The Surprising Reason Your Social Security May Be Taxed

The primary way to qualify for Social Security benefits in retirement is to pay taxes on your wages for a good number of years. But many seniors are surprised — or shocked — to realize that their Social Security benefits are taxable in retirement. Worse yet, one seemingly tax-friendly investment could be pushing your income over the limit for Social Security taxes.

Are municipal bonds backfiring on you?

Municipal bonds are often touted as a great investment for retirees who want steady, predictable income without the tax hassle. That’s because municipal bond interest is always tax-exempt at the federal level. It can be tax-exempt at the state level, too, if you buy bonds issued by or within the state you call home.

The problem, though, is that earning a lot of municipal bond interest could make you more likely to end up getting taxed on your Social Security benefits. And the reason is that municipal bond interest counts in the formula that determines combined income.

Combined income is:

• Your adjusted gross income (AGI)
• 50% of your annual Social Security income
• Tax-exempt interest income you receive, such as what municipal bonds pay

Now here’s the frustrating part. A combined income of $25,000 or more subjects your Social Security benefits to taxes if your filing status is single. If your filing status is married/joint, a combined income of $32,000 or more subject your Social Security benefits to taxes.

Clearly, these are pretty low thresholds. But even if your AGI is low and you don’t collect such a large Social Security check each month, if you earn a lot of interest from municipal bonds, you could face taxes on benefits.

Let’s say you have all of your retirement savings in a Roth IRA, so withdrawals don’t count toward combined income (since they’re not part of AGI). If you receive about $2,100 a month in Social Security, which is in line with the average retirement benefit today, your total Social Security counted toward your combined income is around $12,600.

But if you earn another $15,000 a year in municipal bond interest and you’re single, you get pushed over the line of having to pay taxes on your Social Security benefits. That negates part of the upside of holding municipal bonds.

Know what you’re signing up for

Municipal bonds are often hailed as an investment that eliminates tax-related stress. But that may be overselling the situation a bit.

Not only can municipal bond interest be taxable at the state level, but it could also lead to taxes on Social Security benefits. It’s important to understand these repercussions before adding these bonds to your portfolio.

Of course, taxes on Social Security isn’t necessarily a reason not to buy municipal bonds if they fit your investment strategy and serve a specific need, like providing predictable income in a fairly low-risk manner. The point, rather, is to understand how they might impact your taxes, including taxes that apply to Social Security.

Also know this. If you sell municipal bonds at a profit, you could face capital gains taxes. The tax exemption applies to interest only at the federal and sometimes state level. It’s important to understand this nuance for proper planning.