There's been a lot of talk in the news about how little President Trump may have paid in taxes over the last few years, something he called “smart” during the last presidential election. This is largely due to provisions that would have allowed him to use business losses in one year to offset income in other years. While most of us don't have that luxury, there are a surprisingly large number of ways we can generate tax-free retirement income:
1. Your employer's retirement account. If your employer offers a 401(k) or 403(b) plan, in 2020 you can contribute up to $19,500 per year pre-tax or $26k if you turn 50 or older this year. This reduces your taxes now, but don't you still have to pay taxes on the income when you withdraw it? Yes, but some or even most of that income may not actually be taxed.
First, each person can take a minimum standard deduction of $12,400. For a married couple filing jointly, that’s $24,800 of tax-free income. If you itemize your deductions in retirement, your deductions (and hence your tax-free income) would be even higher.
If you need to withdraw more than $12,400 per person, the next $9,875 (or $19,750 if married filing jointly) would only be taxed at 10% and the next bucket of income up to $40,125 (or $80,250 for married filing jointly) would be taxed at 12%. The point is that you can retire in the same tax bracket as when you were working but find that almost all of your income is taxed at lower rates. On the other hand, your pre-tax contributions come “off the top” and would otherwise have been taxed at your highest marginal rate. This is why it's generally a good idea to defer taxable income until retirement.
If your employer offers a Roth option, it's even simpler to see the tax savings. You don't get any tax break now, but the withdrawals from the Roth account are tax-free after 5 years and age 59 ½. This can be a particularly good option if you can max it out, if you’re expecting to pay a higher tax rate in retirement, or if you plan to retire before qualifying for Medicare at age 65 since tax-free withdrawals from a Roth account won’t count against you when determining your eligibility for health insurance subsidies under the Affordable Care Act.
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Finally, some retirement plans allow you to contribute after-tax. The earnings in these accounts are taxable when you withdraw them, but you can avoid that if your plan allows you to convert them into a Roth account so they can grow to eventually become tax-free. If your plan doesn't allow that, you can always roll the after-tax contributions into a Roth IRA after you leave the company.
2. Roth IRA. As long as you meet the income limits, you can also contribute up to $6,000 (or $7,000 if you're turning 50 or older this year) to a Roth IRA. (If you exceed the income limits, you can still use a "backdoor" approach to contribute.) As with the Roth 401(k), all withdrawals from the Roth IRA become tax-free after you've had the account for at least 5 years and you're over age 59 ½.
3. Health Savings Account (HSA). If you're one of the growing number of employees with a high-deductible health care plan, you and your employer can also contribute up to a total of $3,550 (or $7,100 if you have family coverage) to a health savings account (HSA) in 2020 plus another $1,000 if you turn age 55 or older this year. This can potentially give you the best of both worlds because the contributions are pre-tax and the withdrawals are tax-free if used for qualified health care expenses. Given that you're almost certain to have health care costs in retirement, it's a good bet that you can count on this to produce tax-free income. (You can also use it for non-qualified expenses with no penalty after age 65, but the withdrawals would be taxable in that case.)
4. Long term capital gains. What about investments that aren't in any of the above tax-sheltered accounts? There's good news for you here too. As long as your taxable income is below $40,000 for a single person or $80,000 for a married couple filing jointly, your tax on qualified long term capital gains and dividends would be zero. Just make sure you keep the investment for over a year before you sell it to qualify for that lower rate. (If you keep the investment until you pass away, your heirs can receive a step-up in cost basis, meaning that if they decide to sell it, they may end up paying little to no capital gains tax on your lifetime of gains.)
In addition, if you sell investments at a net loss, you can reduce your taxable income by up to $3k per year and carry the rest of the losses forward indefinitely. That means if you have $10k of current year losses and no other gains or losses for the next few years, you can reduce your taxable income by $3k this year, $3k next year, $3k the following year, and the last $1k in the fourth year. (Think of it as similar to Trump's use of his business losses but at a much lower scale.) This is why it makes sense to have more volatile investments like individual stocks or emerging markets funds in a taxable account. Just be aware that to take the losses, you can't repurchase the same or an identical investment within 30 days before or after the sale.
5. Home equity. There are several ways to get tax-free income from your home. One is to simply live in it. Your home is paying you income in the form of free rent, a concept called imputed rent. Fortunately, this "income" is tax-free.
You can also take a reverse mortgage against your home, which is just what it sounds like. Instead of you paying your mortgage company, the mortgage company pays you and it's not considered taxable income. You also get to keep your home as long as you live in it. However, when you move out or pass away, the home will be used to pay back the mortgage company plus fees.
Finally, you may decide to free up some of the equity by downsizing. As long as you've lived in the home as your primary residence for two out of the last 5 years, you pay no capital gains tax on up to $250k of gain (or $500k for a married couple that files jointly). Like other investments, the home can also pass on to heirs with a step-up in cost basis, which can reduce or eliminate any tax on your lifetime gain if the property is sold.
6. Investment property. Your home isn’t the only way real estate can reduce your taxable income. If you own investment property, you can take depreciation deductions (typically over 27.5 years) just like President Trump did. This will increase the capital gains tax when you sell the property, but you can pass it on to heirs without them ever having to pay tax on the gain throughout your lifetime.
7. Charitable remainder trust. If you have a large amount of taxable investments that you'd like to generate income from and are charitably inclined, consider a charitable remainder trust. It allows you to donate appreciated investments to the trust and take a tax deduction equal to the full value of the investments (which can offset other taxable income). The trust can then sell the investments with no capital gains tax and pay you an income that could be higher than what you would have received if you had to pay taxes on the investments. The remainder would then be paid out to the charities of your choice when you pass away.
8. Social Security. But what about your Social Security benefits? Don't you have to pay tax on them? Not necessarily — if your combined gross income is low enough, you may not have to pay taxes on any of your Social Security benefits. At most, only 85% of your Social Security income can be taxable.
When you add it all up, you can generate quite a bit of retirement income tax-free. You don't even have to be as "smart" as Donald Trump to do so. You just have to understand how to use the tax laws in your favor or consult with a qualified financial professional who does.
