Seniors are often advised to switch to more conservative investments instead of going heavy on stocks. This is because equities can be very volatile, whereas bonds provide more stability.
Bonds also offer the benefit of reasonably predictable interest payments, making them an appropriate investment for retirees. And municipal bonds is a particularly attractive choice for seniors as they offer the benefits of interest that is always exempt at the federal level. Buy municipal bonds issued by your state of residence, and you can also avoid state and local taxes on your interest payments.
But even if municipal bonds do not in themselves raise your federal or state tax burden, they can put you in a position where you end up paying taxes on your Social Security advantage. Here’s why.
An unwanted surprise
Many seniors are shocked to learn that social security income may be taxable. But whether you pay tax on your benefits or not depends on your preliminary income.
Provisional income is calculated based on the sum of your gross income, half of your annual social security income and tax-free interest you receive, such as – wait for it – the interest you charge from municipal bonds. If you are single when the total amount reaches $ 25,000, you will be taxed on some of your social benefits. If you’m married, that threshold rises a bit to $ 32,000, but then you’re still in the boat of getting some of your social security income taxed.
This is why you need to be careful when reading heavily on municipal bonds. While municipal bonds are actually a good investment for retirees, they are often touted for their tax benefits. But they may end up putting you in a position where you owe tax on your social security income.
Also, another thing you should know about municipal bonds is that while the interest they pay you is tax-free at the federal (and possibly state) level, if you sell your bonds at a price that is higher than what you paid for those you still want to see capital gains taxes, just as you would with any other investment. And while government bonds are a good investment to buy and hold on to for many years, you may be tempted to sell them at some point before they expire (e.g., if the value of the bonds increases significantly).
Incidentally, too much municipal bond yields can also lead you into a category where you pay higher premiums for Medicare Part B and Part D. And that can negate many of the savings you will reap from these tax-free interest payments.
This is not to say that you should avoid municipal bonds during retirement. On the contrary – they can be a nice stable, income-generating investment and also a fairly safe one, as municipal bonds have historically low default rates. Just be aware of the fact that they may end up causing you to lose some of your social security income for taxes while increasing your Medicare costs. And seen as how Medicare has already become more expensiveit’s something you need to take into account.