2023 is finally here, and pretty much every regular source of money you have is taxed in some form. Income is taxed according to marginal tax brackets at the federal and state levels (though some states don’t have an income tax).
Saving for retirement is a big deal which is why you need proper tax planning. Tax planning can help you get the most out of your retirement investments so you can enjoy the maximum amount of your hard-earned money. You can avoid tax problems later in retirement by starting early and planning smartly.
Fortunately, there are some neat ways you can accrue tax-free income. Although virtually all of your income is supposed to be taxed in some form, there are a few ways to get-tax advantaged status for specific accounts and even tax-free status for some.
Tax-free income can be a massive windfall for retirement as you have a steady source of passive income. for retirement.
What is a Tax-Free Account?
A tax-free account is an investment account that is either allowed to grow tax-free or has no tax restrictions on withdrawals. Most accounts are not genuinely tax-free and instead are tax-advantaged accounts. Tax-advantage accounts get special tax benefits like deferred tax payments or a reduced tax rate.
Taxed accounts usually run on an earn/use tax basis. That is, for most investment accounts you either pay taxes on the income you put into the account or you withhold taxes on contributions until you actually withdraw the money.
Traditional 401k accounts put pre-tax dollars into the account and you only pay taxes when you withdraw the funds later. A Roth IRA takes post-tax income and can grow tax-free. You don’t have to pay further taxes when you withdraw from a Roth IRA.
With that in mind, we are going to cover 7 different strategies to get some nice tax-free income. Here are the 7 ways to make tax-free income:
1. Roth IRA
First things first, a Roth IRA is probably the simplest and easiest kind of tax-free stream of income to set up.
A Roth IRA is a kind of individual retirement account that individuals contribute to over their lives. People take their post-tax income and put it into a Roth IRA account so it grows over time.
The key feature of a Roth IRA is that it allows for tax-free growth and tax-free withdrawals. Since Roth IRAs are funded by income that has already been taxed, you never have to pay further taxes on your gains. After all, doing so would amount to taxing some income twice.
The best part is you don’t have to pay any taxes when you access the funds. The amount in the account is the exact amount you are entitled to, nothing less.
2. Municipal Bonds
Municipal bonds are one of the most tried-and-true methods of generating a tax-free income.
Essentially, a municipal bond is a loan you give to your state or local government that funds public projects like highways, rail systems, and schools. The person who purchases a municipal bond receives a regular payout that is completely free from federal taxation.
Keep in mind that not all municipal bonds are free of taxation at the state level. Most of the time, they will be but not in all cases.
In general, states will forgo taxation on municipal bonds bought in your state of residence. So if you buy a bond in Kentucky and live in the state, you will likely not have to pay state taxes on any income generated from that bond.
3. Long-term Capital Gains
Technically, gains made from stock held longer than a year are not completely tax-free. However, long-term gains are taxed at a lower rate than your normal federal tax-bracket.
For example, the long-term capital gains tax rate for those in the highest income bracket is only 20%, compared to the 40% tax rate on normal income in that bracket.
However, if you are in the lowest tax brackets—10%-15%— then you get a special surprise. The capital gains tax for long term investments held by those in the lowest income brackets is 0%! That means if you fall in the lowest two tax brackets, you don’t have to pay a single cent in taxes on your capital gains.
Keep in mind that you will likely still have to pay some taxes when you access those funds though.
4. Employer-Provided Insurance
In general, employer-provided insurance is exempt from federal taxation. The IRS states that “the value of accident or health plan coverage provided to you by your employer is not included in your income.” That means employer-provided insurance payments are not subjected to taxation by the US government.
In general, employer-provided insurance payments are also not taxable at the state level, though this may depend on your specific insurance provider. Long-term care provided by insurance is also generally not taxable at the federal or state levels.
5. Income in 7 States
All normal income in the US is subject to federal taxation. However, not every state collects taxes on a regular income. In the US, 7 states currently do not tax regular incomes:
- South Dakota
If you live in these states then you do not have to pay any taxes on income generated in that state. Keep in mind that you must earn the income in the state that you live in.
So for example, if you live in Arizona but work in Nevada, you will have to pay Nevada income tax on any money you generate since it comes from that state.
6. Selling Your House
If you own a house then some revenue generated by the sale of that property may be exempt from taxes.
An individual or married couple must meet the IRS’s ownership and use a test that requires that they have owned and lived in the home for at least 2 of the last 5 years. If they meet those criteria, then they can exclude up to $250,000 (for individuals ) of $500,000 (for married couples) from capital gains taxes when they sell that residence.
7. Qualified Dividends
Qualified dividends are another source of tax-advantaged income. When you invest in common stock, most of the time you are entitled to some portion of the profits which get paid out in quarterly dividend payments.
Dividends come in two types, non-qualified and qualified.
Payments from non-qualified dividends are taxed as ordinary income, which maxes out at almost 40% for earners in the highest income bracket.
Qualified dividends, on the other hand, are generated from stock that the holder has held for a certain period. Qualified dividends are taxed at lower capital gains rates.
In order for a dividend to count as qualified, it must meet three criteria laid down by the IRS:
- It must be paid by the US or qualifying foreign company
- It is not explicitly exempt from qualification
- A specific dividend holding period must be met
The dividend holding period differs depending on the specific stock. In general, the dividend holding period is about 12 months.