Millions of Americans are worried about running out of money in retirement. Boomers and Generation Xers are playing catch up to avoid having to drastically reduce their standards of living in retirement. Lowering your taxes on your retirement income and increasing your tax-free retirement income can help stretch those valuable retirement account dollars. Keep reading for five smart ways to get the most income, tax-free, in retirement.
When people enter retirement, they are often shocked at how much they still have to pay in taxes each year. If they aren’t surprised by their tax bills, they are likely working with a fabulous financial planner (like myself) who has prepared them for a secure retirement income stream. Or perhaps, they just have a tiny retirement income, which doesn’t incur much in the way of tax liability.
As we are hopefully coming to the end of the Coronavirus recession, the government has doled out trillions of dollars in stimulus. Pair this with record deficits during the Trump years, and at some point, taxes will need to increase. This alone should encourage you to be more proactive with your tax planning for retirement. Also, look for ways to ensure you have at least some tax-free income in retirement.
In the plainest terms, the more taxes you expect to owe in retirement, the more assets you will need to accumulate to generate the after-tax income you need to survive in retirement.
Here are five smart ways to have the most tax-free income in retirement.
Roth IRA
Think of the Roth IRA as the starter, tax-free retirement income account. You can put in $6,000, per year, ($7,000 if you are 50 or older). While you don’t get a tax deduction for contributions, your money can grow tax-free and, most importantly, the money comes out tax-free at retirement.
You may ask, why don’t I put all of my retirement savings into a Roth IRA? The main problem with a Roth IRA is the paltry contribution limits, paired with income limitations. If you are reading this, you will likely need to save more than $6,000, per year, in order to reach your retirement income needs.
If you contributed $6,000 each year from the time you were 22 until you reached the age of 65, and earned 10% each year, you would have more than $3.55 million. If you did that until you were 70, that number would jump to more than $5.76 million. That’s the magic of compounding interest at its best, which you could then turn into tax-free income.
Flip this and say you started at 40 years old, contributing $6,000 every year to a Roth IRA. At 65, assuming 10% returns, you would have $590,000. A nice number for sure, but even without taxes, this wouldn’t produce enough income for average Americans to maintain their standards of living in retirement.
Roth 401(k) or Roth 403(b) For Tax Free Retirement Income
The Roth option can be an excellent feature if your employer’s retirement 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.
Even if you started late (at age 50) and contributed $26,000 each year to a Roth 401k, you could become a millionaire. Assuming 10% net returns, the 401(k) could grow to $1.49 million by age 70.
Municipal Bonds and Funds
Muni Bonds are the most investment-specific of these tax-free income options. You will need to decide if these bonds fit your investment needs. The short overview is that income distribution from these bonds is 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 are generally lower than that of taxable bonds. These bonds also have various investment and reinvestment risks, especially now that we are in a rising rate environment.
Tax Season is a reminder to look at the amount of Tax-Free income you can recieve in retirement.
Health Savings Account (HSA)
Health Savings Accounts offer the triple whammy of tax-free income. You can get a tax deduction for contributions, 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 funds 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 $3,600, per year, or $4,600, per year, if you are 55 or older.
Biden Tax Law Changes may make tax-free retirement income even mor valuable in the future.
Cash Value Life Insurance
I call this strategy the “Rich People Roth”. 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 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.
The life insurance portion can also help ensure your spouse can retire comfortably if something happens to you before retirement. I have spoken with quite a few people in the past year (as you can imagine) who have had a spouse pass (way ahead of retirement age). The only bright light is that they will all be ok, financially, because of proceeds from life insurance. The benefit also comes out tax-free.
Be proactive and develop a plan to reach your financial goals, including a comfortable retirement income stream. Diversification of taxation in retirement can help you minimize taxes owed in retirement. Especially if you plan on selling a home, business, or will be receiving an inheritance, talk with your financial planner today about how to plan ahead to pay the fewest taxes on your life savings as you approach retirement.