One of the most stressful expenses for workers today is none other than taxes. Not only do people have to pay taxes on their wages, but in many cases, they're subject to taxes on investment gains, too.
Unfortunately, taxes don't magically go away in retirement. But with the right strategy, you can reduce them substantially and potentially get out of paying them altogether. Here are three tax-free retirement income sources everyone should know about.
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1. Roth account withdrawals
There's a reason a lot of people opt to save for their senior years in a traditional retirement plan rather than a Roth account. Traditional IRA or 401(k) contributions go in on a pre-tax basis, allowing you pay the IRS less money each year. Roth IRAs and 401(k)s, by contrast, are funded with after-tax dollars.
But Roth IRAs and 401(k)s not only allow your money to grow tax-free, but also give you tax-free withdrawals. That's huge for a couple of reasons.
First, you may find that money is tighter in retirement since you're no longer working. So not having to pay the IRS a portion of your withdrawals gives you more breathing room in your budget overall.
Secondly, we don't know what tax rates will look like in the future. If they go up substantially, savers with traditional IRAs and 401(k)s could end up paying a lot more to access their money. A Roth account protects you from that.
2. HSA withdrawals
HSAs are one of the best savings tools out there because they effectively combine the benefits of traditional and Roth retirement plans. With an HSA, your money goes in on a pre-tax basis, investment gains are tax-free, and withdrawals are tax-free as long as the funds are spent on qualifying healthcare expenses.
You should know that once you turn 65, an HSA can be used for any purpose. You won't be penalized for non-medical withdrawals starting at that point.
But if you take a non-medical withdrawal, it won't count as tax-free income. Given that healthcare might be a significant retirement expense of yours, though, you may find that you have no trouble using your HSA funds in a tax-free manner.
3. Municipal bonds
Once you retire, it's important to have access to investments that are fairly stable and pay you on a predictable basis. Municipal bonds tend to fit that bill. They have a historically low default rate, and the interest they pay can supplement your retirement plan withdrawals and Social Security checks nicely.
To be clear, municipal bonds aren’t 100% risk-free, and defaults can happen. However, they’re pretty unlikely as long as the issuer has a strong credit rating.
Municipal bonds are issued by state and local governments to raise money for various projects. While some municipal bonds are backed by a specific revenue stream, many of these bonds are general obligation bonds, which means they're backed by the full taxing authority of their issuers.
Plus, as a bonus, municipal bond interest is always tax-free at the federal level. And if you want to avoid state and local taxes on that interest, just buy municipal bonds issued by your state of residence.
That said, it's only the interest municipal bonds pay that's tax-exempt. If you make a profit on your bonds by selling them at a higher price than what you bought them for, that gain itself may be taxable.
The more tax-free income you have access to in retirement, the more financially secure you might feel. So it's worth utilizing these options if your goal is to pay the IRS as little as possible and keep more money for yourself during your senior years.
