How to Prepare Your Municipal Bond Portfolio for Washington State’s Millionaire’s Tax

Tax-free municipal bond interest will be subject to Washington State’s new 9.9% tax for high-income investors, unless their portfolios are properly adjusted to meet specific exclusion criteria.

Washington State passed Senate Bill 6346 this year, establishing a 9.9% state tax on individual or household income in excess of $1 million per year. Taking effect on January 1, 2028, the tax is estimated to apply to more than 25,000 Washington residents including many of our clients in Issaquah and Bellevue. This start date gives taxpayers a window to prepare, and any investors who hold municipal bonds will need to review their strategies.

Municipal bonds are traditionally popular among high-net-worth investors because their interest income is exempt from federal income tax, while providing steady income streams and historical price stability.

Under the new law, out-of-state municipal bond interest will lose its tax-exempt status at the state level. SB 6346 includes an add-back provision for municipal bond interest. However, interest generated from state and local municipal bonds issued within Washington State remains exempt. This exception creates an opportunity for investors to shift their portfolios toward Washington-domiciled bonds to maintain tax-free income at both the federal and state levels.

Executing this transition is nuanced, and depends on timing, supply constraints, tax friction from selling existing assets, and investment vehicle feasibility.

1.     Timing: Capitalizing on Yields Before Spread Compression

Because this tax is newly enacted, many investors have not yet begun reallocating their portfolios. As higher demand shifts toward Washington State municipal bonds, yields on these local issuances are likely to compress. If this happens, early movers can lock in higher current yields before increased demand drives interest rates down. Similar dynamics exist in high-tax states like California and New York, where high local demand for state-exempt municipal bonds consistently drives yields lower relative to national benchmarks.

2.     Supply Constraints in Washington State Municipal Bonds

Unlike mega-issuer states such as California or New York, Washington has historically represented a much smaller share of the overall municipal market. Because the state previously lacked a personal income tax, there was minimal local tax incentive to hold in-state bonds, leaving a significant portion of Washington issuances held by national funds or out-of-state investors.

With more than 25,000 high-earning households expected to be impacted under SB 6346, local market liquidity and available secondary-market supply could tighten significantly. As high-net-worth investors scramble for the same finite pool of Washington paper, obtaining desirable maturities or credit ratings could grow increasingly difficult. Moving early may therefore be critical not only for securing favorable yields, but also for ensuring portfolio access before supply constraints restrict available inventory.

3.     Choosing the Right Vehicle: SMAs vs. Single-State Funds

Executing this transition requires choosing the right vehicle. Municipal bonds are generally accessed through mutual funds, ETFs, or separately managed accounts (SMAs). Because single-state municipal bond funds specifically dedicated to Washington are limited or non-existent in the fund/ETF market, investors who utilize managed SMAs or hold individual bonds have greater flexibility to customize their allocation heavily toward Washington-domiciled issuances to potentially capture these tax savings.

4.     Tax Friction & Loss Harvesting During Portfolio Reallocation

Rebalancing a municipal bond portfolio requires selling existing out-of-state holdings, which may trigger taxable capital gains or losses. Given recent interest rate increases, many existing bond holdings may currently trade with unrealized losses, potentially allowing for a tax-advantaged transition through loss harvesting. Because each investor's tax picture is unique, any restructuring should be coordinated with a qualified CPA and wealth management advisor.

Note of Consideration

Although Bill 6346 has passed and been signed into law by Governor Jay Inslee, there are already legislative challenges in progress. It is possible that this bill will be overturned, in which case acting early may have undesirable tax and investment consequences. It is important to weigh this risk carefully when determining whether to act now or wait.

Conclusion

The passage of SB 6346 changes the tax landscape for high-income Washington residents who invest in municipal bonds. By transitioning out-of-state municipal holdings into Washington-domiciled issuances ahead of the effective date of 2028, investors may be able to preserve federal and state tax-free income while possibly securing favorable yields before market spreads narrow. Working alongside financial and tax advisors now can help you determine the best approach for navigating these tax changes and find an appropriate strategy for your financial situation.

Frequently Asked Questions

Are out-of-state municipal bonds taxable under Washington State’s SB 6346?

Yes. Under Senate Bill 6346, interest income generated from out-of-state municipal bonds loses its state-level tax-exempt status for taxpayers subject to the 9.9% tax. While federal tax exemptions still apply, the law includes an add-back provision that taxes out-of-state municipal bond interest at the state level once your overall income exceeds the $1 million threshold.

Which municipal bonds remain tax-free for Washington State residents?

Interest generated from municipal bonds issued directly by state and local government entities within Washington State remains exempt from both federal income tax and Washington’s 9.9% state tax. Reallocating out-of-state holdings into Washington-domiciled municipal bonds allows high-earning investors to preserve dual federal and state tax exemption.

When does Washington State’s 9.9% tax take effect, and who is impacted?

The tax takes effect on January 1, 2028, with the first tax returns and payments due in 2029. It applies to Washington individual residents and households earning over $1 million in taxable income per year. Because the tax applies only to income exceeding the $1 million deduction, it is estimated to impact around 25,000 high-income households across the state.

How do I buy Washington-domiciled municipal bonds if single-state funds are unavailable?

Because single-state Washington municipal bond mutual funds or ETFs are scarce due to the state's historical lack of a broad personal income tax, most investors utilize Separately Managed Accounts (SMAs) or purchase individual municipal bonds on the secondary market to customize their portfolios.

Will selling out-of-state municipal bonds trigger a capital gains tax?

Selling existing bond holdings to rebalance your portfolio may trigger taxable capital gains or losses. However, because interest rate adjustments in recent years have left many fixed-income holdings trading below their original purchase price, investors may be able to utilize tax-loss harvesting to offset gains elsewhere while repositioning into local Washington paper.

What else should I be doing to prepare my investments for this tax?

There are a number of other strategies that should be reviewed and considered for investors under this new tax. This Article covers them in depth.

Author

Garrett Grigas CFA, CFP® 

Financial Advisor & Partner

Email: garrett@geverswealth.com

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 Important Disclosure: This material is for informational and educational purposes only and does not constitute individualized tax or investment advice. The discussion of Washington's new tax legislation is based on current law and is subject to change. The tax treatment of municipal bond income depends on the specific security and the investor's individual circumstances. There is no assurance that any particular investment or tax strategy will result in a favorable tax outcome. The appropriate strategy will depend on the investor's tax circumstances, risk tolerance, liquidity needs, diversification objectives, and the relative after-tax attractiveness of available municipal bonds. Municipal bonds are subject to interest-rate, credit, liquidity, market, and other risks. Consult your tax and financial professionals before making investment or tax-planning decisions.‍