He Bought an 8% Municipal Bond for Tax-Free Income. The IRS Used It to Tax More of His Social Security.
A retiree buys a municipal bond specifically to dodge federal taxes, and it works perfectly on the interest. What he never expected was the bill that showed up somewhere else entirely.
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Picture a retiree in his early seventies living on Social Security and a modest portfolio. He spots a municipal bond offering an 8% tax-exempt yield. With the 10-year Treasury paying roughly 4.7%, the choice looks almost too easy. The income is federally tax-free, the payout is generous and he can leave his principal invested.
Then his tax preparer runs the return. More of his Social Security is taxable than the year before. His benefit did not grow enough to explain it. The culprit is the municipal bond he bought precisely to avoid federal taxes.
Tax-Free Does Not Mean Invisible
Municipal bond interest is generally exempt from federal income tax. The IRS does not tax the interest itself, but it still includes those dollars when calculating how much of a retiree’s Social Security is taxable. That calculation adds adjusted gross income (AGI), tax-exempt interest and half of annual Social Security benefits. Once the total crosses $25,000 for a single filer or $32,000 for a married couple filing jointly, up to 50% of benefits can become taxable. Above $34,000 and $44,000, respectively, as much as 85% can become taxable.
Those thresholds have not moved in decades. That leaves plenty of retirees close enough to the line for a new stream of municipal bond income to push them across it. The bond interest remains tax-exempt. It simply causes more of another income source to become taxable. That is the tax torpedo hiding behind the attractive yield.
His Check Is Not Being Cut
This has nothing to do with the retirement earnings test. That rule applies to wages and net self-employment income earned before full retirement age (FRA). Interest does not count, whether it comes from a municipal bond, Treasury or savings account. Social Security will not withhold his monthly checks. The surprise arrives on his tax return instead, when a larger portion of those checks becomes taxable.
Tax-exempt interest can also count when Medicare determines income-related premium surcharges. A large enough position could therefore surface again in higher Part B and Part D premiums two years later.
Find Out What the 8% Really Means
Before considering the tax effects, he needs to confirm what the advertised number describes. An 8% coupon is not necessarily an 8% return. If the bond trades above face value or can be called early, its yield to maturity or yield to worst may be considerably lower.
If the yield to worst, the bond’s lowest potential return under its permitted repayment terms, still approaches 8%, the market is probably demanding compensation for added risk. The issuer may carry weak or no credit ratings, the bond may trade infrequently, or repayment may depend on revenue from a single hospital, housing project or other venture. Municipal bonds are not one uniform category of safe debt. The details can range from a large state’s general obligation to a speculative project whose finances depend on one source of revenue. Tax-free does not mean risk-free.
Look Past the Number on the Screen
Two checks can reveal whether the bond is helping as much as it appears.
- Add the expected interest to the Social Security tax calculation and any upcoming required distributions. Compare the income left after the spillover with what a lower-yielding alternative would provide.
- Review the issuer’s credit rating, financial disclosures, call provisions and yield to worst. Municipal filings are available through the Municipal Securities Rulemaking Board (MSRB’s) EMMA system.
The bond may still deserve a place in his portfolio. He just needs to judge it by the income he keeps and the risk he accepts, not the 8% tax-exempt yield alone.
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