Wealthy investors are rushing to buy munis in an attempt to mitigate the impact of threatened tax hikes. They may be shocked to learn that municipal bonds’ tax-exempt interest is included in the income calculation that triggers Social Security taxes and Medicare premium surcharges.
In the first six months of 2021, municipal bond funds attracted an estimated $56.9 billion in net new money — the most for any first half of the year dating back to 1992, according to data from Refinitiv Lipper.
Municipal bonds typically offer interest payments that are exempt from federal income taxes and sometimes from state taxes in the state where the bond is issued. The interest is also exempt from the 3.8% net investment income surtax that affects individuals with income over $200,000 and married couples with income over $250,000.
“Right out of the box, the Biden administration started talking about taxing the wealthy,” said Marilyn Cohen, founder, and CEO of Envision Capital Management, which deals exclusively in individual bonds. “The unbelievable distaste for paying taxes has become really widespread, and people want to be ahead of the curve.”
Cohen noted that the demand for municipal bonds has outstripped supply, and she predicted the muni market would be particularly imbalanced this summer as maturities in June, July and August will far exceed new issues.
As tax rates increase, tax-free municipal bonds are generally more attractive since the tax-equivalent yield for taxpayers in higher brackets also increases. The tax-equivalent yield is the yield an investor would have to earn in a taxable bond investment to match the yield of a comparable tax-free municipal bond.
But many people don’t realize that tax-exempt interest is included in the “provisional income” calculation, which determines how much Social Security benefits are taxed, and the “modified adjusted gross income” formula that determines high-income surcharges for Medicare beneficiaries.
The problem is exacerbated when investors pay high premiums for municipal bonds. Brokerage firms report the gross coupon income on form 1099, which is reported to both the IRS and the Social Security Administration to use in determining taxation of Social Security benefits and Medicare premium surcharges. The actual yield based on cost may be less than half of the coupon.
“You could have a 1% bond yield to maturity but receive a 5% coupon as income,” Cohen explained.
Up to 85% of Social Security benefits can be taxed when provisional income, which includes adjusted gross income, plus half of Social Security benefits, plus tax-exempt interest, exceeds $34,000 for individuals and $44,000 for married couples.
Although the majority of Medicare beneficiaries pay the standard Part B premium of $148.50 per month in 2021, higher-income retirees pay more once MAGI exceeds $88,000 for single individuals and $176,000 for married couples filing jointly.
There are six income brackets that determine Medicare surcharges, officially knowns as the income-related monthly adjustment amount. In the top income bracket, monthly IRMAA surcharges can exceed $500 per month per person.
“When it comes to putting together an investment or tax strategy, advisers shouldn’t let the tail wag the dog,” said Peter Stahl, president of Bedrock Business Results, a firm that educates financial advisers about retiree health care costs and solutions.
“But if you have clients that are right near the exact amount of a threshold, you can really add value by reducing muni bond exposure or dividend and capital gain income, so folks don’t get pushed into the next bracket,” Stahl said.
For example, a married couple with $220,000 of modified adjusted gross income in 2019 would pay $297 per month per person for Medicare Part B this year for a total cost of $7,128 in 2021. But if their joint income was just $1 higher in 2019 — $220,001 — they would pay an extra $2,138.40 in Medicare Part B premiums in 2021.
“Retirement income planning is all about being aware of different tax thresholds and finding an efficient way of staying beneath them,” Stahl said.
“Our research shows that careful planning around constructing a withdrawal strategy that incorporates looking at Social Security and Medicare is important,” said William Meyer, founder and managing partner of Income Solver, a software program designed to optimize retirement income through tax-efficient withdrawal strategies.
“Since tax-exempt interest is part of the calculation, the key role for advisors is to be aware of income thresholds that can significantly increase a client’s marginal tax on Social Security benefits or boost their Medicare premiums,” Meyer said. “Our software does this automatically, helping advisers to be more efficient and ensure they don’t make a mistake.”
“Retirement planning decisions are really like a set of interconnected gears,” observed David Freitag, a financial planning consultant at Mass Mutual. “It is important to see how a small movement of one gear or a one-off decision can dramatically change the movement of other gears, which then leads to major and different outcomes over time.”
(Questions about Social Security rules? Find the answers in Mary Beth Franklin’s 2021 ebook at MaximizingSocialSecurityBenefits.com.)
Andrew is half-human, half-gamer. He’s also a science fiction author writing for BleeBot.