Buy municipal bonds for retirement? Beware of this trap. | Smart Change: Personal Finances

(Maurie Backmann)

During your working years, it’s a good idea to invest heavily in stocks, as it could lead to strong and steady growth in your portfolio. But as retirement approaches, it’s a good idea to switch to safer investments, such as bonds.

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

Corporate bonds tend to offer higher yields than municipal bonds. But muni bonds have a few distinct advantages. First, the interest income they pay is still exempt from federal tax. And if you buy municipal bonds issued by your state of residence, you can also avoid state and local taxes.

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

But while muni bonds certainly have their benefits, there is one pitfall you need to be aware of if you plan to hold them in retirement. Otherwise, your financial plans could be deviated.

Could the interest on your municipal bond result in taxed Social Security benefits?

Older people who derive all or most of their income from Social Security can often avoid tax on their benefits. But once your retirement income exceeds a certain threshold, taxes on Social Security benefits will kick in.

Meanwhile, the formula used to determine whether your benefits will be taxed includes the interest income you receive from municipal bonds. So while these payments themselves may be tax-exempt, they could trigger a tax on your Social Security earnings.

You could also end up with higher Medicare premiums

Each year, enrollees in the standard Medicare Part B premium pay. But high earners are generally subject to surcharges on their Health Insurance premiums. And if you earn interest income on municipal bonds, that will count in the formula used to determine if a Medicare premium supplement applies to you.

Plus, it’s not just Medicare Part B where these surcharges apply. You could also end up with a supplement on your Part D premiums if your total income exceeds a certain threshold.

Be careful with embedded bonds

Municipal bonds are a very suitable investment for seniors of different income levels. But you might want to consult an accountant or financial planner if you’re concerned that the interest they pay could put you in a bracket high enough to pay surcharges on your health insurance premiums.

However, paying taxes on your Social Security benefits is another story. The income thresholds to which these taxes apply are very low, so staying below these thresholds means having very little money to live on.

As such, the issue of social security should be less of a concern than that of health insurance. But both are worth putting on your radar if you plan to hold muni bonds in your later years.

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Melissa C. Keyes