Is it possible to create a Tax-Free Retirement? 🙏🏼
Is it possible to create a tax-free retirement?
😬 Taxes, taxes, taxes.
Higher net worth investors are often very concerned with saving on taxes, as they should be! Noone should pay any more in taxes than is necessary.
And I can say with confidence, that those who consider them ‘do it yourself’ investors, miss out on potential tax-savings strategies that financial planners are skilled in.
But really, how do I create a tax-free retirement?
Creating a tax-free retirement is a goal many aspire to achieve, and with careful long-term planning – the key here is LONG-TERM, and strategic financial decisions, it may become a reality. This article is not intended to provided specific advice, and I must caveat that you should always check with your tax and legal professionals. But I did want to provide some ideas that I use to help my clients navigate the path to a tax-free retirement, or at least a retirement where they reduce their taxes as much as possible.
🤔 What does a Tax-Free Retirement actually mean?
A tax-free retirement means that the income you receive during your retirement years is not subject to federal income taxes. This can significantly enhance your financial security and allow you to enjoy your retirement without the burden of taxes. There are several strategies to achieve this, including utilizing specific retirement accounts, investments, and tax-efficient withdrawal strategies.
Let’s start with Social Security income and its taxation.
Most of us will receive some sort of social security income in retirement, either through our own earnings records, that of our spouses, or both. (I’m a huge believer in understanding how this works, as early as you start earning – refer to my other blog for more info).
In my work preparing taxes as an Enrolled Agent I see that many people, while retired and receiving Social Security income, are always shocked to learn that their Social Security Income is taxable, sometimes as much as 85% of their income is taxable.
Why? You Social Security income is taxable when you have additional sources of income. It makes sense to understand how you’ll be impacted, LONG before you’re actually impacted. To do so, you must understand how the IRS determines if your Social Security Income will be taxed – which is explained below.
Start by calculating your Combined Income: To determine if your Social Security benefits are taxable, you need to calculate your combined income. This is done by adding half of your Social Security benefits to your other income, which includes wages, pensions, interest, dividends, and capital gains. (link to IRS: https://www.irs.gov/newsroom/irs-reminds-taxpayers-their-social-security-benefits-may-be-taxable)
Compare your Income to the Income Thresholds per filing Status (Married Filing Jointly, Single, etc): For Individuals:
If your combined income is less than $25,000, your Social Security benefits are not taxable.
If your combined income is between $25,000 and $34,000, up to 50% of your benefits may be taxable.
If your combined income is more than $34,000, up to 85% of your benefits may be taxable
For Married Couples Filing Jointly:If your combined income is less than $32,000, your Social Security benefits are not taxable.
If your combined income is between $32,000 and $44,000, up to 50% of your benefits may be taxable.
If your combined income is more than $44,000, up to 85% of your benefits may be taxable. (see this US News & World Report: When to Pay Taxes on Social Security):
Ok, understood. My Social Security income may be taxed if I have outside income.
⬇️ So what can I do to minimize my additional taxable income?
Start with Roth IRAs and Roth 401(k)s.
One of the most effective ways to secure tax-free income in retirement is through Roth IRAs and Roth 401(k)s. Contributions to these accounts are made with after-tax dollars, meaning you don’t get a tax deduction when you contribute. However, the significant advantage is that both the growth and withdrawals are tax-free, provided certain conditions are met.
Roth IRAs:
Contributions to Roth IRAs are made with after-tax dollars, and qualified distributions are tax-free. To qualify, the account must be open for at least five years, and you must be at least 59½ years old when you start taking distributions.
Roth 401ks:
Similar to a Roth IRA, a Roth 401k is offered through an employer. Contributions are made with after-tax dollars, and qualified distributions are tax-free. Same as for the Roth IRA, to qualify, the account must be open for at least five years, and you must be at least 59½ years old when you start taking distributions.
🩻 Health Savings Accounts (HSAs)
We love these possibly triple-tax-free wonders! HSAs are another powerful tool for creating tax-free income in retirement. Contributions to an HSA are tax-deductible, the money grows tax-free, and withdrawals for qualified medical expenses are also tax-free. After age 65, withdrawals for non-medical expenses are taxed at your ordinary income rate, but if used for “Qualified Medical Expenses”, they remain tax-free. There are MANY health expenses in retirement that are not covered by Medicare. You can access the list in IRS Publication 502 – but just to give you an example of costs in retirement where it would be great to have already saved the funds and really take advantage of the ‘triple tax free’ treatment include:
Eye exams and glasses
Chiropractor
Hearing aids
Dental treatment
Long-term care insurance premiums
What else may offer tax free income?
Municipal Bonds.
Investing in municipal bonds can provide tax-free interest income. These bonds are issued by state and local governments, and the interest earned is generally exempt from federal income taxes. Further, if your residence state offers municipal bonds, the interest may also be exempt from state and local taxes.
Cash Value/Accumulation Life Insurance policies.
For my high-income clients in their 30s – 50’s, and who have already maxed on their other available tax-deferred savings opportunities such as those above, I often discuss cash value life insurance policies. Certain types of life insurance policies, such as whole life or universal life, can be used to create tax-free income in retirement. This is because these policies accumulate cash value over time, which may be accessed through tax-free loans or withdrawals. However, it’s essential to understand the terms and conditions of the policy to avoid any tax implications.
And let’s not forget about Tax-Efficient Withdrawal Strategies.
To maximize your tax-free income, it’s crucial to have a tax-efficient withdrawal strategy. This is where I see ‘do it yourself’ investors mess up. As a Certified Financial Planner and Enrolled Agent, I’m mired in tax laws and strategies and can help fit those puzzle pieces together to arrive at tax-efficient withdrawal strategies. Most ‘do-it-youselfers’ are not up to date with the most recent changes in legislation, and may miss out on important strategies.
🙋🏻Can you help me work towards a tax-reduced retirement?
In summary, your financial situation is unique to you, and some of the strategies above may or may not be ones you should consider. I’m always happy to evaluate your picture and help you understand your options moving forward. Everyone should consider the appropriate strategies to reduce their taxes in retirement. The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.
📲 Please reach out today to schedule time with me.