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Roth IRAs are also attractive because your contributions can be withdrawn at any time, penalty-free and tax-free.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

Planning to Sell Your Home in Retirement? Downsize Costs Along With Space
Budgeting

Planning to Sell Your Home in Retirement? Downsize Costs Along With Space

In this hot real estate market, consider the costs of buying and selling a house along with the expenses associated with your new digs.
November 13, 2020
What Biden Will Do: 24 Policy Plays to Expect From the Next Administration
Politics

What Biden Will Do: 24 Policy Plays to Expect From the Next Administration

The Kiplinger Letter forecasts President-Elect Joe Biden’s biggest priorities -- and the likelihood of progress on them.
November 19, 2020
The 13 Best Healthcare Stocks to Buy for 2021
Kiplinger's Investing Outlook

The 13 Best Healthcare Stocks to Buy for 2021

Most of the best healthcare stocks for 2021 will have some sort of ties to COVID, whether it's producing a vaccine or cure, or benefiting from the vir…
November 20, 2020

Recommended

13 States That Tax Social Security Benefits
social security

13 States That Tax Social Security Benefits

You may have dreamed of a tax-free retirement, but if you live in these 13 states, your Social Security benefits are subject to a state tax. That's on…
December 2, 2020
18 States With Scary Death Taxes
inheritance

18 States With Scary Death Taxes

Federal estate taxes are no longer a problem for all but the extremely wealthy, but several states have their own estates taxes and inheritances taxes…
December 2, 2020
Is Your Cash Value Life Insurance Policy Still a Good Fit for You?
life insurance

Is Your Cash Value Life Insurance Policy Still a Good Fit for You?

Over the years, you could have grown out of it. Or maybe your life insurance policy’s performance didn’t live up to your expectations. In any case, yo…
November 30, 2020
The Best T. Rowe Price Funds for 401(k) Retirement Savers
Kiplinger's Investing Outlook

The Best T. Rowe Price Funds for 401(k) Retirement Savers

A dozen T. Rowe Price mutual funds also have a place among the nation's most popular 401(k) retirement products. Find out which funds belong in your r…
November 27, 2020