retirement

4 Tax-Free Income Sources to Supplement Retirement

Choosing your investments with taxes in mind is a smart strategy as you approach retirement. Here are four income-generating possibilities that won’t trigger big tax bills.

Would you rather retire with taxable or tax-free income? With tax rates at historical lows, it is imperative to plan your next move before they rise in the future. Here are four tax-free income sources and their benefits.

Roth IRAs

In contrast to a traditional IRA, a Roth IRA requires you to pay taxes up front on your account contributions, but after age 59½, as long as you’ve held the account for at least five years, you can withdraw the money and interest earned tax-free. This allows you to protect more money for retirement.

The annual contribution limit is equivalent for the traditional IRA and Roth IRA, and both are subject to income restrictions in their own ways. For 2017, the maximum contribution is $5,500 ($6,500 if age 50 or over). For Roth IRAs, if your Modified Adjusted Gross Income (MAGI) is between $118,000–$133,000 as a single individual or $186,000–$196,000 as a married couple, the amount you can contribute to a Roth IRA will be reduced. For traditional IRAs, your contribution isn't limited by your income, but the amount that you can deduct on your tax return could be if you or your spouse has access through a retirement plan through your jobs. See the IRS IRA Deduction Limits page for details.

For some, the Roth IRA is the best option, because its after-tax income compounds tax-free. If you will most likely retain a high level of income, it would be more profitable to fund a retirement account with after-tax dollars and reap the benefits in the long run.

Roth IRAs are also attractive because your contributions can be withdrawn at any time, penalty-free and tax-free. It’s only the gains on which you would face taxes and the 10% early-withdrawal penalty if you withdraw them before age 59½. And even those penalties can be avoided if the withdrawal is covered by one of several exemptions, including:

  • First-time home purchase (up to a lifetime maximum of $10,000);
  • Higher-education expenses at a qualified institution;
  • Unreimbursed medical expenses or health insurance premiums (if unemployed); and
  • Become disabled.

Life Insurance Cash Value

The primary reason people purchase life insurance is for the death benefit; but certain policies can accrue cash value restriction-free and penalty-free. Cash value in a life insurance policy is not a company-sponsored or retirement plan, but an alternate way to accumulate savings into a non-correlated asset class. Some of the different types of policies have been around for hundreds of years and have helped protect families against potential hardships during a recession or depression.

Although the most commonly used retirement accounts are restricted in some regard, life insurance such as whole or universal life, gives the opportunity to accrue retirement savings and guarantees that are not contingent on stock market returns. Just like one would insure his or her home, car or health, several people use life insurance’s cash value to insure their retirement. Similar to a Roth IRA, withdrawals are potentially tax-free under section 7702 of the Internal Revenue Code.

Key tax advantages from life insurance include:

  • No income restrictions;
  • Tax-deferred cash value accrual;
  • Tax-free withdrawals (or loans);
  • Not included into Social Security taxation equation;
  • Pre-bankruptcy, lawsuit and creditor protection (subject to state laws);
  • Withdrawals prior to age 59½ are not subject to IRS penalty; and
  • Tax-free death benefit.

Unlike other investments or retirement accounts, withdrawals escape income taxes and capital gains taxes. You can allocate otherwise taxable investments inside a tax-free life insurance policy, producing large sums of tax-free compounded gains.

Municipal bonds

Municipal bonds (or “munis” for short) are debt obligations issued by cities, counties, states or any political subdivision of the United States and a source of tax-free income.

Besides the typical risks with investing (such as credit and liquidity), the greatest is your Social Security being taxed up to 85% due to municipal bond income. In fact, if you’re retired and already in a high tax bracket, this may not be a feasible solution. Unfortunately, many financial advisers aren’t aware that although municipal bond income is tax-free, it is factored into the equation for Social Security taxation.

Sale of your home

If you’re downsizing and have lived in your home for the last two out of five years from the date of sale, you can exclude up to $250,000 of capital gains taxes from the proceeds if you’re single. If you’re married, you can double that amount, essentially excluding up to $500,000.

Make sure to discuss with a qualified financial adviser on the unique factors of your life and retirement plan to determine which ones would be most appropriate or helpful.

About the Author

Carlos Dias Jr., Wealth Adviser

Founder and President, Dias Wealth LLC

Carlos Dias Jr. is a financial adviser, public speaker and president of Dias Wealth LLC, in the Orlando, Florida, area, offering strategic financial planning services to business owners, executives, retirees and professional athletes. Carlos is a nationally syndicated columnist for Kiplinger and has contributed, been featured or quoted in over 100 publications, including Forbes, MarketWatch, Bloomberg, CNBC, The Wall Street Journal, U.S. News & World Report, USA Today and several others. He's also been interviewed on various radio and television stations. Carlos is trilingual, fluent in both Portuguese and Spanish.

Most Popular

Are You Still Chasing the Almighty Dollar, Even Though You Have Plenty to Retire?
retirement

Are You Still Chasing the Almighty Dollar, Even Though You Have Plenty to Retire?

In our experience, many have saved enough money to retire comfortably. Yet too many worry about their money running out and want more. Maybe it’s tim…
May 6, 2021
Child Tax Credit 2021: Who Gets $3,600? Will I Get Monthly Payments? And Other FAQs
Coronavirus and Your Money

Child Tax Credit 2021: Who Gets $3,600? Will I Get Monthly Payments? And Other FAQs

People have lots of questions about the new $3,000 or $3,600 child tax credit and the advance payments that the IRS will send to most families in 2021…
May 4, 2021
20 Dividend Stocks to Fund 20 Years of Retirement
dividend stocks

20 Dividend Stocks to Fund 20 Years of Retirement

Each of these high-quality dividend stocks yields roughly 4%, and you can expect them to grow their payouts even more. That's a powerful 1-2 combo for…
May 7, 2021

Recommended

7 Money-Smart Ways to Spend Your Tax Refund
Tax Breaks

7 Money-Smart Ways to Spend Your Tax Refund

Since this year's tax deadline was pushed back to May 17, many people are just now filing their tax return. That means there are a lot of tax refunds …
May 8, 2021
33 States with No Estate Taxes or Inheritance Taxes
retirement

33 States with No Estate Taxes or Inheritance Taxes

Even with the federal exemption from death taxes raised, retirees should pay more attention to estate taxes and inheritance taxes levied by states.
May 6, 2021
Taxes, Taxes and More Taxes
tax planning

Taxes, Taxes and More Taxes

In light of the recent proposals by President Biden and Sens. Bernie Sanders and Chris Van Hollen, here’s what could be coming and some ideas on how t…
May 4, 2021
9 Tax Deadlines for May 17 (It's Not Just the Due Date for Your Tax Return)
tax deadline

9 Tax Deadlines for May 17 (It's Not Just the Due Date for Your Tax Return)

Between due dates for extension requests, IRA or HSA contributions, and other deadlines, there's more to do by May 17 than just filing your federal in…
May 4, 2021