Personal Finance

9 Types of Tax-Free Retirement Income

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Just because you’ve stopped working doesn’t mean you’re done paying taxes.

Much of the income you receive in retirement, even if it’s not directly from employment, can still be taxable. But not all of it is subject to federal taxes — especially if you play your cards right.

You can or might be able to avoid paying federal income taxes on the following types of retirement income.

1. Stimulus payments

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The first two rounds of coronavirus stimulus payments authorized by federal laws created in 2020, as well as the third round of payments authorized on March 11, are not taxable income as far as the IRS is concerned. Technically, they are advance payments of tax credits.

In fact, stimulus payments won’t even affect taxes on Social Security benefits, as we detail in “Will Stimulus Checks Increase Your Social Security Taxes?”

2. Social Security benefits

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If what the Social Security Administration characterizes as your “combined income” is below a certain amount, you generally won’t be taxed on your Social Security retirement benefits.

The exact amount depends on whether you file a tax return as an unmarried individual, jointly with your spouse or separately from your spouse. The Social Security Administration lays out the details on its website.

However, even if your combined income is high enough that you would owe taxes on your benefits, there are ways to get around it — legally. We detail them in “5 Ways to Avoid Taxes on Social Security Income.”

3. Health savings account distributions

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Health savings accounts are popular specifically for their tax advantages, as we explain in “3 Ways a Health Savings Account Can Improve Your Finances.”

In short, your contributions to an HSA are tax-deductible, they grow tax-free and withdrawals are tax-free when used for eligible medical expenses.

So, you will never pay federal taxes on money you put in an HSA, provided that you follow the IRS rules for this type of account.

4. Reverse mortgage payments

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The IRS plainly says:

“Reverse mortgage payments aren’t taxable.”

The federal agency considers them loan proceeds, not income.

Whether you get those payments as a lump sum, a monthly advance, a line of credit or all three, you won’t face federal income taxes on the funds.

If this feature alone is making you wonder whether a reverse mortgage is right for you, check out what Money Talks News founder Stacy Johnson has to say in “Should I Get a Reverse Mortgage?” This source of retirement income is not for everyone.

5. Roth IRA distributions

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One advantage of a Roth individual retirement account (IRA) over a traditional IRA is that qualified distributions are not taxed.

Distributions that you receive upon or after reaching age 59 ½, for example, are generally among those that can be considered “qualified.”

This doesn’t mean you’re entirely escaping taxes.

One way that deposits into a Roth IRA differ from those into a traditional IRA is that you pay federal income taxes on them for the tax year in which you earned the money, as opposed to the year for which you withdraw the money. You’re paying on the front end instead of the back end.

This often makes Roth accounts attractive to people who want to avoid taxation in retirement and those who expect to be in a higher tax bracket during retirement than during their working years.

To learn more about the two types of IRAs, check out “Which Is Better — a Traditional or Roth Retirement Plan?”

6. Life insurance proceeds

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The proceeds of a life insurance policy that you receive due to the insured person’s death usually aren’t considered taxable income, according to the IRS. You don’t even have to report proceeds on federal income tax returns. But any interest is taxable.

7. Municipal bond interest

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Municipal bonds are essentially loans to state or local governments, and it would be awfully rude for the federal government to tax you on any interest you make from such loans. The IRS even refers to them as “tax-exempt governmental bonds.

That doesn’t mean municipal bond interest is completely tax-free. You may end up paying in other ways.

For instance, your earnings from municipal bond interest could raise your combined income enough that you must pay federal taxes on your Social Security benefits.

8. Profit from selling your home

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Capital gains from the sale of your primary home might not be subject to federal income tax, depending on how much you made.

“You may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse,” the IRS says.

The qualifications for this tax break include having owned the property and used it as your main home for at least two years of the five years prior to you selling the home.

9. Veterans benefits

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A wide variety of benefits paid through the U.S. Department of Veterans Affairs (VA) are not treated as income.

These benefits, which are laid out in IRS Publication 525, include:

  • Disability compensation and pension payments for disabilities that are paid to veterans or their families
  • Veterans’ insurance proceeds and dividends paid to veterans or their beneficiaries
  • Interest on insurance dividends left on deposit with the VA

10. Reimbursements and expenses for volunteering

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Certain kinds of funds that you receive related to volunteer work for federal programs are not subject to federal taxes.

As laid out in IRS Publication 525, they include various reimbursements to volunteers in:

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.


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