A proper retirement income plan should include multiple sources of retirement income. At least one of those income sources should be non-taxable. This allows a retiree to coordinate various retirement income streams to minimize the overall taxation of that income.
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For example, if a retired couple’s combined income is over $34,000 annually, up to 50 percent of their Social Security retirement benefits may be taxed. If their combined income exceeds $44,000 annually, as much as 85 percent of their benefits may be taxed. (Combined income is the sum of adjusted gross income, non-taxable interest, and half of their Social Security benefits.) Therefore, couples should manage their adjusted gross income so that the percentage of their Social Security income that is taxed is minimized. Here are four places to stash money before you retire so that you can withdraw that money and any earnings as non-taxable income after you retire.
Roth IRA. The money put into a Roth IRA is taxed when you receive it, but it is not taxed when it is withdrawn, including investment earnings, in retirement. Unfortunately, there are income limits that exclude many people from being eligible to contribute to a Roth IRA. For those who are eligible, the annual contribution limit is $5,000 or, if you are age 50 or over, $6,000.
[See 4 Advantages of a Phased Retirement.]
Roth 401(k) or 403(b) account. The IRS now allows you to make Roth contributions inside 401(k) and 403(b) accounts. This is an excellent feature if your plan allows it, because withdrawals of the Roth contributions and earnings in retirement are tax free. An individual age 50 or older can make a total contribution of up to $22,000 to a Roth 401(k) account, an amount that includes $5,500 in catch up contributions. Unlike the Roth IRA, there are no income eligibility limits. However, you will have to pay tax on the Roth contributions in the year you make the deposit and Roth contributions will reduce the amount of traditional 401(k) contributions you can make.
Municipal bonds and funds. Income distributions from municipal bonds are not subject to federal income taxes. (They may be subject to state income taxes.) For this reason, the interest these bonds pay is generally lower than taxable bonds. If you buy and sell municipal bonds on the secondary market, any gain from those sales will be taxed as ordinary long or short term capital gains. There are no income limits for this tax-free benefit.
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Health savings account. This is one of my favorite ways to invest for tax free retirement income. If your employer offers health insurance coverage using a HSA, the combined contributions by the employer and employee to the account can be as high as $6,150 in 2011 (for a family plan) plus an additional $1,000 if you are age 55 or older. Unlike the other tax free income options described above, HSA contributions are tax deductible and there are no income limits.
HSA funds are held by a plan administrator and can be invested for long term growth. The investment options can vary from plan to plan. The employee can withdraw funds from the HSA to pay for (or reimburse) a wide variety of qualified medical expenses, including some expenses not covered by insurance. As long as you follow the rules on which expenses are reimbursable, no taxes are paid on withdrawals, including on investment gains. You can hold the HSA funds and earnings until you retire, and use them to provide tax free income by reimbursing yourself for past expenses and for current expenses, including Medicare premiums.
Mark Patterson is an engineer, patent attorney, baby boomer, and author of The Failsafe Retirement System. He blogs on matters of personal finance and retirement planning at Tough Money Love and Go To Retirement.
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