Guide to Achieving a Tax-Free Retirement

Saving for retirement is the largest financial achievement during your years of employment, setting aside funds for up to 30 years in retirement from approximately 40 working years. In addition to the large dollar amount required to fund retirement, you must also consider other factors such as inflation and taxes, which can greatly raise the total needed.

Creating strategies to reduce or eliminate taxes in retirement, can lower the amount you must save for a successful retirement.

Pre-Retirement Planning

Start With the 135% Rule: Today, many financial advisors recommend saving 135% of current income for a comfortable retirement, well above the traditional 75%, previous generations targeted. The higher estimates take into account that seniors today live longer and have more active lives in retirement.

You may want to fund travel, and hobbies at higher levels than previous generations. Retirees also may help children and grandchildren buy their first home, start a business, or pay for college, which increases expenses rather lowering retirement income needs. Other issues, increasing retirement income needs can include rising health care costs and paying for multiple decades of inflation.

Another rule of thumb commonly used is 8 to 10 times your end of career salary.

Separate Accounts: Utilizing tax-preferred accounts for retirement savings allows funds to grow faster, providing larger balances to draw on when you stop working. Tax-advantaged accounts might include a 401K or 403B from a job, Traditional or Roth IRA accounts, and an HSA (Healthcare Savings Account) to cover medical bills.

Diversifying investments among taxable, tax-free, and tax-deferred options can minimize taxation of income in retirement.

Tax-deferred retirement plans include Traditional IRA, 401k, and 403b accounts. Each contribution lowers taxable income in the year of the deposit, and the funds grow tax-deferred. When you begin taking distributions, 100% of income becomes taxed at the rate of earned income.

Tax-free accounts allow you to receive tax distributions without paying taxes in retirement. A Roth IRA does not grant tax benefits up front, but grows tax-free. The HSA provides both a tax deduction at the time of contribution and tax-free withdrawals provided you use funds for qualified medical expenses.

Choose Tax-Free Over Tax-Deferred When Possible: The fastest way to tax-free retirement income is to maximize contributions into tax-free accounts. You may give up the initial deductions for future tax-free withdrawals. Currently, the Roth IRA allows for $5,500 in annual contributions with a catch-up benefit of $1,000 extra for those over 50. The HSA accounts allow you to contribute up to $3,450 for individuals and $6,900 for a family. You must also meet the health insurance terms to qualify for the account.

Some companies now offer Roth 401K’s which provide much higher contribution limits than a Roth IRA.

Max Out Any Employer Match: Employers offering retirement accounts typically match employee contributions up to a certain percentage. Company matching plans give you free money for retirement.

Double up Contributions: Even with a work plan, most employees qualify for individual retirement accounts such as a Roth IRA. Contributing to multiple accounts each year, not only builds account balances faster, but can offer more tax-free options in retirement.

Withdrawal Strategies in Retirement 

Eliminating taxes in retirement is about receiving multiple income streams in a way that reduces overall taxable income. It begins by saving money in various tax-preferred and taxable accounts during working years, allowing you to withdraw funds strategically to lower the taxation of funds.

Minimizing Capital Gains Tax in Retirement: Retirement income streams often include receiving funds from taxable investment accounts in the form of dividends and capital gains. The new law allows you to earn up to $77,400 in taxable income for couples and $38,700 for singles while remaining in the 5% tax on both dividends and capital gains. Income above these amounts will pay taxes at 15%.

The IRS defines taxable income as gross income minus the standard deduction or itemized deductions, depending on how you file.

Reduce Taxes on Social Security Benefits: The amount of taxation on social security benefits depends on taxable income. The highest level of taxation is 85%, with many seniors able to avoid taxation on most benefits. The IRS calculates taxable income by adding your adjusted gross income and half the social security benefits received. Online calculators can provide an accurate estimate of taxes due on these payments.

The IRS does not include income from tax-free accounts, but does include tax-free interest from investments such as municipal bonds.

Delaying social security payments can create more tax-free income in retirement. However, receiving benefits before full retirement age, while continuing to work, can raise the level of taxes due.

States can also tax, social security payments. The following states tax benefits at the federal level: Minnesota, North Dakota, Nebraska, West Virginia, Vermont, and Rhode Island. Other states tax social security based on specified limits, including Connecticut, Kansa, Iowa, Colorado, New Mexico, Montana, Utah, and Missouri.

Balance Asset Withdrawal Between Tax-Free and Tax-Deferred Accounts: Roth IRAs and HSAs (Healthcare Savings Account) offer tax-free growth. Withdrawing from these accounts in retirement will not increase taxable income.

Traditional IRA and most 401ks, where the bulk of retirement savings lies, offer tax-deferred growth. You will pay taxes as ordinary income on distributions from these accounts. Withdrawing funds strategically can keep income below thresholds, allowing you to pay the lower capital gains tax and reduce or eliminate taxation on social security benefits.

Convert a Percentage of Invested Assets to Rental Property: Rental income results in low or no taxation because the IRS allows you to subtract all expenses on the property including upgrades, maintenance, property management fees, along with depreciation. In many cases, the depreciation combined with other costs will offset most or all of the rental income.

Purchasing property within a Self-Directed Roth IRA will produce tax-free income each year and when you sell the property. To qualify, you must meet established definitions of investment property and follow strict IRS rules.

Time Distributions: Paying attention to taxes might require taking a distribution in December and then again in January to keep taxes to a minimum. Holding investments at least 12 months in non-taxable accounts will qualify for the lower capital gains tax treatment. Working with a tax advisor or tax attorney can help you fine-tune your distribution strategy to minimize taxes in retirement.