5 Legal Ways To Have Tax-Free Income For Retirement
No one likes paying taxes. Even in the current low tax rate environment brought about from Trump's Tax Cuts and Jobs Act of 2017, I hear people complaining about how much they pay in taxes. However, with the right planning, there are ways to get tax-free retirement income that can greatly reduce future frustration.
I enjoy helping people work toward reaching their financial goals but, specifically, financial independence. That is the day in which work becomes an option. The more taxes you will owe in retirement, the more assets (cash, investments, pensions, real estate, etc.) you will need to have saved to fund your retirement.
For example, if you are retired, married, and make more than $44,000 combined, then 85% of your Social Security is taxable. I won't even get into the issues of how the Income-Related Monthly Adjusted Amount (IRMAA) can have a substantially negative effect upon your Medicare Part B and Part D premiums.
And with the passing of the SECURE Act, non-spousal beneficiaries no longer have the option for a stretch IRA, which allowed the balance of these tax-deferred accounts to be slowly drawn down over the beneficiary's lifetime. The new rules require that these accounts must be depleted within 10 years; unfortunately, this can create a substantial tax burden for the beneficiaries you are hoping to provide for through your estate.
Needless to say, it can be advantageous to plan ahead for where your retirement assets will be held and how you will take withdrawals to help minimize the tax bite throughout your retirement years.
Here are five ways you can potentially have tax-free income in retirement:
Think of this as your tax-free starter account. You can put in $6,000 per year ($7,000 if you are 50 or older). You won't get a tax deduction when you put the money in, but the money grows tax-free and, most importantly, the money comes out tax-free in retirement. While this may seem great to some, the problem is that most people will need to save more than $6,000 per year in order to reach their financial goals. Also, there are income limitations for who can contribute and how much. For example, only couples who earn up to a combined $196,000 ($193,000 for 2019) and singles who make $124,000 ($122,000 for 2019) are able to contribute the full amount to a Roth IRA.
Roth 401(k) and Roth 403(b)
This can be an excellent feature if your plan allows it. Similar to a Roth IRA, your growth and withdrawals are tax-free. The difference is that you have the ability to contribute up to $19,500 per year, as well as a $6,500 catch up if you are 50 years of age or older). You will pay taxes on the contributions but there aren’t income restrictions for these plans.
Municipal Bonds and Funds
This is the most investment-specific of the options, so you will need to make sure these bonds fit your investment needs. The short overview is that income distribution from these bonds are not subject to federal income taxes, but they may still be subject to state income taxes. For this reason, the interest rates these bonds pay is generally lower than that of taxable bonds.
There is also the potential for default. A notable example of this occurred when the City of Detroit defaulted on its bond obligations. While income from these bonds may be tax-free, your capital gains may still be taxable.
Health Savings Account (HSA)
This can be the triple whammy of tax-free income. You can get a tax deduction for contributions, the growth and, if taken properly, withdrawals are also tax-free. You will need to have the appropriate type of health insurance in order to use this type of account, and investment options may be limited in some plans. This account is meant to be used to pay for current medical expenses, but you don’t have to pay for them now. You could hold the HSA until retirement with the fund growing and compounding along the way. You could then reimburse yourself for all the medical expenses you paid over the years (make sure to keep your receipts). Expenses can include Medicare premiums. The drawback is that you can only contribute $3,550 per year or $4,550 per year if you are 55 or older.
Cash Value Life Insurance
This is what I call a "Roth on 'Roids". Most people don’t think of life insurance as part of their retirement plan and some believe it isn’t needed in retirement. However, this can be a wonderful tool to bridge the gap to financial freedom if you are married, have kids, have maxed out contributions to your other retirement account(s), or are in a high tax bracket. I won’t list all of the benefits of life insurance except that some policies have benefits you can enjoy before you die. Perhaps more importantly is the potential for tax-free income in retirement.
You should think of cash value life insurance as another asset class for your retirement and tax planning. Essentially, you can set up this account like a Roth IRA without income or contribution limits. You won’t get a tax deduction for your premiums but the money will grow tax-free. If handled properly, it will come out tax-free. Also, these accounts won’t incur IRS penalties for withdrawals before you reach 59 ½. This can be a huge bonus for people looking to retire early or would like to buy other assets with the cash value of their policy.
I don’t have a crystal ball but it wouldn’t surprise me if taxes went up in the future given the current deficit, underfunding of Social Security, and longevity of today’s retirees.
Be proactive and develop a plan to reach your financial goals, including a comfortable retirement. Having more options on how you get taxed on your retirement income will help make that a much easier task.