You saved and invested your whole life now you’re thinking about retirement and you realize your nest egg isn’t quite yours. The government wants their piece of your pie, so what you thought you had is actually lower after you pay taxes. What about your social security, well that thing that has come out of your paycheck since your first day of work is also at risk of being taxed, if you show too much income, and the thresholds for your social security being taxed are extremely low.
But here's the good news: It's possible to earn income during retirement without having to fork part of it over to the federal government. Here are five such ways you may be able to completely avoid Uncle Sam, legally, during your golden years.
1. Keep your Social Security income below set thresholds
As noted above, most retirees will wind up paying tax on their Social Security income, and it's really no fault of their own. If you're married and file a joint return, the 50% taxable range is $32,000 to $44,000, and the 85% threshold is combined income of $44,000 or more. Married couples with combined income of less than $32,000 don't pay taxes on their Social Security benefits.
If you breakdown those number it’s easy to see how you can over shoot the threshold, if you and your spouse have been making $40,000 or more for the past 20 years, then your combined social security benefits is going to be very close to close to crossing over $44,000, and this doesn’t include any money you withdrawal from IRA’s, income from a part time job, or dividends and interest from other accounts.
What is one to do? If you max out your social security you may need shift all of your other assets into tax free accounts, this is doable. Some people suggest taking social security as early as possible to keep the amount you receive lower, that sounds ridiculous, and for most people it is. This question is unique to almost everybody and requires an in-depth look at you’re your financial picture.
2. Invest in municipal bonds within your state
Investing in municipal bonds is another smart way that seniors can avoid paying federal (and often state) income tax.
Municipal bonds are issued by cities, counties, or a state, and their purpose is to raise funds to finance capital expenditures, including the construction of schools, bridges, and highways. The general rule with municipal bonds is that interest earned is free of federal taxation. You'll almost always get away with not having to pay any money to the state, either. The one catch is you'll need to invest in municipal bonds within your state to get this tax-exempt status on the interest. If you claim residence in a state that is where you should be investing. There are fund companies that specialize in this area and some have even created funds specific to your state. The one caveat would be to watch for fund companies that try to enhance returns by adding Puerto Rican bonds into the fund.
3. Contribute to a Roth IRA/401(k)
One of the most popular solutions for generating tax-free income is to contribute to a Roth IRA.
Roth IRAs are funded with after-tax dollars, and as such are allowed to grow free and clear of taxation as long as no unqualified withdrawals are made. Although there are a few exemptions, such as buying your first home or paying for large medical bills, the general rule with any IRA is that you have wait until at least age 59-1/2 to access your money without any penalty.
The other great thing about a Roth IRA, aside from the fact that withdrawals won't count toward your annual income, is that there's no required minimum distribution. With a 401(k) or traditional IRA, the accountholder is required to begin taking distributions by age 70-1/2, but with a Roth IRA there is no required distribution at any age. Thus, you have the option of letting your nest egg grow for as long as you'd like, and you can withdraw any percentage at any time after age 59-1/2.
Companies have started embracing Roth 401(k)’s which is great, but many still have not. If your company doesn’t offer this type of plan that leaves you with doing a Roth IRA on your own, the maximum contribution per year is $5500 for people under 50 and $6500 for people over 50. There are also income limits to be able to invest in a Roth. If you are single, you must have a modified adjusted gross income (MAGI) under $133,000 to contribute to a Roth IRA for the 2017 tax year, but contributions are reduced starting at $118,000. If you are married, your MAGI must be less than $196,000, with reductions beginning at $186,000.
4. Hold your investments for the long term (for select tax brackets)
A fourth way you may be able to generate tax-free income during retirement is by investing in stocks or bonds for the long term.
According to the IRS, short-term assets, or those held for 365 or fewer days and sold, are taxed at a rate equal to your peak marginal tax bracket (between 10% and 39.6%). On the other hand, the long-term capital gains tax rate (for assets held for 366 or more days and sold) has just three brackets (0%, 15%, and 20%), and they're all substantially lower than the short-term marginal tax brackets.
Individuals and joint filers who fall into the 10% and 15% marginal tax brackets will pay a 0% tax rate on their long-term capital gains. This means individual filers can earn up to $37,650, and married filers up to $75,300, without having to pay a cent in long-term capital gains as long as their adjusted gross income stays below these thresholds in 2016. In 2017, these thresholds will increase to $37,950 and $75,900, respectively.
The huge caveat here is that your capital gains while not taxed, is added to the calculation to tax your social security. If you have a long-term profit on a sale of $10,000 and you were at $35,000 in other income, you just pushed yourself into the 85% tax bracket for your social security benefits.
5. Use the home-sale capital gains tax exemption
Finally, retirees may want to consider selling their home or downsizing and utilizing the home-sale capital gains tax exemption to live off of the proceeds during retirement.
According to the IRS, homeowners who've lived in their home for at least two of the past five years can sell their home and pocket up to $250,000 in individual capital gains, or $500,000 in joint capital gains if you're married, without having to fork a single cent over to the government in federal taxes. Since most Americans won't earn more than $250,000 individually or $500,000 jointly in capital gains when selling their home, they should be able to avoid this tax.
Are you wondering where you’ll fall? Call us 715-203-8988, or schedule a call here.
We can walk you through a retirement tax analysis and see if we can help you get to a lower bracket, or even in the 0% bracket.