Lowering Your AGI and Student Loan Payments with Municipal Bonds: A Win-Win Solution

As a student loan borrower on an IDR plan, like SAVE, PAYE or ICR, you might have repeatedly read, “Manage your AGI”, and that saving on taxes will save you on student loans. Introducing some bonds to your portfolio can reduce the level of market risk that you’re taking for a long-term portfolio, while helping keep student loan payments lower while on an IDR plan. 

Bonds can also be used to earn additional income on dollars that you plan to spend within the next three to five years, compared to a bank account or high-yield savings account. Because the time horizon for these funds are short, you don’t necessarily want to subject them to market volatility. Bonds are a great place to earn interest while you wait to spend the funds. 

When developing your investment strategy, it’s important to consider how much risk you’re comfortable taking, and planning out withdrawals from your portfolio. Here’s what to know.

Income and your IDR plan

On an income-driven repayment (IDR) plan, the primary source for certifying your income is line 11, adjusted gross income (AGI), on your most recently filed tax return. For doctors, lawyers, dentists and other high-earning professionals, your income can drive your student payments significantly higher.

Any income that you receive a 1099, W-2 or K-1 form for is reported on your tax return. However, not all of that income is included in your AGI. For example, deductible contributions to a traditional IRA, half of your self-employment tax paid, and income from tax-exempt bonds are reported on your tax return but are “above the line deductions” meaning they are deducted before your AGI is determined. 

Types of fixed-income asset classes

The world of fixed income (bonds) is vast, and there’s a lot to cover when it comes to the various types of bonds and bond instruments. We’ll focus on these main fixed-income asset classes: municipal (tax-exempt) bonds, treasury notes, and corporate bonds. 

Corporate bonds

Corporate bonds are debt securities issued by companies to raise capital for various purposes. Investors receive periodic interest payments, and their principal is returned at maturity. 

The level of risk and interest rates are influenced by the issuing company's creditworthiness. Interest and capital appreciation of the bonds are subject to applicable state and federal income taxes. 

Treasury debts 

Treasury bills, notes and bonds are debt securities issued by the U.S. government to fund its operations. 

T-bills have short maturities (usually less than one year), T-notes have medium-term maturities (two to 10 years), and T-bonds have longer maturities (over 10 years), offering varying levels of yield. Interest and capital appreciation of the bonds are subject to federal income tax but exempt from state income taxes. 

Related: Tax Guide for Student Loan Borrowers

Municipal (tax-exempt) bonds

Municipal bonds are debt securities issued by state and local governments to finance public projects. Tax-exempt municipal bonds provide investors with interest income that’s generally exempt from federal income tax and generally exempt from state income tax only in the issuing state. 

While the tax benefits of these bonds make them appealing to investors, the yield on these bonds is consistently lower than the yield on taxable bonds. 

When does this type of investment strategy make sense?

When considering if you should be incorporating taxable or tax-exempt bonds in your portfolio, there are a handful of important considerations. 

Tax-exempt bonds should only be considered in a taxable brokerage account. 

In qualified retirement accounts (IRA, 401(k), 403(b), Roth IRA), tax-exempt bonds offer no tax benefits because the growth and income in qualified accounts are not subject to taxation until withdrawal. 

Is the tax treatment worth the lower yield? 

This question can be addressed with a math equation that takes into consideration your current marginal tax rate, the yield you could earn on a comparable taxable bond, and the yield you could earn on the tax-exempt bond you are evaluating.

Tax equivalent yield = Tax-free bond yield / 1 – (Federal tax rate + state tax rate)

For student loan borrowers on an income-driven plan, your student loan payment serves as an additional tax on your income:

• 10% of your discretionary income (DI): Saving on a Valuable Education (SAVE), Pay As Your Earn (PAYE), and New Income-Based Repayment (IBR) repayment plans.
• 15% of your DI: Old IBR plan.
• Up to 20% of your DI: Income-Contingent Repayment (ICR) plan. 

For a borrower on an IDR plan, we need to incorporate this additional student loan ‘tax’ into the equation to see if the tax-equivalent yield is worth purchasing a municipal bond in lieu of a taxable bond.

Equivalent taxable bond yield = Tax-free bond yield / 1 – (Federal tax rate + state tax rate + student loan DI rate)

Assessment of risk when investing in bonds 

When you save into a savings account, your investment is insured by the FDIC — your principal investment of up to $250,000 is insured against loss. When investing in bonds, there isn’t a guarantee that the borrower will pay you back. 

If company ABC goes bankrupt and you have an outstanding bond, they might return pennies on the dollar to you, compared to what you had expected. Municipal bonds also have some level of default risk, and there are additional considerations when it comes to which type of municipal bond you’d like to hold. 

General obligation bonds are backed by the issuing state’s tax authority, while public revenue bonds are tied to particular projects and present a bit more risk. U.S. Treasury securities are backed by the full faith and credit of the U.S. government and are generally considered a lowest-risk fixed income security. 

With increased risk comes higher yields, but just as you want a diversified stock portfolio, it’s important to diversify your fixed income portfolio, too. You can also purchase ETFs or mutual funds with a portfolio of multiple bonds, which are more diversified than individual bonds. However, be mindful of fees and expenses. 

Disclaimer: The examples below assume reinvestment of interest payments at the same. These examples are for educational purposes only. They do not constitute financial advice. Consult a financial planner or tax professional about your unique situation.

Case study #1: Married physicians, filing taxes jointly

Felicia and Jorge are both physicians in Illinois with a combined gross income of $800,000.  They file taxes as married, filing jointly, and their marginal federal tax rate is 37%. Their marginal state tax rate is 4.95%. 

They’re both on the SAVE plan and pay 10% of their discretionary income toward student loans. They’ve saved $100,000 for a down payment on a home and plan to purchase it sometime in 2028. They want to earn some interest on their savings but don’t want to invest in stocks because of the relatively short time horizon. They shop for bond options and find these four individual bond options: 

Investment	Price	Maturity date	Coupon rate
State of Illinois Municipal Bond	$1,000	12/31/2027	3.50%
State of Nevada Municipal Bond	$1,000	12/31/2027	3.60%
Utility Company Corporate Bond	$1,000	12/31/2027	5.50%
U.S. Dept of Treasury Note	$1,000	12/31/2027	4.90%

Utility Company Corporate Bond 

They invest $100,000 at a current yield of 5.5%. The interest is subject to federal and state income taxes and has been included in their AGI for student loan purposes.

At the maturity of the bond in four years, they receive their $100,000 initial investment back  — and with interest — they have $124,238. They’ve paid $12,592 in federal/state taxes and additional student loan payments. Their net earnings are $11,646.

State of Illinois Municipal Bond

They invest $100,000 at a current yield of 3.5%. This interest is exempt from federal and state income taxes.

At the maturity of the bond in four years, they receive their $100,000 initial investment. With interest, they have $114,888 and don’t owe federal/state taxes on this income, and they didn’t have to include this income in their calculation for student loans on the SAVE plan. Their net earnings are $14,888.

Tax equivalent yield = 3.5% / (1 – (37% + 4.95% + 10%) = 3.5% / 48.05% = 7.284% 

State of Nevada Municipal Bond

They invest $100,000. Their current yield is 3.6%. This interest is exempt from federal income taxes, but they do have to pay Illinois state income taxes because the municipal bond is issued by another state. 

At the maturity of the bond in four years, they receive their $100,000 initial investment back and with interest, they have $115,340 and don’t owe federal taxes on this income. They also didn’t have to include this income in their calculation for student loans on the SAVE plan. They do owe Illinois State Income tax of $759 on the interest, so their net earnings are $14,581.

TEY =  3.6% / 1 – (37% + 10%) = 3.6% / 53% = 6.792% 

U.S. Dept of Treasury Note 

They invest $100,000. Their current yield is 4.9%. This interest is exempt from state income taxes. The interest is subject to federal income taxes and has been included in their AGI for student loan purposes.

At the maturity of the bond in four years, they receive their $100,000 initial investment back and with interest, they have $121,365.  They have paid $10,042 in federal income taxes and additional student loan payments. Their net earnings are $11,323.

TEY = 4.9% / (1 – ( 4.95%)) = 4.9% / 95.05% = 5.155% 

Investment	Corporate	In-State Municipal	Out-of-State Municipal	Treasury
Coupon rate	5.5%	3.50%	3.60%	4.90%
Gross earnings	$24,238	$14,888	$15,340	$21,365
Federal tax	Yes	No	No	Yes
State tax	Yes	No	Yes	No
Student loan payment	Yes	No	No	Yes
Net earnings	$11,646	$14,888	$14,581	$11,323
Tax equivalent yield on SAVE	5.50%	7.28%	6.79%	5.16%

While the posted coupon rate of the corporate bond appears to pay the most, when you consider the impact of tax savings for Felicia and Jorge’s high income, the In-State Municipal Bond would deliver the highest return overall. 

Case study #2: Married educators, filing taxes separately 

John and Jim are both education professionals in Massachusetts, who file their taxes as married, filing separately. Their combined gross income is $250,000, each earning similar salaries around $125,000. 

Their marginal federal tax rate is 24%, and their marginal state tax rate is 5%. John has student loans and is on the PAYE plan. He pays 10% of his discretionary income toward student loans, which means he pays about 5% of their combined income toward student loans. Jim does not have any student loans. 

They’re 50 years old and have saved well throughout their career. As they get closer to retirement, they’d like to reduce their investment allocation from 100% stocks to 75% stocks. They have a blend of retirement and taxable investment accounts and plan to retire at age 55 and pull from their taxable accounts first. They determined they’d like to shift $100,000 of stocks in their taxable accounts into bonds. After shopping around for bonds, they land on four investment options: 

Investment	Price	Maturity date	Coupon rate
State of Massachusetts Municipal Bond	$1,000	12/31/2028	2.25%
State of Minnesota Municipal Bond	$1,000	12/31/2028	2.50%
Health Care Company Corporate Bond	$1,000	12/31/2028	5.10%
U.S. Dept of Treasury Note	$1,000	12/31/2028	3.85%

Let’s break down how much John and Jim will earn for each bond: 

Health Care Company Corporate Bond

They invest $100,000 with a current yield of 5.1%. The interest is subject to federal and state income taxes and has been included in their AGI for student loan purposes.

At the maturity of the bond in five years, they receive their $100,000 initial investment back and with interest, they have $128,634. They’ve paid $9,736 in federal/state taxes and additional student loan payment. Their net earnings are $18,898.

State of Massachusetts Municipal Bond 

They invest $100,000 at a 2.25% yield. This interest is exempt from federal and state income taxes.

At the maturity of the bond in five years, they receive their $100,000 initial investment back. Including interest, they received $111,837. They don’t owe federal/state taxes on this income, and they didn’t have to include this income in their calculation for student loans on the PAYE plan. Their net earnings are $11,837.

TEY = 2.25% / (1 – (24% + 5% + 5%) = 2.25% / 66.0% = 3.409% 

State of Minnesota Municipal Bond

They invest $100,000 with a 2.5% yield. This interest is exempt from federal income taxes, but they do have to pay Massachusetts state income taxes because the municipal bond is issued by another state.  

At the maturity of the bond in five years, they receive their full initial investment and, with interest, receive a total of $113,227. They don’t owe federal taxes on this income and don't have to include this income in their calculation for student loans on the PAYE plan. However, they owe Massachusetts State Income tax of $661 on the interest, so their net earnings are $12,566.

TEY = 2.5% / (1 – (24% + 5%) = 2.5% / 71% = 3.521%

U.S. Dept of Treasury Note

They invest $100,000 and a current yield is 3.85%. This interest is exempt from state income taxes. The interest is subject to federal income taxes and has been included in their AGI for student loan purposes.

At the maturity of the bond in five years, they received their initial investment, plus interest, at a total of $121,006. They paid $6,092 in federal income taxes and additional student loan payments. Their net earnings are $14,914.

TEY =  3.85% / (1 – ( 5%)) = 3.85% / 95% = 4.053%

Investment	Corporate	In-State Municipal	Out-of-State Municipal	Treasury
Coupon rate	5.10%	2.25%	2.50%	3.35%
Gross earnings	$28,634	$11,837	$13,227	$21,006
Federal tax	Yes	No	No	Yes
State tax	Yes	No	Yes	No
Student loan payment	Yes	No	No	Yes
Net earnings	$18,898	$11,837	$12,566	$14,914
Tax equivalent yield on SAVE	5.10%	3.41%	3.52%	4.05%

Although the tax advantages of municipal bonds might be intriguing, they’re generally only worthwhile for taxpayers in the highest tax brackets. A corporate bond would have the highest net return for John and Jim.

Some final considerations 

While tax-exempt interest isn’t included in your AGI, it might be added back for Alternative Minimum Tax (AMT), determining eligibility for retirement contributions, Medicare premiums and a variety of other calculations. There are a multitude of options when it comes to where to invest the fixed-income portion of your portfolio. 

It’s important to consider how you’d like to allocate your portfolio to best meet your financial goals before determining if some tax savings we discussed here might be helpful for you. As the old saying goes, “Don't let the tax tail wave the dog.” 

If you’d like a partner in navigating these decisions, our team at SLP Wealth has the insight and knowledge to guide you on your financial planning journey. Speak with an SLP Wealth financial planner today.