Municipal Bonds are NOT Tax-Free for Social Security Recipients

Municipal Bonds are NOT Tax-Free for Social Security Recipients

It is fair to assume that most people who turn to municipal bonds do so thinking of them as “tax-free” income. But are they, really? You may have heard that the interest from municipal bonds is “tax-free,” but that is not entirely accurate IF you receive Social Security retirement checks.

Although the interest from municipal bonds is treated differently than that earned on CDs or shot-term dividends, make no mistake. If you receive Social Security checks or will do so sometime soon, there is an indirect way that municipal bonds may cause you to shell out more in taxes than you normally would.

Talking taxes could be a windy – and, quite frankly, boring – enterprise, but here’s the general scoop under Section 86 of the Tax Code: the portion of Social Security checks that is taxed depends on how large your “Provisional Income” is at the end of the year. Basically, if your magic number (Provisional Income, that is) is greater than $25,000 (single) or $32,000 (Married Filing Jointly), you would have to pay tax on up to 85 percent of your Social Security checks. You’re with me so far, right?

Now, here’s the caveat and main thrust of my message: interest from municipal bonds is counted in your “Provisional Income” math – every single penny of it. So when it comes to paying tax on your Social Security benefits, municipal bond interest is no different from the income you receive from your pension, CD, annuity, or IRA.  

The late judge, Learned Hand, of the U.S. Court of Appeals for the Second Circuit, once said, “There are two systems of taxation in our country: one for the informed and one for the uninformed.” From my vantage point, I think if most folks (including some so-called financial advisors) really understood how municipal bond interest impacted them, they’d be asking themselves whether there are certain sources of funds that do not count toward “Provisional Income” math and would, therefore, not cause them to pay any income tax whatsoever.

The answer? Yes, there are! The Roth IRA is one. Certain, properly structured cash-value life insurance policies are another. However, there is a big caution here. Please make sure you consult with an experienced team of financial and tax professionals who truly understand the tax law nuances surrounding these vehicles, as well as your specific situation.

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