6 Legal Ways to Avoid Taxes in Retirement

5 min read

6 Legal Ways to Avoid Taxes in Retirement

No one likes paying taxes. I know I’m not telling you something you don’t already know.

But even with the tax cuts under the Trump tax plan, people are still complaining about how much taxes they are paying. 

With a little help, though, there are a few ways to get tax-free retirement income. 

The more taxes you owe in retirement, the more you need saved to pay for taxes and sustain your lifestyle.  Marriage can even add to the amount of taxes you owe in retirement. 

You may have heard of the marriage penalty, right? For example, if you are retired and make more than $45,360 combined, 85% of your Social Security is taxable. 

With this in mind, it can be advantageous to plan ahead for where your retirement assets will be held and how you will take withdrawals to help minimize the tax bite throughout your retirement years. 

Here Are Six Legal Ways You Can Potentially Earn Tax-free Income in Retirement:

1. The Definition of "Roth IRA" 

Named for Delaware Senator William Roth and established by the Taxpayer Relief Act of 1997, a Roth IRA is an individual retirement account (a type of qualified retirement plan) that bears many similarities to the traditional IRA. 

The biggest distinction between the two is how they’re taxed. 

Traditional IRA contributions are generally made with pretax dollars (like a 401(k)); you pay income tax when you withdraw the money from the account during retirement. Conversely, Roth IRAs are funded with after-tax dollars; the contributions are not tax deductible (although you may be able to take a tax credit of 10 to 50% of the contribution), depending on your income and life situation). But when you start withdrawing funds, qualified distributions (see below) are tax free.


You can contribute to a Roth IRA past the age of 70½, as long as you have earned income. 

You can maintain the Roth IRA indefinitely; there is no required minimum distribution (RMD) during your lifetime. You can keep growing tax-free wealth with no required withdrawals. This can be a great advantage for those with longevity in their family. 

Eligibility for a Roth account depends on income.

Establishing a Roth IRA 

You can open a Roth IRA at any qualified bank or brokerage company.

You can check out some of the best providers with Investopedia's list of the best brokers for Roth IRAs. 

A Roth IRA can be established at any time. However, contributions for a tax year must be made by the IRA owner’s tax-filing deadline, which is generally April 15 of the following year. Tax-filing extensions do not apply.

There are two basic documents that must be provided to the IRA owner when an IRA is established:

  • IRA disclosure statement 
  • IRA adoption agreement and plan document 
  • These provide an explanation of the rules and regulations under which the Roth IRA must operate and establish an agreement between the IRA owner and the IRA custodians/trustee.

Not all financial institutions are created equal.

Some IRA providers have an expansive list of investment options, while others are more restrictive. Also, almost every institution has a different fee structure for your Roth IRA, which can have a significant impact on your investment returns. Your risk tolerance and investment preferences are going to play a role in choosing a Roth IRA provider.  If you plan on being an active investor and making lots of trades, you want to find a provider that has lower trading costs. Certain providers charge you an account inactivity fee if you leave your investments alone for too long. Some providers have more diverse stock or exchange-traded fund offerings than others; it all depends on the type of investments you want in your account. 

Pay attention to the specific account requirements as well. Some providers have higher minimum account balances than others. If you plan on banking with the same institution, see if your Roth IRA account comes with additional banking products.

2. What is a "Roth 401(k)"

 A Roth 401(k) is an employer-sponsored investment savings account that is funded with post-tax money up to the plan's contribution limit.  This type of investment account is well-suited to people who think they will be in a higher tax bracket in retirement than they are now.  The traditional 401(k) plan is funded with pretax money, which results in taxes on future withdrawals.

BREAKING DOWN 'Roth 401(k)'

Employee contributions are made using after-tax dollars with no income limitations to participate. 

A Roth 401(k) is subject to contribution limits based on the individual’s age. For example, the contribution limit for individuals in 2019 is $19,000 per year. Individuals 50 and older can contribute an additional $6,000 in 2019 as a catch-up contribution, according to the IRS. 

Withdrawals of any contributions and earnings are not taxed as long as the withdrawal is a qualified distribution. Distributions are required for individuals at least 70 ½ years old unless the individual is still employed and not a 5 percent owner of the business.

Qualified Distribution of a Roth 401(k) 

Contributions and earnings in a 401(k) are eligible to be withdrawn without an income tax assessment as long as certain criteria are met.  First, the Roth 401(k) account must have been held for at least five years. 

Additionally, the withdrawal must have occurred on the account of a disability, on or after the death of an account owner, or when an account holder reaches at least 59 ½ years old.

Roth 401(k) Vs. Traditional 401(k) 

The main difference between a Roth 401(k) and a traditional 401(k) relates to the taxation of funding and distributions. When a traditional 401(k) is funded, the account holder the contribution is deducted from the employee's pre-tax income. Alternatively, contributions made to a Roth 401(k) are made after taxes are already taken Out. 

When a distribution is made from a traditional 401(k), the account holder is subject to taxation on the contributions and its earnings. Alternatively, the account holder is not subject to any taxation from Roth 401(k) distributions so long as they are qualified.

A Roth 401(k) Strategy 

The benefits of a Roth 401(k) have the most impact on individuals currently in low tax brackets who anticipate moving into higher tax brackets in the future. 

This is because contributions are taxed now at a lower tax rate and distributions are tax-free when the individual is in a higher tax bracket. For this reason, a Roth 401(k) is not advised for individuals who expect to drop tax brackets, such as individuals close to retirement and expect a drop in their income.

3. Municipal Bonds and Funds: What is a 'Municipal Bond Fund

A municipal bond fund is a fund that invests in municipal bonds.  Municipal bonds are debt securities issued by a state, municipality, county, or special purpose district (such as a public school or airport) to finance capital expenditures. Municipal bond funds are exempt from federal tax and may also be exempt from state taxes. Municipal bond funds can be managed with varying objectives that are often based on location, credit quality and duration.

BREAKING DOWN 'Municipal Bond Fund

Municipal bond funds are one of a few investments in the market that offer a tax exemption. 

For investors they offer yield and can be a good fixed income option for conservative portfolio allocations. Municipal bond fund holdings vary by the fund’s objective. They are comprised of municipal bonds which offer investors the advantages of municipal bond securities along with diversification against individual issuer risk. Municipal bonds are structured like standard bond investments with coupon payments and a lump sum payment at maturity. Municipal bond funds pay regular distributions to investors from coupon payments and capital gains. Distributions are determined at the discretion of the fund. 

Strategies can vary by location, credit quality and maturity. Fund companies offer municipal bond funds across the entire credit spectrum. Investment objectives are typically conservative, intermediate or high yield with a consideration for maturity date.

Municipal Bond Fund Taxes 

Municipal bond funds are an attractive option for an investor’s conservative allocation due to their income and tax exemption. They are often sought by high net worth investors in higher tax brackets specifically for their tax exemption advantages. Funds that primarily invest in municipal bonds are exempt from federal tax and may also be exempt from state tax. A municipal bond fund is exempt from state tax if it is comprised of bonds issued primarily in the state of the investor’s residence.

4. Health Savings Account (HSA): What is a 'Health Savings Account - HSA

A Health Savings Account (HSA) is a tax-advantaged account created for individuals who are covered under high-deductible health plans (HDHPs) to save for medical expenses that HDHPs do not cover. Pre-tax contributions are made into the account by you or your employer and are limited to a maximum amount each year. The contributions are invested over time and can be used to pay for qualified medical expenses, which include most medical care such as dental, vision and over-the-counter drugs.

BREAKING DOWN 'Health Savings Account- HSA' 

A Health Savings Account is one of the ways an individual can cut costs if he or she is faced with high deductibles. A deductible is the portion of an insurance claim that the insured pays out-of-pocket. A high-deductible health insurance plan (HDHP) is an insurance plan that has a higher annual deductible than typical health plans, with a minimum and maximum deductible of $1,300 and $6,550, respectively, for individuals. For families, the numbers are minimum $2,600 and maximum $13,100 deductibles. When an individual has paid the portion of a claim s/he’s responsible for, the insurance company will cover the other portion, as specified in the contract. For example, under the HDHP, an individual with a deductible of $1,500 who makes a medical claim for $3,500 will have to pay $1,500 from his personal coffers since the insurer is only responsible for the excess, that is $2,000. 

To supplement the funds that an insured has to pay out-of-pocket, a Health Savings Account (HSA) can be used. You have the option to invest or save that money. It doesn’t have to be used each year. This can be a great option to build a nest egg for health costs in retirement.

Qualifying for an HSA 

An individual who has an HDHP may qualify for a Health Savings Account. An HSA is usually paired with qualified HDHP and offered by a health insurance provider. An HSA can also be opened at a number of financial institutions. 

To qualify for an HSA, the taxpayer must be eligible, as per standards set out by the Internal Revenue Service (IRS). An eligible individual is one who has a qualified HDHP, has no other health coverage, is not enrolled in Medicare, and is not a dependent on someone else’s tax return. 

Any eligible individual can contribute to an HSA in cash only. An HSA owned by an employee can be funded by the employee and/or his employer. Any other person, such as a family member, can also contribute to the HSA of an eligible individual. Individuals that are self-employed or unemployed may also contribute to an HSA, provided they meet the qualifications of owning a Health Savings Account in the first place.

For 2017, the contribution limit to an HSA is $3,500 for self-coverage. Individuals with families can contribute up to $7,000. Individuals who are 55 years or older by the end of the tax year can contribute an additional $1,000 to their HSAs. Contributions made by an employer to an HSA are included in the limit. For example, an individual who opts for the maximum contribution limit of $3,500 can contribute only $2,000 if his employer contributes $1,500.

Tax Advantages of an HSA 

The HSA is advantageous to account owners because funds are contributed to the account using pre-tax income. The portion of pretax income that is used to fund an HSA, lowers a taxpayer’s total taxable income, translating into a lower tax liability for the individual.  In addition, contributions made to an HSA are 100% tax deductible, and any interest earned in the account is tax-free. However, excess contributions made to an HSA incur a 6% tax and are not tax deductible. As long as withdrawals from a Health Savings Account are used to pay for qualified medical expenses that are not covered under the HDHP, the amount withdrawn will not be taxed.

Qualified medical expenses include deductibles, dental services, vision care, prescription drugs, co-pays, psychiatric treatments, and other qualified medical expenses not covered by a health insurance plan. Insurance premiums usually don’t count towards qualified medical expenses unless the premiums are for Medicare or other health care coverage if 65 years or more, health care insurance while unemployed and receiving unemployment compensation and long-term care insurance. Any distributions made from an HSA that are for reasons other than paying for medical expenses, the amount withdrawn will be subject to both income tax and an additional 20% tax penalty. 

Individuals that are 65 years old or older will no longer be able to contribute to an HSA, but can withdraw any funds accumulated in the account for any expense without incurring the 20% penalty. However, income tax will still apply to any non-medical usage. 

Contributions made to an HSA do not have to be used or withdrawn during the tax year. Any unused contributions can be rolled over to the following year.  Also, an HSA is portable, meaning that if an employee changes jobs, he can still keep his HSA. In addition, an HSA plan can be transferred to a surviving spouse tax-free upon the death of the account holder. 

The Health Savings Account is often compared with the Flexible Savings Account (FSA). While both accounts can be used for medical expenses, some key differences exist between both. For example, unused funds in the FSA during a given tax year are forfeited once the year ends. Also, while the elected contribution amount for the year can be changed by an employee with an HSA anytime during the year, the elected contribution amount for an FSA is fixed, and can only be changed at the beginning of the following tax year.

5. Roth IRA Conversion

One of the primary benefits of using a Roth IRA is that you don’t pay income tax when you withdraw funds in retirement. Unfortunately, not everyone meets IRS standards to contribute to a Roth IRA.  The primary reason individuals are not allowed to contribute is that their incomes exceed the Roth IRA income limits. That’s when it makes sense to look into a Roth IRA conversion. What happens instead is that many individuals who do not qualify for income reasons end up investing in 401(k) plans and Traditional IRAs. With a Traditional IRA you receive a tax break today but pay income taxes in retirement. This is opposite of what happens with a Roth IRA. (Compare Roth IRAs and Traditional IRAs.)  The IRS has always allowed certain individuals to convert their Traditional IRAs to Roth IRAs as long as they met specific qualifications and paid income tax on the conversion. But high-income earners were unable to convert until recently. 

No Income Cap to Convert Traditional IRA to Roth IRA 

In the past to be able to convert from a Traditional to a Roth IRA your income needed to be under $100,000.  The IRS rules have changed and there is no longer an income cap in place. With the cap removed, high-income earners can now convert as long as they pay the appropriate tax on the conversion.  There is no 10% early withdrawal penalty if the funds move from a Traditional IRA to a Roth IRA in a 60-day window.

Roth IRA Conversion Taxes 

When you convert from a Traditional IRA to a Roth IRA, you generally pay income tax on the contributions and gains. The taxable amount that is converted is added to your income taxes and your regular income rate is applied to your total income. If the amount is large enough, it may raise your tax bracket for the year in which you do the conversion. 

Note that if the money in your Traditional IRA is post-tax money (you did not take a deduction on the money you contributed), you may not owe tax when you convert to a Roth IRA. 

Discuss this carefully with a financial advisor.

6. Cash Value Life Insurance: What is 'Cash Value Life Insurance

Cash value life insurance is a form of permanent life insurance that features a cash value savings component. The policyholder can use the cash value for many purposes, such as a source of loans, as a source of cash, or to pay policy premiums.

BREAKING DOWN 'Cash Value Life Insurance

Cash value insurance is permanent life insurance because it provides coverage for the policyholder's life. Traditionally, cash value insurance has higher premiums than term insurance because of the cash value element. 

Most cash value life insurance policies require a fixed level premium payment, of which a portion is allocated to the cost of insurance and the remaining deposited into a cash value account. The cash value account earns a modest rate of interest, with taxes deferred on the accumulated earnings. Whole life, variable life, and universal life insurance are examples of cash value life insurance. 

As the cash value increases, the insurance company's risk decreases as the accumulated cash value offsets part of the insurer's liability. For example, consider a policy with a $25,000 death benefit. The policy has no outstanding loans or prior cash withdrawals and an accumulated cash value of $5,000. Upon the death of the policyholder, the insurance company pays the full death benefit of $25,000. Money collected into the cash value is now the property of the insurer. Because the cash value is $5,000, the real liability cost to the insurance company is $20,000 (25,000-5,000).

Cash-Value as a Living Policyholder Benefit 

The cash value component serves only as a living benefit for policyholders. As a living benefit, any cash value may be drawn upon by the policyholder during their life. There are several options for accessing funds. For most policies, partial surrenders or withdrawals are permissible. Taxes are deferred on earnings until withdrawn from the policy and distributed. Once distributed, earnings are taxable at the policyholder's standard tax rate. Some policies allow for unlimited withdrawals, whereas others restrict how many draws can be taken during a term or calendar year. Also, some policies limit the amounts available for removal (e.g., minimum $500).

Most cash value life insurance arrangements allow for loans from the cash value. Much like any other loan, the issuer will charge interest on the outstanding principal. The outstanding loan amount will reduce the death benefit dollar for dollar in the event of the death of the policyholder before the full repayment of the loan. 

Some insurers require the repayment of loan interest, and if unpaid, they may deduct the interest from the remaining cash value. Cash value may also be used to pay policy premiums. If there is sufficient cash value, a policyholder can stop paying premiums out-of-pocket and have the cash value account cover the payment.

Next Steps

If you’d like to take the next steps and create a plan that can minimize taxes and help you reach your retirement goals, please schedule a time with us. We would love to help you accomplish all your goals in retirement! 

You can schedule a time on my calendar >>> HERE

Congratulations again on your retirement, and we look forward to helping you on your investment journey!

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6 Legal Ways to Avoid Taxes in Retirement

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