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5 Ways to Get Tax-Free Income in Retirement

Find out how you can get tax-free income in retirement to ensure that more money stays in your pocket during the later years of your life.

When you’re planning for retirement, there can be a lot of uncertainty.

You don’t know what the future holds. That includes future tax rates.

Thankfully, there are ways you can take income taxes out of the equation.

If you have certain types of investment accounts or income, you can get tax-free retirement income.

This allows you to keep the money you withdraw from these accounts without paying anything to the federal government for income taxes. In some cases, you can avoid state income taxes, too.

What this means for you:

You get more certainty when planning your retirement income.

Here are five common sources of income you can access tax-free in retirement as far as federal income taxes go.

Check with your state’s laws to see if these investments could be tax-free retirement income in your state, too.

1. Roth IRA or Roth 401(k) Withdrawals

Traditional 401(k) plans and traditional IRAs allow you to avoid paying income tax now. You get a tax deduction for your contributions. The money even grows tax-free. 

Unfortunately, they require paying taxes when you withdraw the money from the retirement account. These are called tax-deferred retirement accounts.

No one knows what income tax rates will be in the future. This puts a significant amount of uncertainty in your retirement plans. 

Federal income tax rates are currently relatively low on a historical basis. They could increase in the future. If it does, it could leave you with less retirement income than you’re expecting.

If you want tax-free retirement income, you’ll need to use a different version of these retirement accounts.

Roth 401(k) retirement plans and Roth IRAs require you to pay taxes on the money you contribute to the account. 

The best part, however:

Once the money is in the account, the earnings on the investments grow tax-free.

When you eventually reach retirement age, you can withdraw both the original contributions and the earnings without paying federal income taxes on them.

This takes quite a bit of uncertainty out of your retirement planning.

The money you see in your account will be yours. You won’t have to worry about paying federal income taxes on it.

2. Municipal Bonds Income

Another way to get tax-free income in retirement is municipal bonds.

If you’ve never heard of municipal bonds before, they might sound like a fancy type of investment. 

In reality:

They’re just bonds issued by state and local municipalities rather than corporations or the federal government.

Currently, federal income tax laws allow proceeds and interest from municipal bonds to be federal income tax-free.

State or local tax-free income

Additionally, many states and localities also allow you to receive interest and proceeds from municipal bonds issued in that state or municipality to be state or local income tax-free, as well.

If your state or locality charges an income tax, you may be limited to investing in that state’s or locality’s municipal bonds. In general, states and localities don’t allow you to get tax-free income from municipal bonds issued by other states.

You can still invest in bonds from other municipalities. You may have to pay state or local income tax on the proceeds and interest. They’re still federal income tax-free, though.

If you live in a state that doesn’t charge an income tax, you don’t have to worry about what municipality’s bonds you invest in.

The state doesn’t charge a tax and they’re all federal income tax-free.

You’ll need to check with your state and locality’s income tax laws. This way, you can see if this works for your specific state or local tax situation.

3. Health Savings Account (HSA) Withdrawals

A health savings account is a unique way to get tax-free income in retirement. 

It’s one of the few tools you could potentially use to put away money pre-tax and withdraw money tax-free in retirement.

That means:

It’s technically possible to never pay taxes on the money in a health savings account.

Money withdrawn for qualifying medical expenses can be withdrawn tax-free.

When you’re retired, chances are you’ll have plenty of medical expenses. You can use this money for those inevitable medical expenses without paying taxes on it.

If you don’t have medical expenses, you can still withdraw the money for any reason you want after you’re age 65. You’ll have to pay income tax on the money, though. 

If you withdraw the money before age 65 for non-medical expenses, you’ll also have to pay a 20% penalty in addition to the taxes owed.

Now:

In order to contribute to a health savings account, you have to meet certain rules.

First, you must be covered by a high deductible health plan (HDHP)

The definition of a HDHP changes from year to year. For 2019, the deductible had to be at least $1,350 for a single person or $2,700 for families.

It must also have an out-of-pocket maximum of at least $6,750 for a single person or $13,500 for families.

If you have a qualifying HDHP that allows you to use an HSA, you’re in luck. In 2019, you could contribute $3,500 to the account if you have individual coverage. If you had family coverage, you could contribute $7,000.

Some health savings account providers allow you to invest the money within the account. This allows for faster growth of your money. 

That said:

Some providers have very high fees to invest compared to investments at a provider like Vanguard. 

If you can choose which HSA provider you use, pick one that offers low fees and great service. If you have an HSA through an employer, you can’t likely choose your HSA provider.

4. Life Insurance Cash-Outs

Life insurance policies offer another potential source of tax-free income.

If your spouse dies and you receive the benefit of the policy, it is generally federal income tax-free. 

If the policy was part of employer group coverage and they paid for part of the cost of the policy, part of the benefit may be taxable.

The death benefit can also be taxable if you pay for a life insurance policy with pre-tax money.

Whole life or permanent life insurance

If you have a whole life or permanent life insurance policy, there is another way to get cash from the policy. 

These policies generally build cash value over time. Insurers often let you borrow against this cash value or cash out the policy altogether.

As long as the money you cash out is less than the premiums you’ve paid, the money is usually income tax-free.

Any money taken out in excess of the premiums you paid is considered taxable income.

If you cash out the policy in full, the policy will no longer be in effect. This means you won’t get a death benefit if the insured person dies.

Be very careful before deciding to cash out a whole or permanent life insurance policy. 

Of course:

There are exceptions and other rules for specific situations. Check with your tax professional to make sure your policy works as you expect for income tax purposes.

5. Social Security Benefits

Depending on your situation, your Social Security benefits may be tax-free in retirement.

In general, the lower your income, the higher the likelihood your benefits will be tax-free.

To find out if your benefits are taxable, you must first know your base amount.

You calculate this by taking your adjusted gross income without including Social Security benefits, adding half of your Social Security benefits plus any non-taxable interest you have.

You then compare this number to the following rules.

If you file single, head of household or a qualifying widow or widower, your base amount can be up to $25,000 before your Social Security income starts getting taxed. The threshold is $32,000 for those filing married filing jointly.

Once you exceed that threshold, up to 50% of your Social Security benefits become taxable until you hit the next threshold.

If your base amount exceeds $34,000 and you file single, head of household or qualifying widow or widower, up to 85% of your Social Security benefits are taxable. For married filing jointly people, that limit is $44,000.

Based on this information, your Social Security benefits could be entirely tax-free to as little as 15% tax-free.

Either way,  you get at least some tax-free income from Social Security.

Tax-Free Retirement Income Helps Predictability

Having tax-free retirement income takes one of the many variables out of your complex retirement planning equation. 

When you know you won’t have to pay taxes on certain types of retirement savings, you know exactly how much money you have at your disposal. 

You don’t have to worry about tax rates going up on ordinary income in the future.

Even if tax rates go up, it won’t reduce the amount of tax-free money you have available to live your life. 

Even so:

It usually doesn’t make sense to have all of your retirement savings in assets that allow you to get tax-free income. 

There are many tax concepts you could take advantage of to get tax-free income or at least income at a very low tax rate, but you may have to have some taxable income to take advantage of them. They include: 

  • Standard deduction 
  • Tax credits 
  • Capital gains tax rates 
  • The initial low marginal income tax rates on taxable income 
  • Other planning strategies

This means keeping some income in a tax-deferred retirement account may be a good idea, too. 

This way, you can take advantage of opportunities to have income with a relatively low tax rate.

Then, you can withdraw your tax-free income to fill the rest of your income needs. 

The bottom line is:

You need to evaluate what you think is right for you and your future. Whether that means focusing on tax-free retirement income or a mix of both, you’re responsible for your future retirement.