Saving for retirement in tax-deferred vehicles is a great way to reduce your tax burden today. But it’s also important to limit the tax bite out of your hard-earned savings later by creating a stream of tax-free retirement income.

By most estimates, income tax rates will likely rise in the future. Current rates set in the 2018 tax law are set to expire in 2026, while federal deficits and obligations are growing sharply, calling for more revenue.  

Relying only on 401(k), 403(b), or IRA accounts paired with Social Security and other savings and investments means that all your post-retirement income is exposed to potentially higher tax rates. Additionally, if your combined retirement income from these sources exceeds limits, the portion of Social Security subject to taxes jumps from 50% to 85%. (The limit is $44,000 for married joint filers or $34,000 for single filers.) 

To keep more of your money in retirement years, direct a share of your savings to investments generating tax-free income that can balance out and offset taxable distributions. 

Roth IRAs

The most common vehicle for tax-free retirement income is the Roth IRA. Funded with after-tax dollars, Roth IRAs grow tax-free and yield tax-free payouts. This can be a great tool, especially if you start saving early. Contribute the allowed maximum and you can accrue millions tax-free in your working years. 

However, this strategy comes with significant contribution and income limits. Combined contributions to traditional and Roth IRAs are capped at $6,000 per year, or $7,000 if you are over age 50. At incomes above $196,000 (for married joint filers), the contribution limit is reduced and phases out completely at $206,000. Couples earning more than that are ineligible for Roth IRAs. Single filers become ineligible for a Roth IRA at incomes over $139,000.

High-income earners should check to see if their retirement plan offers the option of a Roth-designated account within their 401(k) or 403(b). Like a regular Roth, these allow tax-free growth and qualified distributions, but are not subject to income limits and have higher contribution levels.  

Life Insurance Retirement Plans (LIRPs)

If your income exceeds the Roth IRA limits, another option is a life insurance retirement plan (LIRP).  

For these cash-value life insurance policies, you’ll pay a premium higher than would normally be charged for the insurance benefits. The surplus accumulates tax-free, and in retirement, you can borrow against these policies tax-free as well. Drawing cash out of the policy every year can reduce your dependence on taxable retirement income. 

Tax-free income from LIRPs does not count as provisional income for purposes of calculating whether Social Security benefits are taxable, so relying on this source helps keep you below that tax threshold. 

LIRPs offer several benefits that enhance their value as a hedge against rising tax rates. First, there is no contribution limit. Second, they are safer than other investments because they come with a floor that prevents losses in market downturns. The death benefits pay off to your heirs tax-free. Finally, many policies can serve as long-term care insurance, allowing policyholders to accelerate the death benefit to cover medical costs if terminally ill. 

As with most tax-minimizing strategies, LIRPs are subject to limits. It’s important to make sure that your plan is structured so premiums fall within these limits to avoid classification as a modified endowment contract (MEC).  The rules for drawing cash out of an MEC plan are different and will limit your tax break.  

The trick is to purchase a policy with a death benefit large enough to qualify as a non-MEC policy and to generate substantial tax-free income, but not so large that policy cost outweighs benefits. A commission-free policy will ensure that more of your premiums earn income for your future.

LIRPs may be a good option for those whose income exceeds the Roth IRA limits, but less useful for those who really don’t need the life insurance benefit. Other options to consider in the mix for tax-free income are municipal bonds and health savings accounts (HSAs), which can be held and saved to offset health care costs and Medicare premiums in retirement. Each vehicle has pros and cons. Please contact us for help with planning for a mix of retirement income that works for your circumstances.