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Municipal bonds, also known as muni bonds, have become a popular option for investors seeking security and tax-free portfolio income. However, these assets may also trigger a costly surprise for retirees.
Demand surged in 2021 amid President Joe Biden‘s proposed tax increases, with a record $96.8 billion of net money flowing into U.S. muni mutual and exchange-traded funds, according to Refinitiv Lipper data.
While plans to hike taxes have mostly stalled, muni bonds are still attractive to higher earners looking for stability, according to financial experts.
However, muni bond interest may create a problem for affluent investors: Medicare premium hikes.
“There are a lot of moving parts, and you need to have someone look at it holistically,” said Matthew Chancey, certified financial planner at CoastalOne in Tampa, Florida.
Higher taxes and premiums
Although tax-exempt muni bond interest may be appealing, those earnings may increase Social Security taxes and Medicare premiums, said Tracy Sherwood, a Williamsville, New York-based CFP at Sherwood Financial Management.
That’s because the formulas for Social Security taxes and Medicare Part B and Medicare Part D use so-called modified adjusted gross income, or MAGI, which includes tax-exempt muni bond interest.
If half of someone’s Social Security payments plus MAGI is more than $44,000 for a joint tax return ($34,000 for individual filers), up to 85% of their Social Security benefits may be taxable.
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But with relatively low thresholds, it’s difficult for some higher-income retirees to avoid paying tax on 85% of Social Security payments, Sherwood said.
The bigger issue is that retirees with income above certain thresholds may owe a surcharge for Medicare Part B and Part D, known as the Income Related Monthly Adjustment Amount, or IRMAA.
The base amount for Medicare Part B premiums in 2022 is $170.10 per month, a 14.5% jump from 2021. However, the payments start to increase for joint filers with MAGI over $182,000 (single filers above $91,000).
“That’s where you’re looking at [Medicare Part B] premiums going up by about $70 or more per month,” said Sherwood. “That’s pretty significant.”
The top Medicare Part B surcharge is $578.30 for couples filing together with MAGI at $750,000 or above.
Retirees may also see premium increases for Medicare Part D, typically covering prescription drugs, with the top surcharge at $77.90 for the highest earners in 2022.
Both calculations use MAGI from two years prior, so retirees need to consider the consequences of their income in advance, Sherwood said.
“It’s something that taxpayers seem so aware of because if they get into this higher bracket, they have to pay higher premiums for a full year,” said Mary Kay Foss, certified public accountant and CPA faculty at CalCPA Education Foundation in Walnut Creek, California.
Of course, added taxes and premiums don’t mean retirees should steer clear of muni bond investing. However, they may consider weighing the pros and cons of tax-exempt interest with a financial advisor.
“There’s no such thing as a good or a bad product,” Chancey said.
Retirees need to assess each investment in its totality — including risk, yield, growth potential, tax implications, creditor protection and more, he said. “I look at every investment, and I ask myself this question: ‘Is the juice worth the squeeze?'”