may no longer be state-tax free.This means the demand for state-specific municipal bonds - largely bought by state residents interested in state tax exemption - will decline. And as the demand for these bonds declines, the price of these bonds will likely fall.

So what can you do?

    1. Don't panic. If you live in a state that has no state income tax (including Alaska, Washington and Wyoming, among others), it's unlikely you even own single-state munis. And if you only have investments in your IRA or other retirement plan, it's highly unlikely you own municipal bonds in the first place.
    2. If you live in a state with income taxes (Oregon or California, for example), check your brokerage and mutual fund account and look for municipal bonds issued in your state. Also, look for municipal bond mutual funds that bear the name of your state. With these securities, you may be at risk.
    3. Contact your investment advisor and ask them if it might be a good idea to sell your single-state holdings in order to reinvest in a more diversified multi-state or "national" bond fund. (Make sure to review the risks before investing.)

    Like most other tax breaks you can find for your family, the tax breaks on municipal bonds were created with the stroke of a pen, and they could be revoked just as easily.