6 Legal Ways To Get More Tax-Free Retirement Income

Having a larger retirement income is great; having a larger tax-free retirement income is even better. Keep in mind that for most people, you will owe taxes on your Social Security, 401(k) withdrawals, pension income, and many other ways you can earn income in retirement. Keep reading as we share six strategies to get more tax-free income in retirement.

Over the past 20 years, I have helped numerous people reach financial freedom. This is the day work becomes an option. If you love what you do, continue working, all the while knowing you could retire any time you so choose. Part of this process often includes tax planning to help minimize the drag of taxes on your retirement income. Simply put, the more taxes you owe on your retirement income, the larger your retirement nest egg will need to be to provide you with a secure retirement income you won’t outlive. Being married can make tax-free retirement income even more valuable as it helps blunt the pain of the marriage penalty on your retirement taxes.

For example, if you are retired and earn more than $44,000 combined, 85% of your Social Security is taxable. This alone should be enough to prompt you to seek proactive tax planning to help you keep more of your retirement income from being eaten by taxation.

Here are six ways you may be able to earn tax-free income in retirement.

Fund A Roth IRA 

Think of the Roth IRA as the starter account for tax-free income in retirement. In 2022, you can contribute $6,000 to your Roth IRA ($7,000 if you are 50 or older). There is no tax deduction for your Roth IRA contributions, but the money grows tax-free, and, most importantly, the money comes out as tax-free income during retirement.

While $6,000 may seem like a lot of money to save each year, this is less than most people reading this should be saving for retirement. This is especially true if you are starting your retirement planning late. The other drawback is the Roth IRA comes with income limitations, and some of you may not be eligible to contribute even if you wanted to.

If you contributed $6,000 per year from the time you were 22 until you reached the age of 65 and earned 10% each year, you would have more than $3.55 million. If you did that until you were 70, that number would jump to more than $5.76 million. That’s the magic of compounding interest at its best. Remember, all of this money could be turned into tax-free retirement income.

Contribute To a Roth 401(k) or Roth 403(b) 

Using the Roth option, your 401(k) or 403(b) can be a great way to build tax-free retirement income, assuming your retirement plan allows for Roth contributions. Similar to Roth IRA contributions, your growth and withdrawals within your Roth 401(k) are tax-free. The difference is that you have the ability to contribute up to $20,500 in 2022, as well as a $6,500 catch-up if you are 50 years of age or older.

Tax-Free Income from Municipal Bonds and Funds  

Buying municipal bonds (either individually or via funds) is the most investment-specific of the tax-free income options. You will want to ensure that investing in municipal bonds will fit as part of your overall investment portfolio, in short. Income distributions from municipal bonds are not subject to federal income taxation, but they may still be subject to state income taxes. For this reason, the interest rates municipal bonds pay is generally lower than that of taxable bonds. These bonds also have various investment and reinvestment risks, especially now that we are in a rising-rate environment.

MORE FROM FORBESNew Standard Deduction And Higher New Tax Brackets For 2022By David Rae

Health Savings Account (HSA)

Investing for retirement via an HSA is the triple whammy of tax-free income. You can get a tax deduction for contributions, the growth, and, if taken properly, withdrawals from an HSA are also tax-free. You will need to have the appropriate type of health insurance plan to open and fund an HSA. This account is meant to be used to pay for current medical expenses, but you don’t have to pay for them now. You could hold the HSA until retirement with the assets growing and compounding along the way. You could then reimburse yourself for all the medical expenses you paid over the years (make sure to keep your receipts). Expenses can include Medicare premiums. The drawback is that you can only contribute $3,650 in 2022 if you are single or $7,300 for a family. There is also an allowable $1,000 HSA catch-up contribution for workers aged 55 or older.

Social Security Income Tax-Free

If your taxable retirement income is small enough, you can receive your Social Security benefits tax-free. I am going to go out on a limb here and say unless you have substantial tax-free income here, you do want to be taxed on your Social Security. The reason is that if your total income is low enough for your Social Security to not be taxable, you are likely sitting near the poverty line.

In 2022, at an income of just $25,000 (single) or $32,000 (married), your Social Security benefits begin to be taxed. Keep in mind this includes your Social Security checks as well as all other taxable retirement income.

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Cash Value Life Insurance 

I call the strategy of using Cash Value Life Insurance for more tax-free income in retirement the “Rich People Roth” strategy. You probably don’t think about your life insurance as part of your retirement plan especially, if you own term life insurance that has no cash value and will likely expire before you reach retirement. However, the Rich Person Roth can be a valuable tool to bridge the gap to financial freedom if you are married, have kids, have maxed out contributions to your other retirement account(s), or are in a high tax bracket. I won’t list all the benefits of life insurance except that some policies have benefits you can enjoy before you die. Perhaps, more importantly is 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 without income or contribution limits. You won’t get a tax deduction for your premiums, but the money will grow tax-free. If handled properly, it will come out tax-free. Also, these accounts won’t incur IRS penalties for withdrawals before you reach 59 ½. This can be a huge bonus for people looking to reach financial independence and retire early (pre 59.5).

While I’d never claim to have the ability to predict the future, it would be surprising to me if taxes don’t increase in the future. Even if tax brackets don’t increase, many tax deductions (mortgage deduction, SALT cap, etc.) are not adjusted for inflation, offering de facto tax increases as inflation does its thing over time.

Be proactive and develop a tax plan to reach your financial goals, including a comfortable and secure retirement. Diversifying your retirement income streams is imperative, and having more options on how you get taxed on your retirement income will help make that a much easier task.