Tax Free Income is worth celebrating. Financial advisor LA shares the five smartest ways to achieve this … [+]
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Millions of Americans worry about running out of money when they retire. Boomers and Generation Xers are playing catch-up to avoid drastically lowering their standard of living in retirement. As you lower your taxes on your retirement income and increase your tax-free retirement income, you can stretch those precious dollars into your retirement account. Read on for five smart ways to get the most tax-free income in retirement.
Often times when people retire they are shocked by how much tax they still have to pay each year. If you’re not surprised by your tax bills, chances are you’re working with a fabulous financial planner (like me) who prepared you for a secure source of income for retirement. Or maybe they only have a tiny retirement income, which doesn’t mean much to tax bill.
As we hopefully reach the end of the coronavirus recession, the government has spent trillions of dollars in incentives. Combine that with record deficits during the Trump years and at some point taxes have to go up. That alone should encourage you to be more proactive in your retirement tax planning. Also, look for ways to ensure that you have at least one tax-free income in retirement.
In the simplest sense, the more taxes you owe in retirement, the more wealth you will need to amass to generate the after-tax income you will need to survive in retirement.
Here are five smart ways to get the most tax-free income in retirement.
Roth IRA
Imagine the Roth IRA as a tax-free starter account for retirement. You can enter $ 6,000 per year ($ 7,000 if you are 50 years old or older). While you won’t get a tax deduction on contributions, your money can grow tax-free and most importantly, money will be spent tax-free in retirement.
You may be wondering why I don’t put all of my retirement assets into a Roth IRA? The main problem with a Roth IRA is the meager contribution limits, coupled with income restrictions. If you’re reading this, you will likely need to save more than $ 6,000 a year to meet your retirement income needs.
If you contributed $ 6,000 each year from your 22nd through 65th year and made 10% each year, you would have over $ 3.55 million. If you did that by the age of 70, that number would climb to more than $ 5.76 million. This is the magic of compound interest at its best, which you can turn into tax free income.
Flip this and say that you started when you were 40 and donated $ 6,000 to a Roth IRA every year. At 65 you would have $ 590,000 on a 10% return. A nice number, but even without taxes, that wouldn’t make enough income for the average American to maintain their standard of living in retirement.
Roth 401 (k) or Roth 403 (b) for tax-free retirement income
The Roth option can be a great feature if your employer’s pension plan allows it. Similar to a Roth IRA, your growth and withdrawals are tax-free. The difference is that you have the option to contribute up to $ 19,500 per year, plus a make-up price of $ 6,500 (if you are 50 years old or older). You pay tax on the contributions, but there are no income restrictions on these plans.
Even if you started late (by the age of 50) and donated $ 26,000 to a Roth 401k every year, you could become a millionaire. Assuming a net return of 10%, the 401 (k) could grow to $ 1.49 million by the age of 70.
Municipal bonds and funds
Muni bonds are the most investment-specific of these tax-free income options. You need to decide whether these bonds suit your investment needs. The brief overview shows that the distribution of income from these bonds is not subject to federal income tax, but they may still be subject to state income tax. Because of this, the interest rates these bonds pay are generally lower than those on taxable bonds. These bonds also carry various investment and reinvestment risks, especially now that we are in an environment of rising interest rates.
The tax season is a reminder of the amount of tax-free income you can get in retirement.
Health Savings Account (HSA)
Health savings accounts offer three times the tax-free income. You can get a tax deduction for contributions, growth, and withdrawals are also tax-free when taken correctly. You will need the appropriate type of health insurance to use this type of account. Investment options may be limited in some plans. This account is intended to be used to pay for ongoing medical expenses, but you don’t have to pay them now. You could hold the HSA until retirement, with funds growing and compounding along the way. You can then reimburse yourself for any medical expenses you have paid over the years (keep your receipts). The expenses can include Medicare premiums. The downside is that you can only contribute $ 3,600 per year, or $ 4,600 per year if you are 55 or older.
Changes to the tax law can make tax-free retirement income even more valuable in the future.
Cash value life insurance
I call this strategy “Rich People Roth”. Most people don’t consider life insurance as part of their retirement plan, and some believe they won’t be needed in retirement. However, this can be a wonderful tool to bridge the gap to financial freedom if you are married, have children, have maxed out contributions to your other retirement accounts, or are in a high tax bracket. I am not going to list all of the benefits of life insurance except that some policies have benefits that you can enjoy before you die. Perhaps more importantly, the potential for tax-free income in retirement.
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 with no income or contribution restrictions. You don’t get a tax deduction on your premiums, but the money grows tax-free. If handled properly, it will be issued tax-free. Plus, these accounts don’t incur any IRS penalties for withdrawing before you reach 59½. This can be a great bonus for people looking to retire early.
The life insurance portion can also help ensure your spouse can easily retire if something happens to you before you retire. I have spoken to a few people over the past year (as you can imagine) who had spousal identification (well before retirement age). The only bright light is that they will all be fine financially based on life insurance revenues. The service is also tax-free.
Be proactive and develop a plan to meet your financial goals, including a comfortable stream of income for retirement. Diversifying taxation in retirement can help you minimize the taxes owed on retirement. Especially if you have a plan to sell a home, business, or inheritance, speak to your financial planner today about how you can plan ahead to pay the lowest possible taxes on your life savings as you near retirement .