Why Retirees Can't Count On Muni Bonds

By Rich White AAA

Municipal bonds, popular fixed-income investments for retirees who want tax-exempt income, are no longer offering the kind of tax protection they once did. These bonds are issued by state and local governments, agencies and authorities to finance public works ranging from highways and hospitals to schools and stadiums. Though great for the cities they provide for, these bonds are no longer the retirement portfolio protectors they used to be. In this article we'll show you how to evaluate and adjust the tax benefits municipal bonds offer.

The Benefits Of Municipal Bonds
According to the Securities Industry and Financial Markets Association, $409.7 billion in municipal bonds was issued in 2009, the second-highest issuance ever. One reason that "munis" are so popular at the household level is their tax advantages. Most interest payments are exempt from federal income tax, and they also may be exempt from state/local income taxes. (For more information on the basics of municipal bonds, see The Basics Of Municipal Bonds.)

Investors can use a trusty tool to evaluate the tax benefit of any given municipal bond or tax-exempt mutual fund. Tax-equivalent yield (TEY) calculates the pretax yield that a taxable bond must have in order to achieve the same after-tax benefit of a tax-exempt municipal bond. Investors can easily determine TEY by using the formula and table below.

Taxable Equivalent Yield (TEY) Table
Tax-Exempt Yield Investor\'s Federal Marginal Tax Bracket
15% 25% 28% 33% 35%
A Taxable Bond Must Have This Yield or Above Pretax
4% 4.7% 5.3% 5.6% 6.0% 6.2%
5% 5.9% 6.7% 6.9% 7.5% 7.7%
6% 7.1% 8.0% 8.3% 9.0% 9.2%
7% 8.2% 9.3% 9.7% 10.4% 10.8%
8% 9.4% 10.7% 11.1% 11.9% 12.3%

For experienced muni investors, tax-equivalent yield calculations will seem like an old and reliable friend. But investors can't always rely on the standard calculations after they retire. The TEY shown in the table above may not be the one they actually get.

Example - Calculating TEY
An investor in the 33% tax bracket is evaluating a tax exempt municipal bond with a 5% yield. To produce an equivalent advantage after taxes are accounted for, a taxable bond would need an equivalent yield of at least 7.5%.

How "Tax Exempt" Blurs for Retired People
Starting in 2007, it became possible (although rare) for up to 100% of the interest produced by a municipal bond to become effectively taxable for a high-income retired person age 65 or older. However, effective January 1, 2007, the Medicare premiums of high-income seniors became subject to "income-relating" provisions of the Medicare Prescription Drug, Improvement and Modernization Act of 2003. (For more on this act, see Income Relating: A New Concept In Medicare.)

In summary, this change imposed:

  • Higher annual Medicare premiums for single filers with modified adjusted gross incomes (MAGI) of $82,000 or more or joint filers with MAGIs of $164,000 or more. (Income thresholds are for 2008 and will be adjusted in later years.)
  • Progressively higher Medicare premiums charged in four MAGI tiers with a two-year offset. In other words, the MAGI reported in the 2006 tax year is used to determine the taxpayer's 2008 Medicare premium.

It's important to note that the MAGI calculation for Medicare income-relating purposes includes all tax-exempt income, such as that from municipal bonds.

So, if you pay Medicare premiums and your MAGI is above the $82,000 or $164,000 limits, you can't be sure municipal bond income is tax-exempt, or that your TEY calculation is accurate without double-checking or making adjustments.

Another Obstacle for Retired People
The income-relating provisions of Medicare were added in 2007, but another way that TEY calculations can be muddied for retired people has been around longer. For single filers earning more than $34,000 or joint filers earning more than $44,000, up to 85% of Social Security retirement benefits can be taxable. As in the Medicare income-relating calculation, tax-exempt income is included in MAGI for the purposes of determining the portion of benefits that is taxable. (For related reading, see Avoid The Social Security Tax Trap.)

In many cases, the effective tax rate that can apply on this tier of income will be 15%. So, the potential federal tax impact on tax-exempt income is 12.75% (or 85% of 15%).

Example - Effect of Social Security Tax on TEY Calculation
For a taxpayer in the 15% federal bracket who invests in a muni yielding 5%, the TEY is indicated on the table as 5.9%. However, if all tax-exempt income is subject to the tax on Social Security benefits (at 12.75%), the after-tax yield on the muni drops to 4.4% while the TEY falls to 5.1%.
5% - (5% * 12.75%) = 4.4%.
4.4% / (1 - .15) = 5.1%

In the real world, this evaluation gets even murkier because senior taxpayers can't assume 100% of municipal bond interest falls within the zone of Social Security tax impact. The zone begins at the $32,000/$44,000 MAGI threshold and continues higher until the maximum 85% portion of Social Security benefits is included in taxable income. Above the top of this zone, there is no further impact.

Estimating and Adjusting Tax Impact
Unfortunately for retired people, taxes aren't easy! The best way to determine the actual TEY on exempt municipals is to use a tax preparation software program, such as Turbotax, or hire a tax preparer or certified public accountant (CPA) to do it for you. Start by plugging in all tax data for the year except tax-exempt income, which is shown on Form 1099-INT, box 8. Then, add your tax-exempt income and observe whether there is any change in the bottom-line tax. Divide any increase in income tax by the totals reported on Form 1099-INT to determine the effective tax rate on tax-exempt income.

Example - Adjustments for Tax-Exempt Income\'s Effect on TEY
Joe and Mary file taxes jointly. Before plugging in tax-exempt income, their bottom-line tax liability is $4,000. After plugging in $10,000 of tax-exempt income, their tax increases to $5,000. Earning $10,000 in tax-exempt income has cost them $1,000 of extra taxes, so the effective rate on tax-exempt income is 10%. If their munis are yielding 5%, the correct tax-exempt yield they should use for TEY purposes is 4.5%, after adjusting for tax impact.
But here\'s the tricky part. Even if this tax estimating process occurs in November or December of a tax year, it will be too late to create much change in the tax-exempt income reported for that year. The solution is to look for other adjustments or deductions that can reduce MAGI below the thresholds for Medicare income-relating or Social Security tax impact. For example, a charitable contribution might be made late in the year. Or perhaps some earned income could be shifted into the next tax year.

There are several other complex issues that can cause municipal bonds to have tax impacts, including capital gains, bonds purchased at discount and the alternative minimum tax (AMT). (To read about these issues, see Avoid Tricky Tax Issues On Municipal Bonds.)

Conclusion
Retirees who receive Medicare or Social Security benefits shouldn't assume their municipal interest is 100% tax exempt. Therefore, they shouldn't blindly trust the same old taxable equivalent yield calculations when making investment decisions. By using tax preparation software or the services of a CPA to model tax impact and make year-end adjustments, seniors can continue to enjoy the advantages of municipal investments and their taxable bond counterparts.

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