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When it comes to planning for retirement, it’s important to consider how taxes might eat into your nest egg once you reach your senior years.
Assuming you’ve left your work income behind, any amount owed to the IRS will come from your retirement savings or income. So the more strategies you can put in place to minimize or eliminate your tax bill, the more money you’ll save.
Of course, to get there, you have to do a bit of upstream work.
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“To generate tax-free income on a regular basis over a long period of time, you have to put a lot of planning in place,” said certified financial planner Avani Ramnani, managing director of Francis Financial in New York.
To put it into perspective: if you want your retirement savings to generate a tax-free retirement income of $ 50,000 per year and you want to adhere to the so-called 4% per annum withdrawal rule – typically a rate intended for to make you money last at least 30 years – you would need a portfolio of at least $ 1.25 million.
Of course, your own annual cash flow requirements from your nest egg may be more or less than $ 50,000. And, you may need to employ a combination of strategies, depending on the specifics of your situation.
A Roth account
If you can save money in a Roth version of an individual retirement account or 401 (k) plan, you can prepare for a fairly easy way to earn tax-free income.
While your contributions are not tax deductible, as they can be with a traditional or 401 (k) IRA, distributions made after age 59 and a half are generally tax exempt.
“The best way to get tax-free income is to pay taxes first – and the best way to do that is to contribute to [a Roth account] throughout your years of working, ”said CFP George Gagliardi, founder of Coromandel Wealth Management in Lexington, Massachusetts.
The maximum you can contribute in a year to a Roth IRA is $ 6,000 ($ 7,000 if you are 50 or older). However, this amount begins to gradually disappear at an income of $ 125,000 for a single taxpayer and $ 198,000 for married couples filing a joint tax return and disappears at an income of $ 140,000 (for singles) and $ 208,000 (for couples).
Roth 401 (k) accounts are more generous: there is no income limit and you can contribute up to $ 19,500 in 2021 (plus an additional $ 6,500 if you’re 50 or older).
There are ways around the Roth IRA income limit. For example, you could contribute to a traditional IRA and then convert the money to Roth. Taxes may be due on the conversion, but you would not pay any tax on subsequent distributions.
If you have access to a health savings account – which can only be combined with a high-deductible health plan – it can be used as a way to plan for tax-free income in retirement.
Unlike the flexible healthcare spending account of the same name, you don’t have to spend HSA money within a certain time frame.
HSA contributions are tax-deductible, account gains increase tax-free, and withdrawals used to pay qualifying medical expenses are also tax-free and without penalty. (At 65, withdrawals can go to anything without paying a penalty, although if the money is used for non-medical expenses, it would be subject to tax).
You can contribute $ 3,600 to an HSA in 2021 ($ 7,200 for family coverage). If you are 55 or over, you can donate an additional $ 1,000.
These bonds are issued by states, counties, cities and others to fund public projects. And, the interest you earn on so-called munis is generally not subject to federal tax. If the bond is issued in your state of residence, it may also be exempt from state tax.
However, “if you buy munis for a state in which you don’t live, you will have to pay state income tax for them,” said Ramnani of Francis Financial.
So, for example, if you live in New York City and buy bonds issued in California, you still have to pay state income tax, Ramnani said.
There may also be some instances in which munis are subject to federal tax, so it’s important to know this before assuming your income is tax exempt.
Any gain on an investment held for more than one year is considered long term and is generally taxed as such. (Otherwise, it is taxed as ordinary income.) The same is true for eligible dividends.
For long-term earnings, the tax rate depends on your income. If you are a single filer with income up to $ 40,000 ($ 80,000 for married couples filing jointly), the rate is 0%. If you can keep your income below these thresholds, those earnings can be tax-free income.
Keep in mind, however, that taxes are only one consideration when it comes to any retirement investment strategy.
“You have to think about the allocation of the portfolio,” Ramnani said. “Did you spread out in a way that was well diversified and in line with your risk tolerance and your objectives? There may be competing objectives or considerations. “
While permanent life insurance policies typically come with much higher premiums than term life insurance, part of the reason for this is the savings aspect of these policies.
“The idea is that you pay these high premiums and one part goes to insurance and the other part goes into a savings and investment compartment,” Ramnani said.
Depending on the specifics, these so-called cash value life insurance policies can be used to produce non-taxable retirement income, said CFP Michael Resnick, senior wealth management advisor for GCG Financial in Deerfield, in the United States. Illinois.
“But there is an added complexity to the distribution, so you have to be careful,” he said.
Likewise, annuities can provide a flow of income in retirement. If you are using after-tax money to fund one, only the interest is generally taxable. However, there are many types of annuities and they can be more expensive than other income options. And, once you’ve given your money back to the insurance company that sold you the annuity, it can be difficult to get it back after a short review period.
Depending on the contract, you may pay what is called a surrender charge if you no longer want the annuity or withdraw more than you are allowed. These fees can be quite high, especially in the early years of the contract.
Depending on how much you receive from Social Security and your other income, your benefits may be taxable, but you may still owe Uncle Sam little or nothing.
The math is basically adding half of your benefits to your adjusted gross income, plus non-taxable interest (i.e. municipal bonds). If this amount is $ 25,000 to $ 34,000 for a single filer ($ 32,000 to $ 44,000 for married couples filing jointly), then 50% is taxable. Below this income bracket, it is not taxed; if it is greater than these amounts, 85% is taxable.
However, even if the calculation results in an amount subject to tax, you will still be able to subtract the standard deduction ($ 12,550 for singles and $ 25,100 for married couples, in 2021). And, if you’re at least 65, you get a larger standard deduction: an additional $ 1,700 for single filers and $ 1,350 per person for married couples.
In other words, your deduction (s) can reduce your actual tax burden to or near zero if you have taxed income.
There are, of course, other types of income that could come to you in retirement that would not be subject to tax.
For example, if you divorce, alimony (spousal support) is not taxable for the beneficiary if the divorce took place after 2018. Also, if you receive a gift from, say, a family member, it is not taxable to you.
The same goes for the life insurance proceeds if you are the beneficiary of the policy. And, any gain on the sale of your primary residence usually comes with an exclusion: Up to $ 250,000 is exempt if you are a single filer and $ 500,000 for married couples filing jointly.