Seven Ways to Maximize Your Tax-Free Retirement Income

Benjamin Franklin once famously said that in this world nothing can be said to be certain, except death and taxes. All of us pay tax to the government be it directly or indirectly. Any individual who runs a business or is employed contributes money towards taxes during their working years. The expectation is that their tax bill would reduce during retirement due to the loss of a steady source of income. However, that may not be the case, and you may have to shell out a hefty tax bill in retirement too, if you have not taken steps to reduce your tax bill. You have to take your income from sources such as Social Security benefits, retirement accounts, pensions, and other savings into consideration while calculating your tax even if you do not have any earnings from a job or business.

While planning for retirement you cannot ignore the impact of taxes on your retirement savings. Typically speaking, the major sources of income during retirement are:

• Social Security benefits
• Distributions from retirement plans like an IRA (Individual Retirement Account) or a 401(k)
• Earnings from investments and savings

You also need to take your tax filing status into account while calculating your tax bill. Did you know that almost 85% of your Social Security benefits may be taxable depending on your retirement income and tax filing status? In addition, any withdrawals made from a traditional IRA or a 401(k) are also taxable.

You need a concrete financial plan to generate tax-free retirement income and reduce your state and federal taxes simultaneously. If you wish to learn how you can lower your taxability in retirement and maximize your tax-free retirement earnings, consult with a professional financial advisor who can guide you on the same.

Herein, we will discuss seven effective ways to generate tax-free retirement income:

1. Do not forget to max out your retirement account contributions:

An effective way to reduce your taxes in retirement is by making regular contributions to your tax-advantaged retirement accounts such as an IRA or 401(k). Herein, you can contribute pre-tax dollars to earn tax-free growth. For 2022, you can contribute up to $20,500 in a 401(k) and an additional $6,500 if you are over 50 years of age, bringing your total to $27,000 annually. Additionally, you can also benefit from matching 401(k) contributions offered by your employer to reach your retirement savings goal sooner. For an IRA, you can contribute up to $6,000 in 2022 and an additional $1,000 (if you are 50 and up), bringing your total contribution to $7,000 per year. However,  traditional tax-free retirement accounts such as 401(k)s and IRAs are not considered to be ideal retirement savings instruments. To lower your taxability during retirement, you can consider investing in the Roth versions of these retirement accounts. By investing in Roth 401(k) and Roth IRA, you can contribute after-tax dollars, earn tax-free growth over time, and make tax-free withdrawals during retirement, provided you are 59.5 years of age and have held your Roth account for a period of at least five years. It is advised that you maximize your contributions to both retirement accounts as the contribution limits for Roth accounts are the same as their traditional versions. If, however, you are already saving in a traditional retirement account, you have the option to rollover your funds to their Roth counterpart. Do note that you will have to pay the ensuing taxes at the time of conversion.

2. Settle down in a tax-friendly state:

During retirement, you not only have to pay federal taxes but also have to shell out a significant sum in state taxes too. The state that you reside in has a considerable impact on your retirement taxes. For example, some states offer tax benefits for retirement accounts but around 22 states do not offer any tax exemption for traditional IRA or 401(k) withdrawals. That said, some states are more tax-friendly compared to other states. These are Tennessee, South Carolina, Arkansas, the District of Columbia, Hawaii, Colorado, Nevada, and Delaware whereas Texas, Vermont, Nebraska, New York, Iowa, Kansas, Illinois, and New Jersey are some of the most non-tax-friendly states in the United States. Say, you move to a tax-friendly state during retirement, doing so would help you reduce your tax liability by approximately $10,000 or more annually compared to living in a non-tax-friendly U.S state. Take Delaware for instance. It 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%. Further, if you reside in either Alaska, Tennessee, Texas, Florida, Nevada, Washington, South Dakota, New Hampshire, or Wyoming, you would not have to pay any state-level personal income taxes. You would have to pay tax on interest and dividends only. You also have the option of earning your retirement income in one state and then shifting to another state to lower your tax bill. For example, say you receive your pension in California which charges high taxes on its residents and shift to Florida for your retirement years where you would not have to pay any state taxes on your pension.

3. Review your investment portfolio:

Any capital gains (whether short-term or long-term) accrued by you during your working years and in retirement are taxable by nature. Moreover, you have to pay similar taxes on capital gains made from mutual funds, dividend earnings, accrued interests, etc., during retirement as before. However, by restructuring your portfolio, you may be able to lower your investment-related taxes as well as preserve your capital. For example, you could opt for a more balanced portfolio composed of municipal bonds, dividend stocks, etc., in place of a more aggressive stock investing strategy. You do not have to pay any taxes on municipal bonds. However, do keep in mind that they may impact your combined taxes on Social Security benefits. You could also invest in dividend stocks. These stocks are essentially qualified dividends received from publicly-traded U.S. companies and foreign corporations with the major benefit being that qualified dividends are taxed more favorably compared to regular dividends. The tax rate varies between 0 to 20% and depends on your taxable income during retirement. You can also reach out to a professional financial advisor to learn about tax-saving strategies and lower your annual tax bill. Further, your advisor can help you invest in tax-saving assets through your tax-free retirement accounts. You could also seek advice on capital gain offsetting strategies and how you can use any losses incurred by you on the sale of securities and related property to offset the capital gains earned in the year. You can use your losses to offset up to $3,000 of your ordinary income provided you have more capital losses than gains. You could also offset future potential profits by the previous year's losses by carrying forward your capital losses to another year to lower your retirement taxes.

4. Use your Social Security benefits strategically:

The IRS allows you to withdraw your Social Security benefits from the age of 62. If you opted to take early retirement, you may be banking on Social Security to fund a major part of your retirement expenses. This may be ill-advised as in reality Social Security benefits are insufficient to fully support your retirement lifestyle. Moreover, since your Social Security benefits are also taxed, it reduces your take-home check as well. But you need not fret as you can use certain strategies to reduce your Social Security tax payments during retirement. Firstly, if Social Security is your sole source of income in retirement, you will pay zero taxes because your taxable income falls below the minimum tax threshold. That said, if you have alternate sources of income such as an IRA, a pension plan, a 401(k), etc., you will have to shell out tax on your Social Security. Additionally, you have to take into account the retirement income of your spouse and your tax filing status when calculating your Social Security taxes. If you need help figuring out your tax liability, you can go through this worksheet prepared by the IRS. If you are a high-income earner, you could end up paying taxes on up to 85% of your Social Security benefits. There is a workaround to this scenario. Some tax-friendly states such as Texas, and Florida, among others, do not charge any tax on Social Security drawings. While others offer deductions, and credits, enabling you to reduce your adjusted gross income, and in effect, your tax liability.

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5. Do not neglect to invest in life insurance or annuities:

Investing in life insurance policies or annuities is another way to boost your tax-free retirement income. In layman’s terms, when you invest in a life insurance policy, you are investing in insurance and premiums. The premiums are used for savings and investments. You can use the cash value from these life insurance plans to generate tax-free retirement income. Do note that this is dependent on the kind of policy taken out by you. You can also invest in annuities such as immediate annuities where a portion of your premiums is treated as the return on principal, and the other part as interest. You only have to pay tax on the interest in this scenario. You can also opt to invest in a Health Savings Account (HSA). Herein, you get multiple tax advantages - you contribute before-tax dollars, you get tax-free earnings, and you can make tax-free withdrawals. This comes with the caveat that HSA funds can be used for an eligible purpose only such as specified medical expenses. If you use your HSA funds for ineligible medical or non-medical expenses, you will have to pay tax on your drawings. Moreover, any individual below the age of 65 or not disabled, must pay a 20% penalty. There is a limit on how much you can contribute towards your HSA. For 2022, you can contribute $3,650 for self-only HSA and $7,300 for a family. Investing in HSA offers dual benefits - you can lower your annual tax bill and make future medical costs affordable.

6. Do consider the impact of Required Minimum Distributions (RMDs):

It is generally advised to keep your funds in your tax-advantaged retirement accounts for as long as you can. By delaying your withdrawals, you can accumulate significantly higher returns and lower your taxability at the same time. However, you cannot do so for an indefinite period of time. Retirement accounts have certain rules when it comes to withdrawals such as RMDs. Herein, you must take out minimum distributions from your retirement savings accounts after reaching a specific age. For example, you must take RMDs from your IRA and 401(k) when you reach 72 years of age as mandated by the IRS. The amount that you must withdraw is calculated based on your life expectancy and account balance. The IRS levies a penalty if you fail to take RMDs in full or by the due date. You must pay a penalty of 50% on the RMD amount you do not withdraw from your retirement account. Keep in mind that until you rectify the mistake the penalty will remain applicable and it is in addition to the taxes owed by you on distributions taken out by you. Thus, it would be in your best interest if you keep a check on your RMDs and ensure that you make timely withdrawals to avoid paying any hefty penalties and reduce your tax outlay at the same time.  

7. Ensure that you spread your withdrawals over a longer period of time:

Till the time you turn 72, you do not have to take out RMDs, however, you can begin withdrawing your funds at the age of 59.5. Doing so would also allow you to lower your tax bill as you can spread the tax bill over a longer period. This would be particularly helpful if you are considering taking early retirement as you can start drawing a small sum from your retirement accounts to spread the tax across a longer number of years. This is doable if you have alternative sources of income (such as part-time work, your own business, etc.) to support your retirement years and do not solely depend on retirement accounts to meet your expenses.

Note: There are certain sources of income that do not fall under the tax umbrella during retirement. These are:

• Your alimony amount is not taxable provided the divorce occurred after 2018.
• If your parents give you a gift, it cannot be taxed too.
• Any life insurance proceeds received by you as a beneficiary are also free from taxes.
• In the event of a sale of your primary home, you can claim a tax benefit of up to $250,000 if you are a single tax filer. This amount increases to $500,000 if you are a married couple and file your taxes jointly.

To summarize

You cannot escape taxes in retirement. However, you can significantly lower your tax bill if you follow the strategies spelled out in the article. With that said, keep in mind that there is no get out of jail free card. A particular strategy may work for you but may not suit someone else’s financial situation. Each individual has a unique financial situation, hence, it is advised that one should deploy a customized tax strategy to maximize their tax-free retirement income.

It may be beneficial for you if you reach out to a professional financial advisor who can create a customized tax-free retirement income plan for you after assessing your financial condition, preferences, life stage, tax filing status, and more. 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.