When is Tax Free NOT Tax Free?

By Jeffrey Levine, IRA Technical Expert
Follow on Twitter: @IRAGuru4EdSlott

Tax free just has a nice ring to it, doesn’t it? There’s just something about those two words that seems to make even grown men giddy. There are many types of  tax-free income. Life insurance proceeds, qualified Roth IRA distributions and municipal bond interest come to mind as three of the most common sources. If these various types of income are all “tax free” though,  does that mean that they all have the same, seemingly non-existent, impact on your tax return? Maybe, maybe not. Consider the following:

Example #1: In 2013, Paul turned 60 years old. His only source of income for the year was $100,000 of tax-free qualified Roth IRA distributions. Jack was also 60 years old in 2013 and had $100,000 of all tax-free income. Jack’s income, however, was comprised entirely of tax-free  municipal bond interest. In this example, both Paul and Jack will have the same tax bill at the end of the year… $0! It made no difference that their tax-free income came from different sources.

So what difference does it make where your tax-free income comes from? Well, in the preceding example,  as noted, it didn’t. That, however, is not always the case.

Example #2: Pam and Jeanette, two single filers, have been a little lazy and are just getting around to filing their 2013 tax returns now. In 2013 Pam was 66 years old. She had $100,000 of tax-free qualified Roth IRA distributions and another $25,000 of Social Security benefits. Pam’s tax bill for 2013 is $0. Jeanette, on the other hand, also had $100,000 of “tax-free” income and $25,000 of Social Security benefits, but her tax-free income was all municipal bond interest. So what’s Jeanette’s tax bill for 2013? $0, right? Wrong!

Believe it or not, Jeanette’s 2013 tax bill is actually $1,245! Now a tax bill of $1,245 on $125,000 of income is certainly nothing I’d complain about – it is, after all, an average tax bill of less than 1% – but it’s certainly not tax free. How can that be? How can two people, both the same age, with the same filing status, the same amount of Social Security benefits and the same amount of “tax-free” income have two different tax bills?!

The answer is that the amount of Social Security benefits you pay tax on depends on the amount of income you have. The formula takes into consideration half of your Social Security benefits as well as most of your other taxable income. Unfortunately for some retirees, it also takes into consideration your supposedly tax-free municipal bond interest. Then, you compare this total of income, known as “combined income” (also as “provisional income”) to certain thresholds and, depending on where your combined income total falls, up to 85% of your Social Security benefits can be included in your adjusted gross income and be subject to income tax. That doesn’t seem fair, but that’s the way it is. For more on the taxation of Social Security benefits, click here.

Tax-free qualified Roth IRA distributions, on the other hand, do not count in the calculation of combined income, so your tax-free income is truly tax free. What a concept.