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Planning for retirement extends far beyond the mere act of saving money; it involves a strategic method of managing your assets to lessen tax obligations. One essential element of this planning process is gaining insight into how different types of retirement incomes are taxed—or may even be exempt from taxation.
To assist you in enhancing your retirement finances, we present a detailed overview of seven sources of potential tax-free income.
Understanding Tax-free Income Options
Certain notable types of retirement income do not incur taxes from the IRS.
By diversifying the sources of your retirement income to include these tax-free options, you can potentially decrease your overall tax liability, allowing for greater longevity of your retirement savings.
It is important to keep in mind that tax regulations are intricate and frequently evolve, particularly as lawmakers may consider extending or solidifying aspects of the Tax Cuts and Jobs Act (TCJA). Therefore, consulting with a financial or tax advisor to navigate your unique situation and any legislative updates is advisable.
This article does not aim to provide an exhaustive list of all possible non-taxable income options.
1. Certain Social Security Benefits
It is often highlighted that up to 85% of Social Security benefits could be taxable. The IRS determines the taxable portion based on your “combined income,” which includes your adjusted gross income (AGI), tax-exempt interest, and half of your Social Security income.
Conversely, depending on your total income, it is possible for some or even all Social Security benefits to be tax-free. For the year 2025, individuals with a combined income of less than $25,000 (or $32,000 for married couples filing jointly) could receive their Social Security benefits without taxation.
For further details, consult: How to Calculate Taxes on Social Security.
2. HSA Distributions
Health Savings Accounts (HSAs) provide multiple tax benefits: contributions are tax-deductible, investment growth is tax-free, and withdrawals for qualified medical expenses are not taxed regardless of age. (Note that there are some potential caveats associated with HSAs.)
Once you reach 65, you can withdraw funds for any reason without incurring a penalty; however, unless for medical purposes, these withdrawals will be subject to income tax.
HSAs have contribution limits that are adjusted annually for inflation, and employers may also add to your HSA. Furthermore, individuals aged 55 and older can make an extra $1,000 catch-up contribution annually.
3. Municipal Bond Interest (Currently)
Interest from municipal bonds is typically exempt from federal taxes, and often from state taxes, provided you reside in the state that issued the bonds. This can create a consistent stream of tax-free income, making it appealing for retirees who might find themselves in higher tax brackets.
Municipal bonds can be especially advantageous during retirement as your return rates may decline due to a more conservative investment approach coupled with increased healthcare expenses.
It’s crucial to acknowledge that while municipal bonds present tax benefits, investors should also examine other elements such as yield, credit quality, and overall portfolio balance when making investment decisions.
Additionally: There is ongoing discussion among some Republican lawmakers regarding potential taxation on municipal bond interest as part of comprehensive tax reform, though no definitive bills have been proposed at this time.
4. Life Insurance Proceeds
Typically, life insurance payouts to beneficiaries are free from taxation. However, any interest accrued on these proceeds may incur taxes, and the tax implications can become quite complex if the policyholder opts to surrender the policy for cash.
Moreover, loans taken out against life insurance policies are generally not subject to tax as long as the policy remains active and the loan amount does not surpass premiums paid.
The IRS provides an online tool that can assist in determining whether the life insurance benefits you’ve received are taxable.
5. Roth Distributions
In contrast to traditional retirement accounts, Roth IRAs and Roth 401(k)s are contributed to with after-tax dollars, allowing qualified withdrawals—including earnings—to be tax-free during retirement. To qualify, you must be at least 59½ years old and have held the account for a minimum of five years.
Roth 401(k)s provide additional benefits for high-income individuals who may be barred from contributing to Roth IRAs due to income thresholds. Starting in 2025, individuals aged 50 and up can contribute an extra $7,500 to their Roth 401(k), enhancing tax-free savings capabilities.
In a notable change for 2025, individuals between 60 and 63 may qualify for a boosted “super” catch-up contribution of $11,250 if their plan permits.
For further information, see New SECURE Super 401(k) Catch-Up Contributions for 2025.
6. Home Sale Capital Gains (Certain Cases)
For those who have lived in their primary residence for a minimum of two of the past five years, up to $250,000 in capital gains from the home sale can be excluded from taxation ($500,000 for married couples submitting jointly).
Note: Although this exclusion can serve as a significant source of tax-free funds, it is not specifically tied to retirement, as eligibility applies to any qualifying home sale, independent of the seller’s age or retirement status.
It is essential to remember that this exclusion can be utilized only once every two years, and any gains surpassing this exclusion will be liable to capital gains tax.
Maintaining comprehensive records of home improvements can assist in increasing your cost basis, thereby possibly lowering taxable gains.
7. Gifts and Inheritances
While not a guaranteed income source, gifts and inheritances typically do not constitute taxable income for the recipient.
The IRS treats inheritances—including cash and property—as non-taxable income. Nonetheless, if the inheritance generates income, that income may be subject to tax.
Additionally, while there is no federal inheritance tax, certain states impose their own taxes on inheritances.
It is crucial to distinguish between inheritance tax (applied to heirs of the deceased) and federal estate tax (imposed on the estate itself), which has a high threshold enabling most taxpayers to evade taxation.
For 2025, the federal estate tax exemption rises to $13.99 million for individuals and $27.98 million for couples filing jointly.
In terms of monetary gifts, the annual gift tax exclusion for 2025 stands at $19,000 per recipient and $38,000 for couples, allowing donations up to these amounts tax-free to numerous individuals without utilizing the lifetime gift tax exemption.
Note: Staying under these per-recipient limits allows you to avoid filing a gift tax return for that year. However, if gifts exceeding the annual exclusion are given, it may necessitate a gift tax return, even if no tax is owed thanks to the lifetime exemption. Furthermore, exceeding the limit does not automatically result in tax liabilities due to the high lifetime exemption limit.
Under existing guidelines, these increased exemption levels are set to sunset at the conclusion of 2025. Unless legislative action is taken, the exemption will revert to around $7 million (adjusted for inflation) in 2026, making 2025 a pivotal year for estate planning and strategies related to gifting.
However, it is anticipated that the Republican-led Congress will likely advocate for the preservation of these higher exemption levels, so it remains essential to stay informed on this topic.
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