Best Ways to Generate Tax-Free Income in Retirement: Think About This Stuff Now (2024)

Nothing feels more deflating than having to pay taxes on every penny you've ever saved and invested.

If you have the wherewithal to think about how you'd like to receive your retirement income in advance, good for you. It'll benefit you down the road, big time!

Let's take a look at a few foolproof ways to not pay taxes (er… at least on the back end) when you're retired. The catch: You have to start thinking critically about many of these options years — years! — before you retire.

Tip 1: Take advantage of a Roth IRA.

Saving money in a Roth IRA means tax-free income once you take it out in retirement. Why is the money tax-free when you take it out in retirement? The reason: Roth IRAs are funded with after-tax dollars and you won't have to pay taxes on distributions made after age 59½.

However, your contributions aren't tax-deductible like they are with a traditional IRA or 401(k).

You can contribute $6,000 in 2021, though you can contribute more if you're 50 or older — $7,000. However, if you make over $208,000 per year as a couple or $140,000 as a single individual, you cannot contribute to a Roth IRA.

Tip 2: Use a Roth 401(k).

A Roth 401(k) is a tax-advantaged retirement savings vehicle that combines features from traditional 401(k) plans and Roth IRAs.

You make pre-tax dollars with a traditional 401(k) and get a tax break up front, lowering your income tax bill. Your money grows tax-deferred until you withdraw it. However, withdrawals get taxed as ordinary income when you retire, and you'll also pay state taxes as well. You must withdraw at age 59 ½ , because you'll pay a 10% penalty if you withdraw if you're under age 59 ½.

A Roth 401(k) means exactly the reverse. You contribute to a Roth 401(k) with after-tax dollars, meaning that you take your tax hit up front. You can withdraw contributions and earnings tax-free at age 59½, as long as you've held the account for five years.

The difference between Roth IRAs and Roth 401(k)s is that you won't face an income cap with a Roth 401(k) like you will with a Roth IRA. In 2021, you can contribute up to $19,500, and if you're age 50 or older, you can contribute an additional $6,500.

Conventional wisdom in the Roth 401(k) versus traditional 401(k) debate says that:

• You should contribute to a Roth IRA if you expect you'll rest in a higher tax bracket in retirement. You sacrifice the deduction today for tax-free withdrawals in retirement.
• You should contribute to a traditional IRA if you expect that you'll sit in a lower tax bracket in retirement. Your current tax savings will outweigh the tax hit later on.

You probably won't know exactly what tax bracket you'll fall into upon retirement. Who knows what will happen? However, making an educated guess now can make a major impact on your future tax bite.

Tip 3: Make "too much?" Consider a backdoor Roth.

If you make over the $140,000 limit for single filers and the $208,000 limit for married filers, you can invest in a regular IRA, then convert the money to a Roth. When you make the conversion, you'd pay taxes but you could skip the taxes on distributions when you retire.

How exactly does this backdoor Roth IRA work? You make a nondeductible contribution to a traditional IRA, then quickly — emphasis on quickly! — convert those savings into a Roth.

You'll avoid paying taxes on any gains on your contribution because the money will not have time to grow before you make the conversion.

It's important to know the IRS’s pro rata rule, which has you look at your IRA assets as a whole. Let's say you have $5,000 of untaxed money in your traditional IRA and convert it to a Roth IRA. You'd owe money on the entire $5,000 as well as any money you've accrued through your traditional IRA. Imagine if you had $100,000 or more in your account. You could get taxed for the full amount!

Tip 4: Access a health savings account.

When you have a high-deductible health plan, you can get a health savings account, known as an HSA. You can access tax-free income in retirement through your HSA. Once you collect money in your HSA, you can invest it without paying taxes on your capital gains and dividends. As long as you use the money on qualified healthcare expenses, you don't pay taxes on the money you take out of an HSA.

You can put your HSA money into more than just a low-return savings account. You can invest in stocks, bonds, mutual funds, and ETFs, for example. Putting your money into investments with the potential for higher returns can offer you a great long-term savings and retirement strategy.

You don’t have to spend HSA money within a certain timeframe. Big win!

Tip 5: Invest in municipal bonds.

Wow, I don't know how to get the snore train started better than typing the words "municipal bonds!" Ha!

However, if we're talking about tax-free income, you'll want to consider municipal bonds, especially if your investment objective involves switching to more conservative investments as you get older.

States, counties and cities issue municipal bonds in order to fund public projects. You generally don't have to pay federal or state tax on munis, though some require you to pay federal tax — do some checking before you jump on this option. However, if you choose to invest in bonds issued in another state, expect to pay state income tax on those.

Generate Tax-Free Income in Retirement

What's the key to effectively making these decisions? Know the implications of taxes on all your investments so you choose the right options for you. Consider all your options, especially the ways you can most effectively preserve your wealth.

Get a tax and/or financial advisor on your team if you need advice making great decisions about your future.

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