Building your retirement nest egg is hard and time consuming. Instead, why not boost the amount of money available to you to pay for things you want or need? You do that with solid retirement planning that boosts your tax-free retirement income.
Tax-free retirement income achieves the same goal as a larger retirement savings balance. You end up with more money to spend.
All it takes is thoughtful retirement planning. Your aim: Shift money into assets that generate tax-free income. That often takes far less time than waiting for investments to grow. Likewise, sometimes you qualify by patiently holding onto an asset until profits on its sale qualify for tax exempt treatment.
Retirement Planning: Six Moves
So, here are eight types of retirement income that are tax-free.
Roth IRA withdrawals. "Roth IRA contributions are taxed when they're made, not when they're withdrawn," said Andrew Schrage, co-founder and CEO of MoneyCrashers.com, a personal finance education website. "As long as you abide by the rules for Roth distributions, you won't pay taxes on principal, interest or capital gains taken out of the account in retirement."
Your contributions are always tax-free and penalty-free at withdrawal. That's because they are made with money on which you've already paid income tax. You can withdraw earnings without owing income tax or penalty once you reach age 59-1/2 and the account is five years old.
Top-notch retirement planning means being aware of exceptions to the age 59-1/2 and five-year-old account requirement. One of them: You can escape penalty but not tax if you use your withdrawal to pay for unreimbursed medical expenses if you're unemployed.
If you're under age 59-1/2 but the account is more than five years old, earnings can be withdrawn tax free under certain conditions. One of those is that you've become disabled.
No RMDs From Roth 401(k)s
Roth 401(k) withdrawal. "Roth 401(k)s have the same tax benefits and withdrawal rules as Roth IRAs, with one important exception: You do need to take RMDs after age 72," Schrage said.
RMDs are required minimum distributions. Your first RMD from an IRA must be taken by April 1 of the year after you turn 72. After your first one, IRA RMDs must be taken by Dec. 31 of each year. RMDs rules do not apply to Roth 401(k) accounts.
Also, remember that you can't contribute to the Roth IRA if your modified adjusted gross income (MAGI) exceeds certain levels. In 2022, those caps are $144,000 for single tax filers and $214,000 for marrieds filing jointly. The amount a single can contribute fades as their MAGI rises from $129,000 to $144,000. The phaseout range is $204,000 to $214,000 for married joint filers.
Another retirement planning tip: No such caps apply to Roth 401(k) accounts.
Munis In Your Retirement Planning
Municipal bond income. Interest income from municipal bonds isn't taxed at the federal level. It's usually not taxed by the issuing state either if you live there. But city and other local taxes often do apply. "Combined with relatively stable price performance for high-grade bonds, this federal tax benefit makes munis popular with retirees seeking dependable, long-term income," Schrage said.
The same rules generally apply to interest income from muni-bond mutual funds. Likewise, funds that only hold U.S. Treasury bonds may be exempt from state taxes.
Qualified dividends and capital gains. The key distinction for dividends is whether they are "qualified." This IBD retirement planning article explains what makes a dividend qualified.
Qualified dividends are taxed at rates of 0%, 15% or 20%, depending on your taxable income and filing status. Nonqualified dividends are taxed at ordinary income rates. Those range up to 37% this year and next.
The 0% rate applies to single tax filers, for example, with taxable income up to $41,675 this year and $44,625 next year. The 0% rate applies to qualified dividends received by married joint filers with up to $83,350 taxable income this year or $89,250 next year.
As for capital gains, that income — from assets held more than a year — is taxed at a peak rate of 20%. But a 0% rate applies to taxpayers who meet the same income caps that govern eligibility for the 0% rate for qualified dividends.
Short-term rates on assets held less than a year are the same as ordinary income rates. Those top out at 37% this year and next. There is no 0% rate on short-term gains.
Even if you're not eligible based on income for the 0% rate, perhaps your young-adult children of elderly loved ones would be.
Sale Of Your Home
Capital gains on the sale of your primary residence. "The IRS exempts up to $250,000 in capital gains from the sale of your primary residence once every two years," Schrage said. The exemption cap is $500,000 for married joint filers. "When the time comes to downsize, that could cover much of your primary home's price appreciation."
Paying For Health Care In Retirement
Health savings account (HSA) withdrawals. "HSA withdrawals for nonmedical expenses are taxable as regular income after age 65," Schrage said. "But they don't incur the hefty 20% penalty that people under age 65 pay. HSA withdrawals for qualifying medical expenses aren't taxed by the feds, period."
Withdrawals that you use to pay for other expenses are taxable.
An HSA can hold money that you first contributed years earlier, well before retirement.
Life insurance proceeds. You have only limited control over receiving money from someone else's life insurance policy. But you'll likely know in advance that you are a beneficiary. In that case, you'd be able to do some potentially profitable advance planning. The key fact is this: proceeds from a policy are federally tax-free.
There's also a scenario in which certain income from a life insurance policy is free from income tax if you are the policyholder rather than the beneficiary. That occurs if you buy the type of policy that returns the premiums that you've paid if you outlive the policy term or cancel the policy before the term ends. Those returned premiums are not taxable, Schrage says. The policy is probably a universal life contract. And premiums that can be returned are sometimes referred to as premiums repaid.
Retirement Planning: Upside To Reverse Mortgages
Reverse mortgage payments. "The IRS considers reverse mortgage income to be loan payments rather than taxable income," Schrage said. "Just remember that those payments deplete your equity in your home over time. Those payments can reduce or eliminate any windfall your heirs see if and when they inherit the house."
Follow Paul Katzeff on Twitter at @IBD_PKatzeff for tips about personal finance and strategies of the best mutual funds.
