Everyone has to deal with taxes; they’re oftentimes unavoidable. But if you play your cards right, you can spend as little money as possible on them. You may even be so lucky as to avoid paying income tax altogether in retirement and get this… the government might actually give you money when tax season rolls around in a little something called the EITC, the Earned Income Tax Credit.
Retirement won’t save you from the tax forms and some headaches, but there is money you get that Uncle Sam can’t touch, as long as you play by the rules. And you have to know and understand the rules to win this game. So pay attention now and learn how you can actually avoid paying any income taxes on these things when you hit retirement!
Avoid Paying Income Tax on This Money
1. Social Security benefits
Social Security income may be the biggest portion of your total retirement income (it is for most Americans). But you will still have to file a tax return in retirement in almost every case, and you have to decide whether to file your tax returns either individually or file jointly with your spouse.
Good news here: if your combined income is low enough, you won’t be taxed on your Social Security retirement benefits. Zero, zip, nada!
You’ll have to figure out exactly what that total income number is, but you can definitely look it up before tax season rolls around. Some tax may be required if your total combined income from all sources exceeds the maximum amount allowed.
According to the IRS, the quick way to see if you will pay taxes on your Social Security income is to take one half of your Social Security benefits and add that amount to all your other income, including tax-exempt interest. This number is known as your combined income (combined income = adjusted gross income + nontaxable interest + half of your Social Security benefits). If your combined income is above a certain limit (the IRS calls this limit the base amount), you will need to pay taxes on some of it.
The limit is $25,000 if you are a single filer, head of household, or qualifying widow or widower with a dependent child. The limit for joint filers is $32,000. If you are married filing separately, you will likely have to pay taxes on your Social Security income so consider filing jointly and it might just avoid the tax altogether!
2. Health Savings Account distributions
Health savings accounts (HSAs) are a popular choice for seniors who are enrolled in a high-deductible health plan (HDHP). When used for medical expenses, withdrawals are tax-free, but that’s not all.
Pretty much everything about an HSA is amazing. They grow tax-free too, and they’re also tax-deductible. All you need to do is your homework on how they work and you’re set. Plus, when it comes to your health, what better way to stay worry-free than with an account made specifically for these types of needs?
Right now, seniors enrolled in Medicare are not eligible for HSAs, but a bill has been introduced to change that.
3. Reverse mortgage payments
Since the IRS considers reverse mortgage payments to be loan proceeds and not income, they simply aren’t taxable. And that’s true no matter whether you get a line of credit, a monthly advance, or even a lump sum. Even if you opted for all three of these ways, you won’t have to worry about any taxes.
4. Roth IRA distributions
You’ve probably have heard of qualified distributions, right? Well, when it comes to a Roth IRA (Roth individual retirement account), qualified distributions are not taxed. That’s the money you receive after the age of 59½, typically.
But here’s another benefit of the Roth IRA, especially for those who think they’ll be in a higher tax bracket during retirement. Contributions made to this type of account are taxed when you make deposits, not when you withdraw. Traditional IRAs work in the opposite way. The trick is to figure out when and how you want to pay your taxes. It’s all about the long game!
5. Life insurance proceeds
According to the IRS, you won’t be taxed on the proceeds of a life insurance policy that you receive in the event of a loved one’s death. Imagine having to deal with that event and being taxed on top of it.
6. Municipal bond interest
The federal government cannot tax you on municipal bonds since these are loans to local or, in some cases, state governments. That’s one advantage, but don’t forget about your combined income.
Going back to an earlier point, don’t forget that if your combined income reaches a certain point, you’ll still be expected to pay federal taxes on your Social Security. If you go this route, try to find a proper balance.
7. Profit from selling your home
Alright, there are a few ifs and buts for this one, but it’s worth thinking about. If you decide to sell your primary home, you won’t have to worry about capital gains depending on the amount you’ve gained from the transaction. You could qualify for a tax break if you’ve used the property as your main home and owned it for at least two years over the course of five years, prior to making the sale.
How much could you save? Well, you could exclude $250,000 from your income or even double that ($500,000) if you decide to file jointly with your spouse.
Since you may be downsizing in retirement, this is a great way to save.
8. Veterans benefits
A number of benefits paid through the U.S. Department of Veterans Affairs are not taxed since they aren’t treated as income.
When it comes to disabilities, for example, compensations and pension payments for veterans and their families are not taxed. Same with insurance proceeds and interest on insurance dividends deposited with the VA. Check out IRS Publication 525 for more information on the topic.
9. Reimbursements and expenses for volunteering
Volunteers also get a break from taxes if they work for federal programs. The same publication as mentioned earlier, IRS 525, will have all the information you need. But here are three places you can volunteer and benefit from this:
- The Service Corps of Retired Executives (SCORE)
- The Tax Counseling for the Elderly (TCE) program
- National Senior Service Corps programs
The EITC – You May Actually Get FREE Money from the Government!
The Earned Income Tax Credit (EITC) is a tax credit available to lower income earners. In retirement, it’s pretty likely your income will be lower than when you actually were working and if it’s considered to be low income, you may qualify for the EITC.
In some cases, the EITC can be greater than your total income tax bill, and that means providing an income tax refund to you and families that may have little or no income tax withheld from their pay or other earnings. You can use an EITC calculator to see if you qualify for the Earned Income Tax Credit, and if so, how much it might be worth to you in retirement.
How much is the EITC? The maximum tax credits for the return you’ll file in 2020 for the 2019 tax year are:
- $6,557 if you have three or more qualifying children
- $5,828 if you have two children
- $3,526 if you have one child
- But even if you have no qualifying children in retirement, you can get as much as $529 back as a refund in 2019 when qualified!
Proper tax planning will save you money.
First of all, think long-term tax planning. This provides general guidance as to how much you should withdraw from which accounts from year to year, and how to coordinate your sources of income with your Social Security benefits to deliver more after-tax income.
Then, look at your annual tax planning because each year tax rates and deductions can change. Annual tax planning done in the fall of each year can uncover tax planning opportunities that cannot be discovered with long-range tax planning alone.
You won’t enjoy doing your taxes in retirement. But if you can avoid paying income tax, or even better you get some free “EITC money”, then tax season may be more like Christmas in April than you might have hoped for!
Have you thought about taxes and retirement yet? If not, doing some advance planning might save you hundreds or even thousands in your golden years. If you are not thinking about it, why aren’t you? It sneaks up on you in a hurry, I can attest to it!