Seven Ways to Get More Tax-Free Retirement Income

Even though we pay taxes to the government for our benefit, no one enjoys handing over their hard-earned money to the IRS (Internal Revenue Service). Yet everyone does pay a certain share of their money towards taxes, at least in their working years. It is in retirement where most people expect their tax bill to go down because of the loss of a steady income source. But this may not always be the case and you may have to pay a hefty tax bill in retirement, too. Even if you do not have any work-related earnings, your income from sources like Social Security benefits, retirement accounts, pensions, and other savings can lead to a significant tax output.

When you plan for retirement, it is critical to consider the impact of taxes. Generally, in retirement, your income stems from three defined sources: Social Security benefits, distributions from retirement plans like an IRA (Individual Retirement Account) or a 401(k), and money from other investments and savings. Apart from your retirement income, your tax filing status also impacts your tax bill. For instance, nearly 85% of your Social Security benefits may be taxable, given your retirement income and tax filing status. Further, your distributions from a traditional IRA and a 401(k) are also taxable.

You need sincere planning to generate a tax-free retirement income for a long time. The good news is some effective strategies can help you get more tax-free retirement money, reducing your overall outlay. Depending on your combined income, you can use these strategies to minimize state and federal taxes at the end of each retirement year. To learn more about how you can reduce your taxability in retirement, do reach out to a professional financial advisor who can advise you on the same.

Here are seven effective ways to get more tax-free retirement income:

1. Maximize tax-free retirement account contributions:

To reduce taxes in retirement, you can focus on maximizing your tax-advantaged retirement account contributions. Retirement accounts like an IRA or 401(k) allow you to deposit pre-tax dollars and enjoy tax-free growth. For 2023, you can contribute up to $22,500 in a 401(k) if you are younger than 50. If you are 50 or older, you can contribute up to $30,000 annually. Further, if your employer is offering matching 401(k) contributions, ensure to tap the benefit as it can take you to your goal sooner. In terms of IRA, you can contribute up to $6,500 in 2023 if you are younger than 50. If you are 50 or older, you can save up to $7,500 annually. That said, traditional tax-free retirement accounts like a 401(k) and an IRA are not the ideal tax-advantaged mediums to save for retirement. If you want to reduce your taxes during the retirement period, you can opt for the Roth versions of these retirement accounts. Roth 401(k) and IRA allow you to make after-tax contributions, earn tax-free growth over time, and obtain tax-free withdrawals during retirement, subject to simple age restrictions and holding period rules. For instance, if you have been holding the Roth IRA for more than five years and are above the age of 59.5 years, you can get 100% tax-exempt withdrawals.

You can consider maximizing your contributions to both retirement accounts. The contribution limits for Roth accounts are the same as their traditional counterparts. If you are already saving money in a traditional retirement account, you can go for a rollover, where your funds are redirected from the original accounts to their Roth versions.

2. Live in a tax-friendly state:

You owe a significant sum towards federal taxes during retirement, but you have to pay a hefty sum towards state taxes. The state you live in has a direct impact on your retirement taxes. For instance, approximately 22 American states have no tax exemption for traditional IRA or 401(k) withdrawals, but some states offer tax benefits even on these accounts. Undoubtedly, some states are more tax-friendly than other states. Some of the most tax-friendly states in the U.S include Tennessee, South Carolina, Arkansas, the District of Columbia, Hawaii, Colorado, Nevada, and Delaware. Texas, Vermont, Nebraska, New York, Iowa, Kansas, Illinois, and New Jersey are a few of the most non-tax-friendly states. If you shift to a tax-friendly state during retirement, you can lower your annual tax bill by approximately $10,000 or more compared to living in a non-tax-friendly U.S state. Among these states, Delaware has no estate or inheritance tax, low-income tax rates (between 2.2% and 6.6%), and an average joint state and local sales tax of 0%. Alaska, Tennessee, Texas, Florida, Nevada, Washington, South Dakota, New Hampshire, and Wyoming do not levy any state-level personal income taxes. These states only tax interest and dividends. You can also earn retirement income in one state and relocate to another state to reduce your tax bill. For instance, you get a pension in California (high tax state) but relocate to Florida for retirement years; hence, pay no state taxes on the pension income.

3. Reevaluate your investment portfolio:

Gains from investments are taxable during your working years and in retirement. Capital gains realized from mutual funds, dividend earnings, accrued interests, etc., attract similar tax treatment during retirement as before. However, you can reduce your investment-related taxes by structuring your portfolio wisely. Changing your investment holdings during retirement can help lower taxes and preserve capital. For instance, you could ditch the aggressive stock investing strategy and opt for a more balanced portfolio comprising municipal bonds, dividend stocks, etc. Municipal bonds are free from federal taxes. However, they may affect combined taxes on Social Security benefits. Alternatively, you can choose dividend stocks that are essentially qualified dividends received from publicly-traded U.S. companies and foreign corporations. Qualified dividends are taxed more favorably than regular dividends. The tax rate can be anywhere between 0% and 20%, depending on your taxable income during retirement. Other than this, you can consult your professional financial advisor to suggest some tax-saving strategies. Your advisor could ask you to invest in tax-saving assets through your tax-free retirement accounts. Further, you can also ask your advisor about capital gain offsetting strategies. You can use the losses from the sale of securities and related property to offset the capital gains earned in the year. This will lower your tax bill. If you have more capital losses than gains, you can use your losses to offset up to $3,000 of your ordinary income like bank interest. There is also an option to carry forward your capital losses to another year, which means you could offset the future potential profits by the previous year’s losses to reduce retirement taxes.

4. Be tactical about Social Security benefits:

You can begin to take your Social Security drawings from the age of 62. In the case of early retirement tax planning, you might be relying on Social Security to fund a majority of your retirement expenses. However, in reality, the Social Security benefits are insufficient to fully support your retirement life. These benefits are also taxed, which eventually reduces your paycheck. But you can lower your Social Security tax payments during retirement by using the right strategies. If Social Security is your only retirement income source, you will pay zero taxes because your taxable income is below the minimum tax bar. However, if you have income from other sources like an IRA, a pension plan, a 401(k), etc., your Social Security becomes taxable. Your Social Security taxes are also influenced by the retirement income of your spouse and your tax filing status, such as married filing separately, married filing jointly, single, etc. The IRS has a worksheet that can help you determine your tax liability. Generally, if you have a high income, you could pay taxes up to 85% of your Social Security benefits. But some states like Texas, Florida, etc., have no charge on Social Security receipts. Other tax-friendly states also provide deductions, and credits, allowing you to lower your adjusted gross income, and thereby, your tax liability.

5. Opt for life insurance or annuities:

If you want tax-free retirement income, you can invest in life insurance policies or annuities. When you invest in a life insurance policy, a part of it goes towards insurance, and the other premiums are redirected towards savings and investments. Depending on the type of policy, the cash value from these life insurance plans can be used to generate retirement income that is free from taxes. Alternatively, you can consider annuities to lower your retirement taxes. You can opt for immediate annuities, where a part of your premiums is considered as the return on principal, and the other interest. In this case, only the interest is taxable. Investing in a Health Savings Account (HSA) is also a tax-friendly solution. HSAs offer triple tax advantages. You contribute pre-tax dollars, your funds grow tax-free, and during withdrawal, you pay no taxes on the sum taken. However, HSA funds should be used towards an eligible purpose (specified medical expenses only). If the money from an HSA is used for ineligible medical or non-medical expenses, the withdrawals will be taxed. Further, in this case, individuals under 65 years or not disabled pay a 20% penalty. Your HSA contributions are limited each year. For 2023, the upper limit of self-only HSA is $3,850 and for a family is $7,750. It is in your best interest to take full advantage of your annual HSA contributions and optimize tax benefits. HSA will also make future medical costs affordable.

6. Keep in mind Required Minimum Distributions (RMDs):

Generally, it is advisable to keep your funds safe in the tax-advantaged retirement accounts for as long as you can. The longer you delay your withdrawals from these accounts, the more returns you can accumulate and defer taxes. However, you cannot indefinitely keep money in your tax-advantaged retirement accounts. These accounts have withdrawal rules like RMDs, where you are subject to take minimum distributions from your retirement savings accounts after a specific age. For instance, the IRS mandates you to take RMDs from your IRA and 401(k) as you turn 73. The amount of the RMD depends on your life expectancy and account balance. If you fail to take RMDs in full or by the due date, you would be liable to a penalty by the IRS. The IRS levies a penalty of 25% on the RMD amount you do not withdraw from your tax-advantaged retirement accounts. This penalty is applicable until you rectify the error. Further, the penalty is in addition to the taxes you owe on these account distributions. Hence, if you want to reduce the outlay from your retirement corpus, it is best to keep a check on your RMDs and ensure you withdraw them timely and in full to avoid paying any hefty penalties.

7. Spread your withdrawals over a longer time frame:

As mentioned, RMDs do not begin until you turn 73. However, legally, you can withdraw funds from your tax-free retirement accounts from the age of 59.5. Keep in mind that you can allocate your withdrawals over a longer period to distribute the tax bill over more years. This means that each year you withdraw less money and save on taxes because you would be in a lower tax bracket. If you are considering early retirement, assuming that you do so in your 60s, you can begin taking a low amount from your retirement accounts to distribute the tax across a longer number of years. This is possible when you do not solely depend on retirement accounts to sustain your retired lifestyle expenses. If you have income from other sources, like part-time work, etc., you can lower your tax bill by taking only minimum distributions from retirement savings accounts, like an IRA or 401(k).

Note: There are some other sources of income that are not taxable during retirement. For instance, if you get divorced and receive alimony, the amount you get is not taxable, provided the divorce happened after 2018. A gift from parents is also not taxable, and the life insurance proceeds you get as a beneficiary are also free from taxes. Moreover, if you sell your primary home, you can claim tax exclusion up to $250,000 if you are a single tax filer and $500,000 if you are a married couple filing tax jointly.

To conclude

You would owe taxes in retirement. But by keeping these strategies in mind, you can significantly reduce your tax bill. However, there is no single perfect strategy. A particular tactic may be right for your financial circumstances but might not suit someone else. Each person’s financial situation is different, and hence, it is always beneficial to adopt a customized tax strategy to get more tax-free retirement income.

Consider engaging with a professional financial advisor who will work with you to understand your financial condition, preferences, life stage, tax filing status, and more, and create a custom tax-free retirement income plan for you. Use the free advisor match service to connect with 1-3 financial advisors based on your financial requirements. All you need to do is answer a few simple questions about yourself and the match tool will find advisors that match your financial needs.