Diligence by Who? You or Your Financial Advisor?

When planning for retirement, you need to look at multiple sources of income and be sure that some of the income sources are tax-free. The more, the better. So, how do you plan for a retirement income stream that minimizes overall taxation?

Four Instruments that Provide tax-free Retirement Income

Here are four great ways to provide yourself with tax-free.

1. Roth IRA is a great retirement investment that can result in a steady stream of tax-free retirement income as long as they are considered qualified. However, you must qualify for an IRA and the requirements are adjusted year by year as is the amount eligible for savings. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

If you do qualify, money put into a Roth IRA is taxed when you receive it, so it is not taxed again when it is withdrawn. In 2018, the eligibility requirements are:

1. Single or head of household, earning less than $120,000 to fully contribute to a Roth IRA.
2. Married filing jointly or a qualified widow(er) earning less than $189,000 to fully contribute to a Roth IRA.
3. Married filing separately earning less than $10,000 to fully contribute to a Roth IRA. (Note that those married but filing separately can use the limits for single people as long as they have not lived with their spouse in the past year)
4. Municipal Bonds and Funds provide income distributions not taxable by the federal government though they are may be subject to state income tax. Because they are not subject to federal income tax, interest paid on these bonds is typically less than taxable bonds.

There is no income limit to investing in tax-free municipal bonds and funds.

3. Health Savings Accounts (HSAs) are available if your employer offers health insurance using an HSA. Combined contributions by the employer and employee to this account as of 2018 can be as high as $6,900.00 for qualifying plans.

Following the rules about which expenses are reimbursable, no taxes are paid on withdrawals.

In addition, the HSA funds and earnings can be held until retirement then uses to provide tax-free income by reimbursing the holder for past and current allowable expenses which include Medicare premiums.

4. Roth 401(k) or 403(b) allow Roth contributions inside these accounts making those contributions and their subsequent retirement earnings, tax-free. These accounts are not subject to income eligibility limits but they are subject to taxes in the year that contributions are made.

Making the Most of Your Home

Another way to make a smart investment for your retirement is to pay off any mortgage that you have on your home before you retire which allows you to live in your home for the cost of property taxes and home insurance alone.

For many retirees, this is a huge reduction in their monthly expenses allowing the money be used elsewhere.

Regardless of where it comes from, getting an unexpected chunk of change usually makes for a pretty good day, week, or even year. But if you aren’t intentional about what you do with your extra cash, you could follow in the footsteps of many lottery winners who squander their winnings and end up unhappy and broke.1  Even if the gift you receive isn’t a significant amount, you’d be amazed at how some smart planning can make a big difference down the road. Let’s look at some ways you can you use your raise, refund, or windfall to get ahead financially.

1. Pay Off Debt

Big debt, small debt, it doesn’t matter. Debt is debt. Start with high-interest debt and work your way down. Did you know that the average American household carries over $16,000 in credit card debt and pays an average of $1,292 in interest annually?2  Sure, using your extra influx of money to reduce debt isn’t as fun as going on a trip, but think of the satisfaction you’ll feel when you see your balance decrease, knowing that you are saving yourself thousands of dollars in interest in the long run.

2. Beefing Up Your Retirement Savings

Even if you diligently contribute to a 401(k) or IRA, chances are you aren’t maxing out those accounts. Let’s say you receive a $3,120 tax refund, the average amount according to the IRS.3  You then deposit that $3,120 in an IRA and see a 7% rate of return annually. In 20 years, you will have earned approximately $8,000 on that investment due to compound interest. Let’s go a bit further. If you invest your tax refund every year for 20 years, your retirement savings could see a boost of almost $150,000! If you’ve received a raise, use some of it to increase your contribution percentage right away. That way, you won’t get used to living with that extra money and it puts you ahead for the future.

3. Invest In Education

Most of us dream of our kids going to a great school and getting a solid foundation for their future career, but have you considered how much of an investment it will take to get them to that point? The numbers can be daunting. These days, a high school graduate can expect to pay upwards of $200,000 for an undergraduate degree at a top school4 and over $10,000 each year for in-state tuition alone at a public institution.5  The costs will vary depending on room and board and other educational costs, but either way, it’s a lot of money.

One option is to open a 529 account with your tax refund and, once again, let compound interest help you get ahead. Not only will your investment pave the way for your child’s future, but it could also give you a tax break.

4. Build Your Emergency Fund

An emergency fund provides you with a cushion for those times when life gives you lemons. If you don’t have readily available savings, something as simple as an unexpected car repair or medical bill could derail your finances. Or, if you know you have a large purchase or a life milestone approaching, such as welcoming a baby into your family, having an emergency fund will help you avoid digging into long-term savings or going into debt to cover costs. You can’t put a price on the peace of mind that an emergency fund will give you, so think about investing some of your tax refund to boost your short-term savings.

5. Be Generous

Giving your tax refund away may not help you get ahead, but it could make a lasting impact on someone else’s life. Find a charity or cause that is close to your heart and pay it forward. Your gift could also help you when the next tax season rolls around. Just make sure to get a receipt for your contribution and itemize your deductions.

Have You Received Some Extra Cash?

It’s okay to treat yourself when you find yourself with excess income, but don’t splurge just because the money is there. Make a list of your financial priorities and then map out how your additional money could give your financial future a boost. If you would like guidance on how to use your raise, refund, or windfall, call my office at (949) 221-8105 x 2128 or email me at michael.loo@lpl.com.