Many experts tell us that when we retire, it can be important to have several options in income sources, some of which are tax free. Tax rates are going up for a lot of us, starting with the expiration of the Bush tax cuts at the end of 2010. Now is the time for baby boomers to think about and make plans for generating tax free retirement income. Let’s briefly review some of the available options for doing that.
2. Roth 401(k). Less available and even less well-known is the Roth 401(k). Some 401(k) plans and administrators permit employees to designate part or all of their 401(k) contributions as Roth contributions so that all withdrawals from the Roth component are tax-free. You can have both regular and Roth contributions in the same 401(k) account, with the understanding that the total combined contributions cannot exceed the annual limit. A key distinction between a Roth 401(k) and Roth IRA is that the former is not subject to income limits. A taxpayer is entitled to have a Roth 401(k) and a Roth IRA in the same year. For more information, read this IRS publication on Roth 401(k) rules. Before you do anything, check with your plan administrator to confirm that your plan has the Roth feature.
3. Municipal Bonds. Most investors know that municipal bonds generate income that is free from federal income tax and also from state income tax in the state where the bonds are issued. Although muni bonds and funds took a hit in 2008, they have begun to recover. The tax equivalent yields of muni bonds are now generally better than that of Treasury bonds, which is a good indicator. To calculate a taxable equivalent yield, divide the muni bond’s yield by 1 minus your marginal tax rate and compare that to a similar Treasury security. Of course, to minimize default risk through diversification, you need to own a variety of munis. That can be expensive. A better route may be through a municipal bond fund or ETF.
4. Cash Value Life Insurance. Some baby boomers still own whole life insurance policies that we bought when we were younger. These can now have substantial cash value. Keep in mind that if you access that cash value, that portion which represents a return of the premiums you paid over the years is tax-free. Check with your insurance company to get the specific numbers.
5. Residential Home Sale Capital Gains. If you sell your main home to downsize or to relocate to a less expensive area, you can exclude up $250,000 of your capital gains from taxes. ($500,000 if you are married). That is a fantastic way to generate spendable income tax-free. If you have a second home or vacation home, the rules on capital gains taxation have changed.
6. Pension and Annuity Income. If you have a cash basis in an income annuity or pension (meaning that you contributed to it), some of the income that you receive will not be taxed. This IRS publication breaks it down in detail.
7. Social Security Income. If all of your retirement income comes from Social Security, you probably won’t pay any taxes. Hopefully you will have other income. The rules on taxation of Social Security benefits if you still work can be hard to understand but here is my attempt at explaining it.
When you are putting together your plan to have at least some tax-free retirement income, be wary of the impact of required minimum distributions (RMD) from retirement plans which kick in at age 70 1/2. Because RMD rules do not apply to Roth IRA and Roth 401(k) funds, they are ideal tax-free income sources.
Good luck with your tax-free retirement income planning!