No one loves paying taxes. Building a retirement income you can’t outlive is a challenge for many Americans. Increasing the amount of tax-free retirement dollars you receive will help minimize these two challenges.
As a Certified Financial Planner, I love helping people stay on track to reach financial freedom. This milestone will help you live a happier, healthier, and wealthier retirement. The larger your tax burden in retirement, the more retirement income-producing assets (cash, investments, real estate, 401(k), Cash Balance Pension Plans, etc.) you will need to accumulate to maintain your standard of living as you age.
Marriage can make the tax benefits of these retirement accounts even more valuable. You may have heard of the marriage penalty. Well, this refers to the often higher tax bills that come to high-earners who happen to be married. Keep reading as I share five ways to get the most tax-free income in retirement.
Contribute To A Roth IRA
Think of the Roth IRA as the starter retirement account. You can contribute up to $6,500 in 2023 ($7,500 if you are 50 or older). In most cases, there are no tax deductions on your contributions, but your Roth IRA will grow tax-free, and most importantly, the money comes out tax-free during retirement. While this may seem significant to some people, the problem is that most of you will need to save substantially more than $6,500 per year to reach financial freedom and other financial goals. Also, there are income limitations on who can contribute and how much. For example, only couples who earn up to a combined $228,000 each year and singles who make $153,000 or less can add to a Roth IRA in 2023.
If you contributed $6,500 per year, from the time you were 22 years old until you reached age 65 and earned a 10% return each year, you would have more than $3.85 million. If you worked a little longer and saved until age 70, that number would jump to more than $6.24 million. That’s the magic of compounding interest at its best, which you could then turn into a stream of tax-free retirement income.
Set Up A Roth 401(k) Or Roth 403(b) Now
For those looking to have even more tax-free income than a Roth IRA can deliver, consider contributing to a Roth 401(k) or Roth 403(b). Your employer will need to offer this option. For those who are self-employed, you can set up your own Roth Solo 401(k).
A Roth 403(b) or Roth 401(k) has similar tax benefits to a Roth IRA; your growth and withdrawals are tax-free. The difference is that you can contribute up to $22,500 per year, plus a $7,500 catch-up contribution if you are 50 or older, for 2023. You will pay taxes on the contributions, but there are no income restrictions for these plans.
Tax-Free Income From Municipal Bonds And Funds
Interest rates on bonds have jumped recently, making investment in municipal bonds more appealing. The tax-free income from municipal bonds may make them more competitive with their corporate bond counterparts. Before investing here, make sure these bonds fit your financial needs.
The short overview of tax-free income from municipal bonds is that the distribution from these bonds (or bond funds) 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 taxable bonds. These bonds also have various investment and reinvestment risks, especially in a rising rate environment.
There is also the potential for default with municipal bonds. A notable example 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 when buying or selling bonds.
Utilize A Health Savings Account For Tax-Free Income
A Health Savings Account can be the valuable triple whammy for tax-free income. First, you can get a tax deduction for contributions each year to an HSA. Second, the growth of investments within an HSA is tax-free. Third, when taken correctly, withdrawals from an HSA are also tax-free. You will need to have the appropriate type of high deducible health insurance plan to be eligible to contribute to this type of account, and investment options may be limited in some plans.
HSAs are meant to be used to pay for current medical expenses, but you don’t have to use the account on those costs 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 (keep your receipts). Expenses can include Medicare premiums. The drawback is that in 2023 you can only contribute $3,850 per year or $4,850 per year if you are 55 or older. Couples can contribute $7,750 plus the $1,000 catch-up contributions. These amount are adjusted each year.
Tax-Free Income From Cash Value Life Insurance
The strategy for maximizing tax-free income from life insurance has been called the “Rich People Roth” in wealth management circles. Most people don’t think of life insurance as part of their retirement plan, and some believe it isn’t needed for those who already retired. However, cash value life insurance can be an excellent 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. More importantly, perhaps, is the potential for tax-free income in retirement. You should only consider this strategy once you have maxed out your other retirement accounts, especially if you don’t need large amounts of life insurance.
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, those dollars will come out tax-free. Also, these accounts won’t incur IRS withdrawal penalties before you reach age 59 ½. Not worrying about early withdrawal penalties can be a huge bonus for people looking to retire early.
Be proactive and develop a plan to reach your financial goals, including a financially secure retirement. Having more options on how you get taxed on your retirement income will help make that a much easier task.
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