Is There Such Thing as a Tax Free Retirement?
“I’m going to sell my house and buy a condo on the beach!”
“I’m going to buy my dream car!”
“We’re going to travel the world!”
Big retirement dreams. We all have them. Generally, they involve spending the money we will spend our working years saving up, so we can enjoy retirement to the fullest.
Dreaming about what we’ll do with all that free time can be a lot of fun.
Alas, the actual process of setting up a solid retirement strategy can seem like an overwhelming challenge. After all, tomorrow isn’t promised, let alone an idyllic future that may be years away.
Someday, most of us will make it to the finish line we call retirement. We’ll be proud of ourselves for having done the best we could to plan for our anticipated income and expenses so we won’t outlive our money.
Saving money consistently throughout our working lives requires self-discipline. It takes a serious commitment and a good financial advisor to pull it all together. Even so, there are outside forces that we can’t control – like the ever-changing tax code. So how are we supposed to plan for those?
Some Hard Facts:
- The current US tax code is currently approved for just five more years: through the year 2025.
- The national debt is rising at an alarming rate – 36% faster than the economy,* in fact – and is unsustainable.
In our country, as in our households, the burden of carrying lots of debt is the more significant issue, since there are only two ways to fix that problem.
- Cut expenses (which means lowering the federal budget) or
- Make more money (which means raising taxes)
The Good News – Currently, we are in a relatively low-tax environment. While plotting and charting future income and expenses, it makes sense to consider that tax rates are likely to be higher in the future. Unfortunately, this may coincide with retirement, which is when we may need the income most. So, shouldn’t a solid retirement plan include tax planning?
When looking at a tax free retirement, it’s the difference between a micro-tax strategy versus a macro-tax strategy. While most are familiar with annually working with a tax preparer to pay the lowest possible taxes for the year, a macro-tax strategy takes a more holistic approach.
It involves planning to pay the least overall taxes over a much longer period of time. That might even mean paying a little more in taxes now, to gain a much larger tax benefit in the future. One example would be opting to pay taxes on qualified retirement accounts now – while tax rates are lower, we're getting what amounts to a discount on our tax bill – instead of later.
While most of us would like to avoid paying taxes altogether, earned income will be taxed, either now or later. Choosing when and how it is taxed will determine how much of your retirement account will end up going to the IRS and how much you’ll have left to pursue your dreams, or leave for your loved ones.
Some look at tax options as the three buckets that I have illustrated below.
With the current tax code, there is a small window of opportunity that may allow you to maneuver retirement accounts to your advantage in retirement.
Although it’s more fun to dream about a French Riviera cruise in retirement, paying less in taxes would also be nice. These sources of tax free retirement income might help you get there:
- Social Security benefits
The rules governing taxes on social security benefits vary from state to state and with your “provisional income” – that’s your non-social security income plus half of your annual benefits.
Social Security benefits are taxed at the federal level. Still, generally, you can avoid those taxes if Social Security is your sole source of retirement income, or if your provisional income falls within specific guidelines.
There are also 37 states that do not tax Social Security,** so if you live in one of those states, you won’t pay local taxes either. Even in states that do tax these benefits, lower earners may qualify for an exemption that lets you avoid state taxes on your Social Security benefits.
- Municipal bonds
As investors age, advisors generally encourage moving to less risky investments – more bonds, fewer stocks – thus giving you a better chance of preserving your principal. Municipal bonds are one of the best tools in this situation since you don't pay taxes on the semiannual interest payments you receive from these investments.
This interest income is always exempt from federal taxes. If you buy state-issued bonds in your home state, you won't pay taxes on the interest income from those, either.
While this sounds attractive at first glance, the minuscule returns often sour the overall result.
- Health Savings Accounts
For those with a high-deductible health insurance plan, health savings accounts (HSAs) are worthy of consideration as an additional long-term savings tool because HSA funds don't expire.
The balance carries from one year to the next to pay for medical expenses. Still, you can invest any funds you don't use right away and add potential growth for your portfolio.
HSA contributions are tax-free, as are the gains on your HSA investments. During retirement, withdrawals are tax-free when used to pay for medical expenses like deductibles and copays.
While this should be considered as part of an overall strategy, it’s not a big tax move that’s going to pay for your summer beach home.
- Roth IRA or 401(k) withdrawals
Traditional IRA and 401(k) accounts offer an immediate tax break when you make contributions to those accounts. The downside to these comes later when your withdrawals are taxable during retirement.
Roth IRAs work the other way around. With these accounts, you’ve already paid tax on the funds used to deposit, but the growth earnings and withdrawals during retirement are yours tax-free! Of course, some rules must be followed for your withdrawals to be tax-free.
Also, while there are restrictions on who can participate in a regular Roth IRA, there is a popular loophole, known as a ‘Back-Door Roth’. This allows individuals who do not qualify for a Roth to fund one. Sounds promising, and it may be. But the devil is in the details.
Another option is to convert 401k funds or IRA funds into a Roth IRA. This means you pay the tax now, and then the Roth can start to grow tax-free. It is important to note that a Roth and a Roth Conversion are both subject to a five year holding period.
- Life Insurance
Sometimes overlooked, permanent life insurance policies can also serve as a source of tax-free income during your golden years. Indexed Universal Life if a popular option when looking to create tax-free income in retirement.
The cash value of the policy grows tax free and can generally be accessed tax free as well.2 The growth is based on indexing, an interest-crediting method that enables the policy holders to have interest credited based on a portion of the rise in a stock market index.
You will not usually owe any taxes on funds you access from a properly-structured IUl policy through loans. It involves a very complex application of the tax code to pursue a more tax free retirement. You will want to review your illustrations carefully.
Tax Free Retirement? – While a social security strategy should be part of an overall plan, HSA plans won’t add significantly to your retirement plan. Also, most will find the low growth rate from municipal bonds outweighs any tax benefits.
For most to fund their retirement dreams, they will be looking at investment strategies that may be met with investment accounts and insurance solutions.
These solutions can potentially offer tax-free returns. However, there are considerations to be taken before leaping at what appears as a bargain.
The Strategy – As you look at options that bring tax-free income in retirement, realize that most of those strategies involve paying those taxes now. That affects the investor in two ways:
- It may move the investor to a much higher tax bracket in the year the conversion is made and
- The money used to pay the taxes now is gone and you will lose the growth on those funds.
Between these two factors, the end result may be disadvantageous. Although tax-free is an excellent idea, it takes sophisticated software to analyze all options in order to choose the best retirement scenario for an individual.
A financial advisor with tax expertise may help you take full advantage of the current low-tax environment. In a best-case scenario, seek an advisor that provides holistic and stress-tested investment advice that incorporates a long-term macro-tax strategy to make your money go even further.
Krista McBeath is an Investment Advisor, Chartered Financial Consultant, a Licensed Insurance Advisor, a Fiduciary, and an experienced tax advisor who specializes in financial planning, investments, and insurance.
She utilizes advanced tools for in-depth calculations that analyze tax and retirement scenarios to help their clients avoid a future tax time-bomb. Whether this means enjoying more of your hard-earned money in retirement or passing along assets to loved ones, with less tax burden, planning makes the difference.
Related Articles: Is Roth IRA Conversion a Good Idea, What is the Path for Becoming a Client, Save Taxes in Retirement
Benefits paid at the death of a policy holder are, according to the current tax law, distributed typically income tax-free to heirs. Funds accessed through policy loans are generally received by the policy holder as income tax-free as well, so long as certain standards are met. Loan which are not repaid will reduce the death benefit amount and available cash value. Please consult your policy illustration for complete details, benefits and restrictions regarding policy loans and the death benefit.