How to Create Tax Free Income for Retirement
When asked, what will be the largest expense you will encounter during retirement? most people will answer either mortgage or health care. In reality, it most likely will be income taxes. Depending on your income, the tax bill could be as much as 35% – 52% depending on what state you live in. Its time to start looking for tax free income.
We all have three tax buckets we draw our income from. The first bucket is called the tax always bucket. This usually represents rents, royalties, dividends, salary, and bonus. The second tax bucket is known as the tax later bucket. This usually comprises of deferred compensation, 401(k), profit sharing, pension, and IRA. The third bucket, known as the tax never bucket, is comprised of Roth IRA, tax free municipals, reverse mortgage income and certain forms of life insurance. How much tax-free income do you have in your retirement planning portfolio? Most people will answer this question as a big zero. Most will have tax later income and almost all will have some form of tax always income, but very few will have the tax never bucket of income.
Let’s explore the four forms of the tax never bucket of income.
The simplest way to receive tax free income is by contributing to a Roth IRA. The money inside a Roth IRA will grow completely free of taxation as long as you make no unqualified withdrawals. The better news is there are no age contribution limits so even if you are 75 or older and you want to keep adding to your Roth, you can, unlike a qualified pension/profit sharing/ 401(k) plan where you must begin to withdraw taxable income at least by age 72. The negative aspect of a Roth IRA is the limitation as to how much you can put in. In 2022 the Roth IRA contribution limit is the lesser of $6,000 ($7,000 if you are age 50 or older) or Your taxable compensation for the year.
The second limitation is, if you are married filing jointly and your modified adjusted gross income (MAGI) is under $204,000 then the limit of contribution stated above is the max you can put in. However, if you earn between $204,000 but less than $214,000, your contribution will have a reduced amount. Finally, if you earn over $214,000, the amount of contribution is $0.
Converting from a current qualified retirement plan into a Roth IRA may make sense if you are able to pay the immediate taxes due from other sources.
The risks associated with a Roth IRA pertain primarily to where the money is invested. If invested in the market and due to the sequence of returns, this could have adverse effect on future retirement if market losses occur in the first ten years prior to retirement or ten years after retirement.
Tax Free Municipal Bonds
One of the major advantages of municipal bonds is their tax exemption from federal income tax and in many cases local and state taxes as well.
The interest income is tax-exempt, however, capital gains realized from the selling of the bond are usually subject to federal and state taxes. There are many types of bonds to consider, however, the risk with bonds is if interest rates increase, the value of the bond decreases so unless the bond is held to maturity, a loss could be incurred.
Money received from a reverse mortgage will not be taxable income. The funds will be considered loan proceeds rather than income. This is an incredible way of tapping into an income source that is very rarely considered. You may elect to have a lump sum, monthly advance, line of credit or any combination of the three while you have the opportunity of continuing to live in your home. Another advantage of income from a reverse mortgage is it will typically not affect your social security or Medicare eligibility and can be used to pay for long-term care or living expenses when other means are not available.
A reverse mortgage can help increase one’s retirement cash flow by reducing the mortgage on the house. As an example, if one was paying $3,000 a month for the current mortgage, a reverse mortgage could eliminate that $3,000 a month, providing a reduced total expense for retirement purposes.
Permanent Life Insurance
Most people have a tendency when mentioning life insurance as a retirement vehicle to turn their heads with distain. I believe this is due to lack of knowledge in how life insurance can be utilized as a terrific tax-free income builder, while at the same time guaranteeing the family a death benefit in the event of an early demise thus guaranteeing the family a retirement income from the death proceeds.
While a true retirement permanent policy design will minimize the death benefit and maximize the cash accumulation, it does not take away from the fact that it does create a self-completing retirement plan.
There are two ways to take income out of a life insurance policy. One is through withdrawals up to the basis and the second is to take loans from the cash value similar to borrowing the equity from your home. Loans are tax free as is the withdrawal to basis.
Another advantage, depending on the type of the permanent insurance policy design, you may have the ability to get returns based on a market index but not take any losses when the markets reverse thus preventing one from having to make up the losses due to market volatility. This will help with regard to the sequence of returns mentioned earlier.
In conclusion, with proper planning, one can create a portfolio of tax-free income which could in turn free up other dollars to be invested.
If you would like to learn more about any of the above tax buckets, and how they pertain to you, please do not hesitate to reach out.