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How to create a tax-free income in retirement (5 Ways) Thumbnail

How to create a tax-free income in retirement (5 Ways)

Taxes are one of the largest expenses retirees are faced with. People are routinely living into their 90’s (and beyond) and if you don’t have a good plan for tax-efficient income in retirement, you may end up paying more than your fair share in taxes over your lifetime. Taxes can take a large bite out of your retirement nest egg and one way to ensure your investments last longer is to be more tax-efficient with them. This article will show you some strategies to create tax-free income in retirement. 

If you want to learn more about this topic, sign up for our Saving Money On Taxes In Retirement Webinar by clicking here. We host this webinar every Tuesday at 6:30 p.m. Pacific Time.

1. Understanding Tax-Free Income

understanding tax free income

The first step to creating tax-free income in retirement is understanding what tax-free income means. Tax-free income is any income that is not subject to federal or state income tax.

Several examples of tax-free income include qualifying distributions from a Roth IRA, municipal bond interest, loans from permanent life insurance and an inheritance.

Understanding these types of tax-free income is crucial as you plan for your retirement.

2. Maximizing Contributions to Tax-Free Retirement AccountsRoth IRA contributions

The second step is to maximize your contributions to tax-free retirement accounts.

One of the most popular tax-free retirement accounts is the Roth IRA. Roth IRA contributions are made after-tax, which means you won't get a tax break when you contribute. However, the withdrawals you make in retirement from a Roth IRA are tax-free. Roth IRA’s are also not subject to required minimum distributions unlike traditional IRA’s. Retirees with high account balances in traditional IRA’s face large RMD’s as they age which creates even larger tax bill.

In 2023, the maximum contribution to a Roth IRA is $6,500, or $7,500 if you're 50 or older. Maximizing your contributions to your Roth IRA can help you create a steady stream of tax-free income in retirement.

Another option to consider is the Roth 401(k), which is a type of retirement account that allows employees to contribute after-tax dollars to their retirement accounts. As with Roth IRA contributions, Roth 401(k) contributions grow tax-free and are not taxed when withdrawn. Unlike Roth IRA’s, Roth 401(k)’s are not subject to income limitations. So high income earners can still contribute to a Roth 401(k) no matter how much income they earn.

What if you make too much money to contribute to a Roth IRA?

For high income earners who can’t contribute to a Roth IRA because they make too much money, there is a strategy known as the “Backdoor Roth IRA strategy” that enables high income earners to get money into their Roth IRA.

In addition, for those of you who have an after-tax component to your 401(k) plan, one of our favorite strategies is the “Mega Backdoor Roth IRA contribution.” Taking advantage of both of these strategies are part of a well designed plan to create tax free income in retirement.

3. Investing in Tax-Free Municipal Bonds

Investing in tax-free municipal bonds is another way to generate tax-free income in retirement. Municipal bonds are issued by state and local governments to help fund public projects such as schools, highways, and bridges.

One of the main benefits of investing in municipal bonds is that the interest earned is tax-free. This is because the interest paid on municipal bonds is exempt from federal income taxes and in some cases, state income taxes.

While not every municipal bond is tax-free, investing in a diversified portfolio of tax-free municipal bonds can create a steady stream of income that is not subject to income tax.

4. Taking Advantage of Other Tax-Free Income Sources

rental income and tax free income in retirement

There are other strategies to generate tax-free income in retirement. For example, rental property income can be tax-free if you have sufficient deductions to offset your rental income. Business income from a business you own can also be tax-free if you take advantage of small business tax deductions and credits.

Additionally, some retirees choose to move to a state that doesn't have an income tax. This means they can live on their savings, investment income, and Social Security benefits without being subject to state income tax.

5. Strategic Tax Planning

Finally, strategic tax planning can help you maximize your tax-free income in retirement. This may include spreading out your withdrawals from taxable retirement accounts such as 401(k)s or traditional IRAs over multiple years to minimize the tax impact.

This may also involve doing strategic Roth conversions during your “gap years.” These are the years between retirement and your Required Minimum Distribution starting date which is either age 73 or 75 depending on your birth year. Once you retire, delay taking your Social Security benefit and live off of cash and taxable investments to stay in the lowest bracket possible. During these gap years, do Roth conversions while in the lower bracket. Delaying your Social Security benefit has the positive effect of getting large increases (up to 8% per year until age 70) and also making more of your future income stream subject to cost of living increases. If you plan correctly you can have half or all of your Social Security be tax free as well. 

Consider tax-efficient investments that can help minimize the tax impact of your investment income. Investing in ETFs can be much more tax efficient than mutual funds.

Tax-Loss Harvesting can reduce your tax bill too

In your taxable accounts make sure to tax-loss harvest when the market goes down. Strategically capturing losses can enable you to realize gains in the future tax free.

By taking advantage of these tax planning strategies, you can create an efficient retirement plan that maximizes your tax-free income.

Creating a tax-free income in retirement is an important consideration as you prepare for this new chapter in your life. By understanding tax-free income, maximizing your contributions to tax-free retirement accounts, and investing in tax-free municipal bonds, you can start building a reliable stream of tax-free income.

Additionally, taking advantage of other tax-free income sources and strategic tax planning can help you maximize your retirement income and minimize the tax impact. All of these can lead to a comfortable and enjoyable retirement without worrying about excessive taxes.

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This commentary reflects the personal opinions, viewpoints and analyses of the Seaside Wealth Management, Inc. employees providing such comments, and should not be regarded as a description of advisory services provided by Seaside Wealth Management, Inc. or performance returns of any Seaside Wealth Management, Inc. client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this commentary constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Seaside Wealth Management, Inc. manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.