The Hidden Tax on Municipal Bond Income

[Editor's note: This post was updated, and a correction appended below, on February 7, 2017.]

Q: Is municipal bond interest counted towards your modified adjusted gross income? I’m confused and need to know how munis will affect my Medicare premium. — Larry, Kent, Wash.

A: Municipal bonds can be a sweet deal for tax-conscious investors. That's because interest income generated by these bonds — which are issued by states, cities and other public entities — is typically exempt from federal income tax.

And investors who buy munis issued by a government, school board, or public authority within their home state might also get a break on state or local income taxes.

That said, Uncle Sam doesn’t always turn a blind eye to income thrown off by muni bonds, says Steve Pitchford, a certified financial planner and certified public accountant with B|O|S, a San Francisco wealth advisory firm.

While you aren’t taxed on muni bond income, you do need to include it when calculating your modified adjusted gross income, or MAGI, in certain situations. Muni bond income, for example, impacts how much you pay in Medicare Part B monthly premiums.

Medicare Impact

As your MAGI increases, so do your monthly Medicare Part B costs.

If your MAGI is below $85,000 (or $170,000 for couples filing jointly), you pay $121.80 each month for Part B. As your MAGI goes up, so does your payment, which tops out at $389.80 for individuals with MAGI of $214,000 (or $428,000 for couples filing jointly).

Keep in mind that what you pay today is based on your previous year’s tax return, which reflects the interest you earned the year prior. “The interest you earn this year will make a different two years from now,” Pitchford says.

Social Security Impact

Muni bond interest can also impact how your Social Security is taxed. In this case, the IRS looks at what it calls combined income, which is your adjusted gross income plus tax-exempt interest and half of your Social Security benefits.

If your combined income is less than $34,000 for individuals and $44,000 for couples filing jointly, up to 50% of your Social Security benefits will be taxed. Beyond that, up to 85% of your benefits could be taxed.

Are They Worth It?

To be sure, muni bond income comes with some hidden costs, but “that isn’t reason not to invest,” says Pitchford.

The big question then is whether the benefits of investing in municipal bonds are worth paying higher Medicare premiums or getting hit with a bigger tax on Social Security.

You’ll want to run the numbers yourself, but if your tax-exempt interest is such that it puts you over these thresholds, odds are that what you save in federal taxes — and state taxes, depending on where you live and where you invest — will outweigh what you pay.

For most investors, Pitchford recommends sticking with a low-cost national municipal bond fund. (See our recommendations on the Money 50.) You’ll get a diverse portfolio of bonds, and the federal tax break to boot. (Since you’re in Washington, which has no state income tax, it’s even more reason to go with the national fund.)

Keep in mind too that municipal bond tax perks only apply to the interest generated by these investments. “If you sell a bond at a gain,” says Pitchford, “you pay the same tax as you would any other investment.”

Correction: A previous version of this article incorrectly described the impact of municipal bond interest income on federal taxes. Muni interest has no effect on whether you qualify for deductions related to IRA contributions, student loan interest, self-employment tax, or rental losses. It also does not factor into the Medicare surtax (formally the "net investment income tax").