There are still ways to earn tax-free income. This is the first of our updated two-part series on the best federal-income-tax-free opportunities for individual taxpayers. Here goes.
Unlike withdrawals from traditional IRAs, qualified Roth IRA withdrawals are federal-income-tax-free (and usually state-income-tax-free too). What is a qualified withdrawal? It’s one that’s taken after you’ve met both of the following requirements:
1. You’ve had at least one Roth IRA open for over five years.
2. You’ve reached age 59½, are disabled, or deceased.
After you’ve departed this cruel orb, your heirs can take federal-income-tax-free qualified Roth IRA withdrawals, with proper planning.
Exemption from required minimum distribution rules
Unlike with a traditional IRA, the original owner of a Roth account (the person for whom the account is originally set up) is not burdened with the obligation to start taking required minimum distributions (RMDs) after reaching age 72 or face a stiff 50% penalty. Therefore, you can leave a Roth account untouched for as long you live. This important privilege, along with the aforementioned tax-free withdrawal privilege for heirs, makes the Roth IRA a great asset to set up, maintain, and eventually leave to your heirs — to the extent you don’t need the Roth IRA money to help cover your own retirement-age living expenses.
The trick is getting money into a Roth IRA. There are two ways to do that.
Make annual Roth contributions
Making annual Roth IRA contributions makes the most sense for folks who believe they will pay the same or higher tax rates during retirement. Higher future taxes can be avoided on Roth account earnings because qualified Roth withdrawals are federal-income-tax-free (and usually state-income-tax-free too).
The downside is you get no deductions for Roth contributions.
So if you expect to pay lower tax rates during retirement (good luck with that), you might be better off making deductible traditional IRA contributions (assuming your income is low enough to permit deductible contributions), because the current deductions may be worth more to you than tax-free withdrawals later on.
The absolute maximum amount you can contribute for any tax year to a Roth IRA is the lesser of (1) your earned income for that year or (2) the annual contribution limit for that year.
Basically, earned income means wage and salary income (including bonuses), self-employment income, and alimony received under a pre-2019 divorce decree.
For both your 2021 and 2022 tax years, the Roth contribution limit is $6,000 or $7,000 if you’ll be age 50 or older as of year-end. This assumes you’re unaffected by the AGI-based phase-out rule explained immediately below.
* For 2021, eligibility to make annual Roth contributions is phased out between modified adjusted gross income (MAGI) of $125,000 and $140,000 for unmarried individuals. For married joint filers, the 2021 phase-out range is between joint MAGI of $198,000 and $208,000.
* For 2022, the phase-out ranges are $129,000-$144,000 and $204,000-$214,000, respectively.
Key point: Your ability to make annual Roth contributions is unaffected by your age. You can keep making annual contributions as long as: (1) you have enough earned income to back them up and (2) your contribution privilege is not wiped out by the phase-out rule.
Make Roth conversion
A few years ago, an income restriction made individuals with MAGI above $100,000 ineligible for Roth conversions. The restriction is gone. Now even billionaires are eligible for Roth conversions. That’s an important break, because conversion contributions are the only way to quickly get large amounts of money into a Roth IRA. However, it’s important to keep in mind that a conversion will trigger taxable income. So you need to consider the federal income tax hit that will accompany a conversion. There may be a state income tax hit too. Consult your tax advisor before pulling the trigger on a conversion.
Tax-free Social Security benefits
While most folks are taxed on between 50% and 85% of their Social Security benefits, individuals with modest incomes can receive a bigger percentage tax free. Potentially up to 100%.
* If you’re unmarried with provisional income below $25,000, 100% of your benefits are tax-free. With provisional income between $25,000 and $34,000, you’ll be taxed on up to 50% of your benefits. Above $34,000, you could be taxed on up to 85%.
* If you’re a married joint-filer, with provisional income below $32,000, 100% of your benefits are tax-free. With provisional income between $32,000 and $44,000, you’ll be taxed on up to 50% of your benefits. Above $44,000, you could be taxed on up to 85%.
Provisional income means your adjusted gross income (AGI) from page 1 of Form 1040, plus half of your Social Security benefits, plus any nontaxable interest income (typically from municipal bonds).
AGI equals the sum of your taxable income items reduced by the sum of your so-called above-the-line deductions for things like deductible contributions to a traditional IRA; up to $300 in cash contributions to IRS-approved charities if you don’t itemize ($600 if you’re a married joint-filer); self-employed retirement plan contributions; self-employed health insurance premiums; the deductible portion of self-employment tax; alimony payments made under a pre-2019 divorce agreement; and up to $250 of an educator’s qualified out-of-pocket expenses, plus up to another $250 if your spouse is also an educator who incurs qualified expenses and you file jointly.
The point is, at least 15% of your Social Security benefits will be tax free and maybe more, potentially up to 100%, depending on your provisional income. As a bonus, some states exempt all or part of your Social Security benefits from state income taxes. For example, Colorado exempts the first $24,000 from state income tax.
Tax-free IRA withdrawals on top of tax-free Social Security
As I just explained, between 50% and 100% of Social Security benefits can be tax-free for folks with modest incomes. If you are in that category, you might also have some otherwise taxable withdrawals taken from your traditional IRA. Good news: You can shelter all or part of those withdrawals from federal income tax with your standard deduction.
* For 2021, the basic standard deductions amounts are $12,550 for singles, $18,800 for heads of households, and $25,100 for married joint-filers.
* For 2022, the basic standard deductions amounts are $12,950, $19,400, and $25,900 respectively.
* If you’re age 65 or older as of year-end, the standard deduction amounts are a bit higher.
The point is, a good chunk, or maybe all, of your Social Security benefits might be tax-free and ditto for otherwise taxable withdrawals from your traditional IRA. Nice!
Tax-free home sale gains: one of the best tax-saving deals ever
In one of the best tax-saving deals ever, an unmarried seller of a principal residence can exclude (pay no federal income tax on) up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000 of gain. In today’s surging residential real estate markets, this break can be more valuable than ever. Naturally, there are some limitations. You must pass the following tests to qualify.
1. Ownership test: You must have owned the property for at least two years during the five-year period ending on the sale date.
2. Use test: You must have used the property as a principal residence for at least two years during the same five-year period (periods of ownership and use need not overlap).
3. Joint-filer test: To be eligible for the larger $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.
4. Previous sale test: If you excluded gain from an earlier principal residence sale, you generally must wait at least two years before taking advantage of the gain exclusion deal again. If you’re a married joint filer, the larger $500,000 exclusion is only available if neither you nor your spouse claimed the exclusion privilege for an earlier sale within two years of the later sale.
If you don’t qualify for the maximum $250,000/$500,000 gain exclusion due to failure to pass all the preceding tests, you may still qualify for a prorated exclusion (reduced) exclusion amount if you had to sell your home for job-related or health reasons or for certain other IRS-approved reasons. For instance, say you’re a married joint filer. You and your spouse used a home as your principal residence for only one year before having to move for job-related reasons. You qualify for a prorated exclusion of $250,000 (half the $500,000 maximum allowance for a joint-filing couple, based on passing the ownership and use tests for only one year instead of for two years).
But wait, there’s more
My next column will cover more tax-free income opportunities. So please stay tuned for the rest of the story.