While certain muni-bond ETFs may escape the AMT and offer other financial benefits, caveats remain. And financial advisors should be aware of them.
For example, although the income from municipal bonds isn’t taxed federally, the IRS still includes muni-bond income as part of a person’s modified adjusted gross income (MAGI) to determine taxes on Social Security income. This is an important issue for clients nearing or already in retirement who are putting together their retirement income sources.
Here’s the general math: If half of the client’s Social Security benefit plus other sources of income, including tax-exempt muni-bond interest, is more than $44,000 for married tax filers ($34,000 for single filers), up to 85% of the Social Security benefit would be taxed. This could turn out to be a nasty surprise for clients with large chunks invested in muni bonds who are generating significant tax-free income. Put another way, “tax-free” doesn’t necessarily mean free from taxes on Social Security income.
Finally, tax-exempt interest received from muni-bond ETFs could increase premiums for Medicare Part B or Medicare prescription drug coverage. For married clients filing jointly with MAGI greater than $170,000 ($85,000 for single filers), they will be subject to pay additional amounts for Medicare Part B and prescription drug coverage.
In the end, municipal-bond ETFs remain a popular destination for investors. But it’s up to advisors to explain both the positives and negatives while letting investors have the final say.
Ron DeLegge is founder and chief portfolio strategist at ETFguide, and is the author of "Habits Of The Investing Greats."