Everyone loves the idea of “tax-free income.” It just sounds good. “Tax-free” and “income” are good things individually and are even better when you put them together. This post will offer some ideas on the ways you might be able to generate tax-free income. Now, whether tax-free income is the best strategy for you depends upon your personal situation and could be the subject for an entire article. But if tax-free income is your goal, here are some ideas on how you can make it happen.
The tried-and-true way to generate tax-free income is through municipal bonds. “Munis” are bonds that are sold to generate funding for a public project, like roads, schools, and parks. Because the funds are used for the benefit of the general public, the interest or dividend payments that you receive are tax-free. You can build a portfolio of individual bonds, or you can use mutual funds or exchange-traded funds (ETFs) to get exposure to the muni side of the bond market. Pro: It’s possible to build a steady stream of quality tax-free income. Con: Because of the tax-free nature of munis, they pay a lower interest rate than a similar taxable bond. So, getting “enough” tax-free income can require a substantial investment.
Distributions from your Roth IRAs, Roth 401(k)s, and Roth 403(b)s are another way to generate tax-free income, but you have to follow the rules. The contributions that you have made, when returned to you, are never taxed. Earnings are tax-free if you’ve held the account for more than five years. You’ll pay income tax and a 10% penalty on distributions from earnings that you take before you turn 59-1/2. Pro: Potential higher returns because of the investment flexibility in Roth accounts. Con: Limits on contributions. For 2019, you can make contributions of $6,000 into your Roth IRA or $7,000 if you are over 50. If you are lucky enough to have an employer-sponsored plan [401(k) or 403(b)], you can contribute up to $19,000 through payroll deductions or $25,000 if you are over 50.
The best-kept secret in the tax-free income space is health savings accounts (HSAs). These are accounts that offer tax advantages to money that you set aside to pay medical expenses. If you have a qualifying high-deductible health insurance plan, you can contribute to an HSA. Your contributions are made with pre-tax dollars; they can be invested and grow tax-free over the years (if you don’t use them for current medical expenses); and they can be withdrawn tax-free if used in retirement for health care expenses. That’s a triple tax-free benefit! Pro: Those triple tax-free benefits. Cons: The contribution limits. In 2019, you can contribute only $3,500 as an individual or $7,000 as a family. The important thing to remember to make HSAs work as a source of tax-free retirement income is to refrain from using them prior to retirement. You can pay normal medical expenses out of current cash flow and allow the HSA account to grow, increasing the potential tax-free distributions in the future.
Cash value life insurance, structured properly, can also be a source of tax-free income in retirement. This strategy is certainly not for everybody and should be considered only by those who have already maxed out the amount they can contribute to qualified retirement plans and have the rest of their financial house in order. This strategy takes planning, and you should consult with a trusted professional, not just an insurance salesman with commissions on the mind. Structured properly, a life insurance policy could provide significant tax-free cash flow. Pro: No limits on contributions. Cons: Policies are subject to health underwriting; potential high cost; more complicated tax rules.
Chances are that your situation won’t lend itself to all the strategies discussed above. But if your goal is to create a stream of tax-free income, you can probably put a few of them to work.
Schedule a 15-minute discovery call with a fee-only financial advisor to discuss your personal situation.