4 Ways to Get Tax-Free Income in Retirement

Retirement is not a goal. It is a late-life journey that must be strategically and financially sustained for as long as possible.

That means using the money you have saved and invested to generate money to live on in retirement, and to make that money last.

However, many retirees are surprised to learn that they will pay taxes in retirement on that income, and usually that tax burden rises as you get older.

If you have a 401(k) or IRA, for instance, you will be required to take money out every year beginning at age 72, and pay taxes on that withdrawal.

It doesn’t matter if you don’t need the money. It must be taken. The IRS calls these withdrawals required minimum distributions (RMDs) and they last until death.

Investments, such as dividends and bond interest, also get taxed. Being tax-smart in retirement can make a huge difference in your lifestyle after you stop working.

Here are four ways to generate tax-free income after retirement.

Open a Roth IRA

A Roth IRA is an individual retirement account that you open during your working years.

Roth IRAs were first conceptualized back in 1997. This financial product is named after former Delaware Senator William Roth.

With a traditional IRA, contributions grow in tax-deferred value throughout retirement. The contributions lower your taxes in the year you contribute.

During retirement, each traditional IRA withdrawal is taxed according to your tax bracket in retirement. That’s why RMDs sting; they’re unavoidable and only get larger as your investments grow with the market.

Roth IRAs, however, are funded with after-tax contributions, meaning they are not tax deductible in the year you contribute. But, once you begin withdrawing from a Roth IRA the withdrawals are tax-free.

You can withdraw from a Roth IRA at any time. To stave off penalties, you should only do so under qualifying conditions.

For example, you shouldn’t withdraw from a Roth IRA until five years after first contribute funds. Most qualified withdrawals require that you are at least 59 ½ before you begin withdrawals.

Roth IRAs are subject to income limitations. If you are single, you can’t make more than $139,000. Qualifying couples can’t make more than $206,000 combined annually.

You can contribute $6,000 annually to a Roth IRA, or $7,000 if you are age 50 or over.

Unqualified and early Roth IRA withdrawals are subject to tax and 10% penalty.  

Use a Roth 401(k) or 403(b)

A 401(k) is a workplace plan, but you can open one with a Roth twist. A 403(b) plan is similar type of retirement account used primarily by the employees of tax-exempt organizations and the public school system.

A Roth version of a 401(k) or 403(b) is called a Roth 401(k) or Roth 403(b). Your contributions to these plans not tax-free in the year you contribute but qualified withdrawals are tax-free.

Unlike a Roth IRA, you can contribute up to $19,500 annually to these plans in 2020. If you are age 50 or over, you can contribute an extra $6,500 for a maximum of $26,000.

Also unlike a Roth IRA, there are no income limitation requirements. Many companies now offer them as a way to retain high-income employees who would be otherwise unable to use a Roth IRA.

Roth 401(k) and Roth 403(b) plans feature the same early withdrawal penalty conditions as a Roth IRA.

Consider municipal bonds

Municipal bonds are tax-exempt debt securities.

When you buy a municipal bond you are extending a loan to a state, municipal, or local government to cover their funding expenses.

The yield rate for municipal bonds vary according to your state of residence and tax bracket. On the average, a 2-year municipal bond rate yields 0.73% and a 30-year bond 1.52%.

When the bond matures you are paid back your original investment plus the annual coupon rate.

While “muni” bond yields are lower than taxable bond yields, the tax-free nature of the income means that the adjusted return is often competitive with taxable fixed income.

Municipal bonds are always tax-exempt on the federal level. Depending on where you live, they may even be tax-exempt on the state level.

Be aware that if you buy out-of-state municipal bonds your home state may tax the interest from the income that is generated.

Look at health savings accounts

One budget variable that many retirees struggle with is medical coverage throughout retirement.

The average retirement age is 63. However, many people live to their 70s or mid-80s if they are healthy. The longer you live, the more money you will require for medical care.

The average retired couple might need $400,000 to pay for medical expenses throughout retirement.

One way to prepare for medical costs during retirement, and make even more retirement contributions that are exempt from current income tax, is to open a health savings account (HSA).

An HSA is a kind of personal savings account to help pay for various medical expenses like copayments, coinsurance, deductibles, and so on. You must be on a high-deductible health plan to use one.

The money you contribute into an HSA is not taxed. It accrues interest tax-free and any unused funds are rolled over for the next year.

Your HSA withdrawals are never taxed as long as the withdrawal are for medical reasons, either now or later in, in retirement. That means you get a tax break today, tax-free investment growth and the ability to withdraw it tax-free as well.

As your HSA balance grows you can choose to invest it, the same as you would money in an IRA or 401(k).