10-Year Treasury Yields Rise Above 5% as Income Seekers Pile In, and Tax-Free Muni Interest Can Still Trigger Social Security Taxes

Quick Read

• Municipal bond interest is exempt from federal income tax, but the IRS still includes it in "combined income" when figuring out how much of your Social Security benefits are taxable.

• Adding $12,000 of muni interest can push a retiree's combined income above $34,000, causing as much as 85% of Social Security benefits to become taxable even though the interest itself is tax-free.

• Compare two tax-return scenarios, one with muni interest and one with taxable choices such as CDs or Treasuries, to see which leaves you with more money after taxes.

Imagine a retiree receiving $30,000 a year in Social Security and another $10,000 from an IRA. With bond yields climbing, he may think he has found a smart move: shift some savings into municipal bonds and collect interest the IRS does not tax.

But there is a catch for Social Security recipients. Although municipal bond interest is generally free from federal income tax, the IRS still uses it when deciding how much of a retiree's benefits to tax. That can make the investment far less attractive than it first appears.

Tax-Free Interest Still Enters the Social Security Tax Test

The IRS relies on a measure called combined income to determine how much of your Social Security is taxable. It adds adjusted gross income, tax-exempt interest, and half of your annual benefits. So even though municipal bond interest is usually exempt from federal income tax, it still counts in the formula.

That total is then measured against a base amount of $25,000 for single filers or $32,000 for married couples filing jointly.

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For retirees in Howard's muni example, once combined income goes beyond $34,000 for individuals or $44,000 for joint filers, as much as 85% of benefits can become taxable.

Take Frank, a hypothetical retiree. Before he buys municipal bonds, half of his Social Security plus his other income comes to $25,000. That puts him right at the single-filer threshold, so none of his benefits are taxable yet.

Then he purchases municipal bonds paying $12,000 a year in tax-exempt interest. His combined income rises to $37,000, clearing both thresholds. The interest itself remains federally tax-free, but $7,050 of his Social Security benefits now becomes taxable. He has not received any additional Social Security income, yet his federal tax bill could still go up.

Between the two thresholds, each extra dollar of income can make up to one-half of a dollar in benefits taxable. Above the upper threshold, where Howard's higher-bracket investors often land, that rises to 85% of each extra dollar until the overall cap is reached. Frank's exact taxable amount still depends on the full IRS worksheet, but the muni interest pushes more of his benefits into taxable income.

It is important to keep the percentage and the tax rate separate. Even for the investors Howard is talking about, the 85% figure is only the maximum share of benefits that can be counted as taxable income. That taxable portion is then hit at your ordinary rate, just like IRA withdrawals.

Why Midrange Retirees Get Caught Off Guard

Municipal bonds are often compared with taxable investments using a taxable-equivalent yield, which estimates how much a taxable bond would need to pay to match the muni's after-tax return. But that comparison can miss the effect on Social Security. For someone like Frank, tax-free interest can still raise the amount of benefits subject to federal income tax.

Retirees with higher incomes may see less of a surprise. Once 85% of Social Security is already taxable, more municipal bond interest will not increase that share. But crossing the $34,000 threshold does not automatically mean reaching the maximum. The additional tax burden can be especially noticeable for retirees whose benefits are still moving into taxable territory.

This middle group grows larger over time. The threshold amounts are fixed in the law and are not adjusted for inflation. Benefits, meanwhile, rise with cost-of-living increases. A 3.6% raise for 2027 lifts the average retired worker's check to about $2,170 a month, moving more people closer to the line.

This quiet threshold creep is one of several IRS rules that can reduce retirement income without making headlines. We included it, along with eight others, in a free tax trap guide for retirees.

Run the After-Tax Numbers Before Chasing Yield

Before buying munis, run two versions of your tax return through software or the IRS worksheet: one including the muni interest and one using a taxable alternative such as Treasuries or CDs. Then compare the total tax bill in each case. Pay close attention to how much of your Social Security becomes taxable, because that amount can change more than you might expect.

The hardest mistake to reverse is locking a large part of your savings into long-term bonds based on a yield that ignores this interaction. If rates rise, selling early can mean taking a loss.

Filing status, state taxes, and other income can all change the result, so check your own numbers. For a retiree like Frank, the best yield is the one that leaves the most money after taxes. Sometimes that is the bond with the less flashy label.

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Now you can learn the mistakes even experienced investors make (and ways you can sidestep them before it’s too late) with this new guide: 13 Retirement Mistakes and How to Avoid Them from Fisher Investments. (sponsor)