Buying Municipal Bonds for Retirement? Beware This Pitfall.

During your working years, it’s a good idea to invest heavily in stocks, since that could lead to solid, steady growth in your portfolio. But as retirement nears, it’s smart to shift over to safer investments, like bonds.

Bonds don’t tend to be as volatile as stocks, and so at a time when you might need to tap your investments for income, they’re a good bet. And if you’re going to buy bonds, you might want to focus on municipal bonds (or muni bonds) over corporate bonds.

Corporate bonds tend to come with higher yields than muni bonds. But muni bonds have a few distinct advantages. First, the interest income they pay is always tax-exempt at the federal level. And if you buy muni bonds issued by your state of residence, you can avoid state and local taxes, too.

Also, historically speaking, muni bonds tend to have lower default rates than corporate bonds. That means they could be a safer bet for your retirement portfolio.

But while muni bonds certainly have their perks, there’s one pitfall you should be aware of if you’re going to hold them during retirement. Otherwise, your financial plans could be thrown off-course.

Could your muni bond interest result in taxed Social Security benefits?

Seniors who get all or most of their income from Social Security can often avoid taxes on their benefits. But once your retirement income exceeds a certain threshold, taxes on Social Security benefits will come into play.

Meanwhile, the formula used to determine whether your benefits will be taxed includes interest income you receive from muni bonds. So even though those payments themselves might be tax-free, they could trigger a tax on your Social Security income.

You could get stuck with higher Medicare premiums, too

Each year, there’s a standard Medicare Part B premium enrollees pay. But higher earners are commonly subjected to surcharges on their Medicare premiums. And if you earn interest income from muni bonds, it will count in the formula used to determine if a Medicare premium surcharge applies to you.

Furthermore, it’s not just Medicare Part B where those surcharges apply. You could get stuck with a surcharge on your Part D premiums as well if your total income exceeds a certain threshold.

Be careful with muni bonds

Muni bonds are a very appropriate investment for seniors across different income levels. But you might want to consult with an accountant or financial planner if you’re worried that the interest they pay will bump you into a high-enough bracket to pay surcharges on your Medicare premiums.

Paying taxes on your Social Security benefits is a different story, though. The income thresholds at which those taxes apply are very low, so staying below those thresholds means limiting yourself to very little money to live on.

As such, the Social Security issue should be less of a concern than the Medicare one. But both are worth putting on your radar if you plan to hold muni bonds during your senior years.

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