The reason: If you own municipal bonds, Uncle Sam may heavily tax your Social Security benefits. It depends on your provisional income, which is calculated by adding:
<Your adjusted gross income (AGI).
<Tax-exempt interest income from municipal bonds and municipal bond funds.
<Half of your annual Social Security benefits.
Let's say you have an AGI of $20,000, tax-exempt income of $7,000, and $15,000 in Social Security benefits. You're in the danger zone because your provisional income is $34,500 ($20,000 plus $7,000 plus $7,500 or half of your benefits).
On a joint tax return, you can only have provisional income of up to $32,000 without having to pay tax on your benefits. ($25,000 for single filers) If you go over those amounts, up to 50 percent of your benefits are taxed. If your provisional income is more than $44,000 on a joint return or $34,000 for a single filer, up to 85 percent of your benefits are taxed.
As you can see, tax-exempt income gets the same weight as taxable earned or investment income. Your municipal bond income is really taxable because it causes you to pay higher taxes on Social Security benefits.
There's another factor to consider: Your tax bracket might drop in retirement, which reduces the advantage of owning munis.
You're may be better off investing in Treasury bonds, which are safer and more liquid than munis, or in corporate bonds, which offer higher yields.
Consult with your financial adviser and crunch some numbers if you're getting ready to retire and collect Social Security.
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