When it comes to comprehensive retirement planning, tax planning will always be a fundamental part. When living on a fixed income, as most people do in retirement years, the negative impacts of unexpected taxes can be catastrophic.
While no one knows exactly what U.S. tax laws will look like in a few years or decades, a tax-free retirement account is the only way to completely avoid the tax problem in retirement.
Definition of a Tax-Free Account
An account is considered tax-free if there is no federal or state tax owed on the income in the account, whether upon income arrival or upon distribution or withdrawal.
Through these types of accounts, money can be invested and grown without owing future taxes on that growth, even when withdrawing funds for spending.
Examples of Tax-Free Accounts
There is only one type of tax-free retirement accounts, which includes Roth cooperative accounts and Roth 401(k) plans. Under specific withdrawal rules and annual income and contribution limits, the invested money can grow tax-free in a Roth cooperative account or Roth 401(k) plan without being taxed, and it remains tax-free when withdrawn in retirement.
There are no other types of tax-free retirement savings vehicles. Because this tool is incredibly valuable for retirement planners and not for the interest of the Internal Revenue Service—which loses the opportunity to tax the large account value that it can become—there are strict rules governing how Roth accounts can be used to remain tax-free.
Tax-Deferred Accounts
The main difference between tax-free accounts and tax-deferred accounts is that individuals cannot create tax-exempt accounts in the United States. However, individuals can invest in certain types of bonds—such as municipal bonds—that pay tax-exempt interest. Typically, this interest is exempt from federal taxes unless it meets some other criteria to be exempt from local and state taxes as well.
Tax-Deferred Accounts
All investments have the potential to generate income or appreciate in value, or both. Income from these investments derives from two main sources: interest and dividends.
If the investment is held in a taxable account, the income is added to the owner’s taxable income for the year and results in an increase in the tax owed.
Any sales of assets held in a taxable account that are sold for more than the amount invested will also result in an increase in income and the tax owed on the following income. In contrast, there will be no tax owed if the same investments were made in a tax-free account.
Tax Deductions for Contributions to Tax-Free Accounts
Generally, you will not receive tax deductions for these contributions. The benefit of a tax-free account is tax-free growth.
The main sacrifice of this benefit—aside from the strict rules governing tax-free accounts like Roth accounts—is that you will not receive a deduction for the initial contribution to the plan, and contributions must be made with after-tax money.
However, there is one type of account that can also be used during retirement and provides early tax benefits and tax-free growth on earnings: the Health Savings Account, or HSA. With a Health Savings Account, you get a tax deduction on income when you contribute money, but when the funds in the health savings account are used for medical expenses and qualified health insurance expenses, the distributions are taken tax-free.
Questions
Repeating
How much can I contribute to a tax-free retirement account?
The amount you can contribute to a tax-free retirement account depends on the type you have. For the tax years 2021 and 2022, the maximum contribution to a Roth IRA is $6,000 per individual, plus an additional $1,000 for filers aged 50 and older. The limits for Roth 401(k) plans are much higher – you can contribute up to $19,500 to your Roth 401(k) plan in 2021 ($20,500 in 2022), plus $6,500 if you are 50 years old or older. The amount can be significantly higher if your 401(k) plan is for self-employment.
What are other ways to reduce taxes in retirement?
Aside from investing in tax-free accounts, there are several other ways to reduce taxes during retirement. You can reduce the amount you withdraw, or stop working part-time to lower your tax bracket, for example. Alternatively, you can convert some taxable accounts into Roth IRAs to pay taxes when you are in a lower tax bracket, then watch them continue to grow tax-free. Talk to a advisor about the best ways to reduce your tax liability in retirement.
When do you pay taxes on Roth IRA contributions?
Technically, your contributions are not taxed directly. You will pay income tax on any money you use to contribute to Roth before it is put into your Roth account. Since it has already been taxed, it is allowed to grow tax-free from then on.
Source: https://www.thebalancemoney.com/tax-free-retirement-accounts-faqs-2894621
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