Seniors are often advised to shift toward more conservative investments rather than go heavy on stocks. That’s because stocks can be very volatile, whereas bonds offer more stability.
Bonds also offer the benefit of reasonably predictable interest payments, which makes them a suitable investment for retirees. And municipal bonds are a particularly attractive choice for seniors, since they offer the benefit of interest that’s always exempt at the federal level. Buy municipal bonds issued by your state of residence, and you can avoid state and local taxes on your interest payments, too.
But while municipal bonds themselves may not raise your federal or state tax burden, they could put you in a position where you end up paying taxes on your Social Security benefits. Here’s why.
An unwanted surprise
Many seniors are shocked to learn that Social Security income can be taxable. But whether you’ll pay taxes on your benefits or not will hinge your provisional income.
Provisional income is calculated based on the total 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 collect from municipal bonds. If you’re single, once that total reaches $25,000, you’ll face taxes on some of your Social Security benefits. If you’re married, that threshold increases slightly to $32,000, but then you’re still in that boat of having some of your Social Security income taxed.
That’s why you’ll need to be careful when loading up heavily on municipal bonds. Though municipal bonds are, in fact, a good investment for retirees, they’re often touted for their tax benefits. But they could end up putting you in a position where you owe taxes on your Social Security income.
Furthermore, 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 off your bonds at a price that’s higher than what you paid for them, you’ll still face capital gains taxes, the same way you would with another investment. And even though municipal bonds are a good investment to buy and hold onto for many years, you may be tempted to sell them at some point before they mature (say, if bond values increase notably).
Incidentally, too much municipal bond interest could also propel you into a category where you’re paying higher premiums for Medicare Part B and Part D. And that could negate a lot of the savings you’ll reap from those tax-free interest payments.
This isn’t to say that you should avoid municipal bonds during retirement. Quite the contrary — they can be a nice steady, income-generating investment, and a fairly safe one as well, since municipal bonds have historically low default rates. Just be aware of the fact that they could end up causing you to lose some of your Social Security income to taxes while raising your Medicare costs. And seeing as how Medicare has already gotten more expensive, that’s something you’ll need to account for.
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