3 Tax-Free Income Options for Retirement

With the tax filing deadline already passed and the reality that many of us owed more than we wanted to pay, many people may find themselves wondering, “Is there a way for me to pay less in taxes?” While your tax professional is your go-to person for this concern in the short-term, tax-free income for retirement could be a solution for the long-term problem. Your financial advisor can help you determine the best route to take for tax-free income, but a Roth IRA, Roth 401(k) or permanent life insurance are great options to investigate first.

Roth IRA

So, what is a Roth IRA? A Roth IRA is a retirement savings account you can contribute to using after-tax dollars. When you reach retirement age and need to withdraw funds, you won’t be hit with taxes on the money you’ve put away. To qualify for a tax-free and penalty-free withdrawal of earnings, Roth IRA distributions must meet a five-year holding requirement and occur after age 59.5. Depending on which vehicles you are utilizing for retirement savings, this may be one of your few options for tax-free income. For example, if your employer doesn’t offer a Roth 401(k), or perhaps doesn’t offer any work-sponsored plan at all, this could be one of your few available options for tax-free income for retirement.

But there are income limitations that determine if you are allowed to contribute to this type of account. If you are single and your adjusted gross income (AGI) is more than $133,000, you are not eligible to contribute to a Roth IRA. If you are married and filing jointly, your AGI must be lower than $196,000 to contribute. If your AGI is under $118,000 as a single person or $186,000 as a married couple, you can contribute a maximum amount of $5,500 a year, or $6,500 if you are over 50, thanks to the catch-up provision. This provision allows you to contribute an additional $1,000 a year in order to catch up if you’ve put off saving for retirement. (For related reading, see: Top 10 Mistakes to Avoid on Your Roth IRA.)

Roth 401(k)

In addition to a Roth IRA, a Roth 401(k) is another option to explore. A Roth 401(k) is similar to a traditional 401(k), except you contribute after-tax dollars instead of pre-tax. Roth IRAs and Roth 401(k)s are similar in that regard. Unlike the Roth IRA, contributions to a Roth 401(k) are not subject to income limitations, so if you are a high income earner, you can still contribute after-tax money into your account.

A Roth 401(k) allows you to contribute a lot more money than a Roth IRA towards an account where the money can grow tax-free—$18,000 versus $5,500 for those under 50. Depending on your AGI, you may not be eligible to contribute to a Roth IRA, so your Roth 401(k) would be your other investment option for tax-free retirement income.

While a work-sponsored Roth 401(k) is a great option, don’t forget to consider a Roth IRA because the Roth IRA will have more investment choices available to you. A Roth 401(k) is limited to what the plan offers, whereas a Roth IRA is not. If you are utilizing some of the other tax-free income savings vehicles, contributing to a Roth IRA will create additional tax-free money for you in retirement. (For related reading from this author, see: The Roth 401(k): Should I Invest in It?)

Permanent Life Insurance

In addition to Roth IRAs and Roth 401(k)s, you can utilize a permanent life insurance policy as a source of tax-free income in retirement.1 Permanent life insurance is a life insurance policy that builds cash value. Permanent life insurance could play a dual role in your strategy with an emphasis on insurance in your early years and potential tax-free income in your retirement years.

Chances are if you have children or are financially responsible for a parent, you will need life insurance anyway. While term may be an inexpensive option for the short run, some people prefer to pay more upfront for a permanent policy so they are not limited to having coverage for a set length of time. Depending on the type of permanent insurance you buy, some products have the potential to provide income for life after you reach a certain age. Additionally, unlike a Roth IRA and Roth 401(k), it has the potential to provide you with tax-free income prior to age 59.5 if you fund it properly. (For related reading, see: Cut Your Tax Bill With Permanent Life Insurance.)

With multiple retirement savings vehicles to choose from, deciding on which combination will work best for you can be tough. Exploring your options with a financial advisor will allow you to get answers to your questions and figure out a plan to help you reach your goals. Contact your financial professional today for help and guidance with your personal situation.

(For more from this author, see: 3 Key Steps to Save More for Retirement.)

1 Before you purchase a life insurance policy, be sure you are familiar with all its potential benefits and risks. Policy loans and withdrawals will reduce the policy's cash value. Loans are subject to interest charges. Guarantees are based on the claims-paying ability of the issuer and do not protect against market fluctuation.

The opinions voiced in this article are for general information only. They are not intended to provide specific advice or recommendations for any individual and do not constitute an endorsement by NPC. Please remember that investment decisions should be based on an individual's goals time horizon, and tolerance for risk. NPC does not render legal or tax advice. The information being provided is strictly as a courtesy. When you link to any of the web sites provided herewith, you are leaving this site. We make no representations as to the completeness or accuracy of the information provided at these sites. Nor are the companies liable for any direct or indirect technical or system issues or any consequences arising out of your access to or your use of third party technology, sites, information and programs made available through this site. By clicking on the link above you will leave our website and assume total responsibility and risk for your use of the site.  To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA or Roth 401(k) must be in place for at least five years, and the distribution must take place after age 59.5 or due to death, disability, or a first-time home purchase (up to $10,000 lifetime maximum). Before taking any specific action, be sure to consult with your tax professional.