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6 Types of Retirement Income That Aren’t Taxable

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As you approach retirement, it is vital to consider the tax implications of different income sources carefully. It’s essential that you plan ahead and understand how your income will be taxed during this phase of your life. There are many sources of retirement income that are not subject to taxation or carry different kinds of tax benefits. By taking advantage of these income sources, you can maximize your retirement income and enjoy a more comfortable retirement. Additionally, you can consult with a professional financial advisor who can advise you on different kinds of tax-exempt retirement income.

In this article, we’ll explore some of the most common types of non-taxable retirement income and how you can maximize your retirement income.

What are the different kinds of non-taxable retirement income?

Several types of retirement income are not taxable making them great investment options. We will discuss six different kinds of retirement income below:

1. Withdrawals from retirement accounts

The 401(k) and IRA (Individual Retirement Account) retirement plans are two of the most well-known retirement accounts in the US. Both these retirement accounts provide tax benefits in retirement, but they do so in different ways. A Roth IRA allows you to contribute after-tax money and subsequently make tax-free withdrawals in retirement (provided you adhere to certain conditions), while a 401(k) allows you to contribute pre-tax money, thereby reducing your taxable income for the year. The right choice for you will depend on your present financial situation and future goals.

As mentioned above, contributions to a Roth IRA are made with after-tax dollars, which means that they are not taxed when they are withdrawn in retirement. This can be a good option for people who expect to be in a higher tax bracket in retirement. Additionally, you can make tax-free withdrawals if the account has been open for at least 5 years and the owner is 59.5 or above. This can be a good tax-free retirement income source.

But what if you have already signed up for a regular 401(k) or a traditional IRA plan? You have the option to convert them to a Roth IRA account. Ensure that you deposit the withdrawn funds from your previous account to a Roth IRA account within 60 days. However, keep in mind that you will have to pay taxes on your contributions and earnings that you have transferred to your Roth IRA account. Given that the aim is to maximize returns at the time of retirement, a Roth IRA plan works well as a source of tax-free retirement income.

2. Withdrawals made from a Health Savings Account (HSA)

A HSA is a tax-advantaged plan that caters to the healthcare needs of people. In this plan, either the employer or the individual contributes money to an account that is invested over time. This sum can then be used for specified medical expenses based on the plan’s scope.

Contributions to an HSA are tax-deductible, which means that you can reduce your taxable income by the amount you contribute to your HSA. Additionally, any interest that your HSA earns is also tax-free. Moreover, you can make tax-free withdrawals from your HSA to pay for eligible medical expenses. HSAs offer triple tax benefits –  dDeferred tax growth, tax-free spending, and deductible contributions. Furthermore, the money in an HSA can also be utilized for investment purposes (such as stocks and securities), thus giving you flexibility as an investor. The only catch is that you have to meet certain conditions to start an HSA account. You must have a high-deductible health plan and no other health coverage (including Medicare). Also, if you are listed as a dependent on someone’s tax return, you cannot hold an HSA account.

3. Municipal bonds

Municipal bonds, popularly known as munis or muni bonds, are another tax-free retirement income option. A municipal bond is a form of debt security issued by states, cities, and municipalities with the objective of funding projects aimed at public welfare, such as roads, public infrastructure, schools, etc.

The tax treatment of muni bonds can vary depending on the specific bond and the investor's situation. In general, however, the interest that investors earn on muni bonds is exempt from federal income tax and may also be exempt from state and local taxes for residents of certain jurisdictions. In addition to the tax benefits, muni bonds are generally considered to be a relatively safe investment. These bonds are backed by the creditworthiness of the issuing government, which means that investors have a low risk of losing their principal investment. However, like all investments, muni bonds carry some degree of risk, and investors should carefully consider the risks and potential rewards before investing in municipal bonds.

4. Life insurance plans

In the case of a life insurance policy, the money beneficiaries receive from the policy is typically not considered taxable income by the Internal Revenue Service (IRS). In this sense, beneficiaries need not report the proceeds on their federal income tax returns. However, it is important to note that any interest the beneficiaries earn on the proceeds of the life insurance policy may be taxable. Additionally, if you are a beneficiary of another individual’s life insurance policy, the proceeds you receive are tax-free.

 5. Social Security benefits

One of the most common sources of retirement income is Social Security benefits. According to the Social Security Administration, up to 85% of Social Security benefits may be taxable, but the exact amount will depend on the individual’s income and other factors. However, if you are entirely dependent on Social Security benefits and have no other sources of income, the payments are tax-free.

While it is not advisable to only depend on Social Security payments as your retirement income, they are a source of retirement income. Take care to withdraw your taxable income before retiring or placing your retirement income in a Roth IRA account.

Additionally, it is essential to note that any workplace compensation extended to you in case of an injury or illness sustained due to work is tax-exempt under the law.

Also see: 10 Reasons You Should Consider Claiming Social Security Benefits Early

6. Inheritance

If you receive an inheritance, you may have to pay inheritance tax. But this can depend on several factors. For instance, not all states in the United States impose an inheritance tax. Another factor that can affect the amount of inheritance tax an inheritor is required to pay is their relationship to the deceased. The deceased’s spouse and sometimes children are exempted from paying this tax.

Additionally, gifting can be a great way to transfer wealth to others without incurring any tax liability. You can give away ‘gifts’ or money or other assets to your friends, family members, or other individuals without paying taxes on the value of those gifts. The annual gift tax exclusion for 2022 is $16,000, and $17,000 for 2023. This means you can give a gift of the above-mentioned value to a recipient without having to pay taxes. These limits are per recipient. So in essence, you can give several gifts up to $16,000/$17,000 in value to different people without incurring the gift tax. The value is different for married couples. It is best to consult with your tax professional for more information on gift taxes.


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Other income types that are exempt from taxation

1. Income from annuities

An annuity is a financial product that provides regular payments to an individual. With an annuity, you do not have to pay taxes on your earnings until you withdraw the money or start receiving payments. This is because annuities are tax-deferred. If the annuity was purchased with pre-tax funds, the withdrawn money would be taxed as income. If the annuity was purchased with after-tax funds, only the earnings on the annuity would be taxed when the money is withdrawn.

2. Veteran benefits

The U.S. Department of Veterans Affairs (VA) provides a variety of benefits to veterans and their families. These benefits are not treated as income for tax purposes, which means that they are not subject to federal income tax. Some examples of VA benefits that are not treated as income include disability compensation and pension payments for disabilities, insurance proceeds and dividends paid to veterans or their beneficiaries, and interest on insurance dividends left on deposit with Veteran Affairs.

3. Income from the sale of a house

For many retirees, their home is their largest asset. In the same light, retirees might not have to pay federal income tax on the capital gains from the sale of a house.

In the United States, you can exclude up to $250,000 of the capital gains from the sale of your home from your taxable income if you are single and up to $500,000 if you are married and filing your taxes jointly. This means that if you made less than the maximum exclusion amount from the sale, you would not have to pay any federal income tax on the capital gains. However, if you made more than the maximum exclusion amount, you would have to pay taxes on the amount that exceeds the exclusion limit.

4. Volunteering

If you receive money for volunteering for federal programs, it may be exempt from federal taxes. This means that you would not have to pay taxes on these funds, even though they are considered income. The exact details of which funds are exempt from federal taxes and how they are treated for tax purposes will vary depending on the specific program and the type of funds that are received. It is essential to check with the relevant federal agency or a tax professional to determine whether your volunteer work-related funds are subject to federal taxes or not.

To conclude

Retirement income is generally subject to income tax, just like any other type of income. However, some types of retirement income are not taxed or taxed at a lower rate. While there are a variety of tax-free retirement saving plans available, you must choose a plan that fits your needs and future goals. Overall, the tax treatment of retirement income will depend on the specific type of income and your financial situation. It's always a good idea to consult with a financial advisor or tax professional to understand the tax implications of your retirement income.

Use the free advisor match tool to match with experienced financial advisors who can guide you effectively on how you can save taxes in retirement and secure your financial future. Give us basic details about yourself, and Paladin Registry will help connect you with 1-3 professional financial advisors that may be suited to help you.

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The blog articles on this website are provided for general educational and informational purposes only, and no content included is intended to be used as financial or legal advice.
A professional financial advisor should be consulted prior to making any investment decisions. Each person's financial situation is unique, and your advisor would be able to provide you with the financial information and advice related to your financial situation.