Municipal bonds may not be subject to federal income taxes, but that doesn’t mean the IRS excludes the income from all tax calculations. When it comes to taxing Social Security benefits, tax-free municipal bond interest can become a “stealth tax” that quietly eats away at income. Bondholders should be aware of these potential tax consequences when deciding between tax-free muni bonds and other kinds of fixed-income investments.
Below, MunicipalBonds.com takes a look at the impact of muni bonds on Social Security income and some steps that bondholders can take to address the issue.
AGI vs. MAGI Calculations
Most taxpayers are familiar with adjusted gross income (AGI) and modified adjusted gross income (MAGI) when it comes to preparing their tax returns. These figures are commonly used to calculate the amount of tax credits and tax deductions in order to minimize a person’s tax liability. The AGI figure is also used to determine a taxpayer’s income bracket and ultimately figure out what tax rate they must pay for a given year.
Adjusted gross income is calculated by taking the total income for a given year and subtracting certain adjustments that are listed on the first page of IRS Form 1040. These items include individual retirement account (IRA) contributions, half of self-employment taxes paid, alimony payments, health savings accounts, and student loan interest. A person’s AGI determines whether or not they qualify for certain tax credits.
Modified adjusted gross income adds back certain items that were subtracted in the AGI calculation along with some others – including municipal bond interest payments. A person’s MAGI is used to determine if they qualify for certain tax benefits like the ability to deduct IRA contributions on a tax return. In addition to these tax benefits, MAGI is used in determining whether or not – and how much – Social Security income is taxed.
Impacts on Social Security
Social Security benefits may be subject to income tax depending on a taxpayer’s benefit and the amount of income that they’re earning.
The easiest way to figure out the tax on Social Security income is to take half of an individual’s benefit and add their income – including tax-exempt interest. If the total is more than a base amount, then up to half of the Social Security benefit may be taxable. The 2015 base amount is $25,000 for individuals or $32,000 for married couples. In order to figure out the exact tax exposure, individuals must complete Worksheet A on IRS Publication 915.
Up to 85% of Social Security benefits may be taxed if half of an individual’s benefit plus their income – including tax-exempt interest – exceeds $34,000 for individuals or $44,000 for married couples. This situation may be applicable for those holding municipal bonds, especially because these bonds are commonly used by wealthier individuals to minimize their tax exposure. As a result, it’s important for them to take these factors into consideration.
The Bottom Line
Many investors rely on simple tax-equivalent yield comparisons when deciding between municipal and taxable bonds. While this takes into account a person’s income, it fails to account for the impact of after-tax returns for individuals receiving Social Security income. Investors may want to take a closer look at these dynamics with their financial advisors to avoid being hit by a “stealth tax” and minimize their overall tax exposure.