Do you know all the ways to collect tax-free income? Surprisingly enough, there are still more than a few ways to do it. Here’s a summary of what we think are the best federal income tax-free opportunities for individual taxpayers.
Break 1: Tax-free Income Accumulation And Withdrawals With Roth Iras
Roth IRAs have two big tax advantages.
Advantage 1: Tax-Free Withdrawals
Unlike withdrawals from traditional IRAs, qualified Roth IRA withdrawals are federal-income-tax-free and usually state-income-tax-free too. What’s a qualified withdrawal? It’s one that’s taken after you’ve met both of the following requirements:
You’ve had at least one Roth IRA open for over five years.·
You have reached age 59 1/2, are disabled, or are deceased.
After your death, your heirs can take federal-income-tax-free qualified Roth IRA withdrawals, with proper planning.
Advantage 2. Exemption from Required Minimum Distribution (RMD) Rules
Unlike with a traditional IRA, you (as the original owner of a Roth account) are not burdened with the traditional IRA owner’s obligation to start taking RMDs after reaching age 72. Traditional IRA owners face a stiff 50 percent penalty that does not apply to Roth IRA owners.
Therefore, you can leave a Roth account untouched for as long as 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.
Method 1. Make Annual Roth Contributions
Making annual Roth IRA contributions makes the most sense if you believe you will pay the same or higher tax rates during retirement. You can avoid higher future federal income tax rates on Roth account earnings because qualified Roth withdrawals are federal-income-tax-free.
The downside: you get no tax 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 (a) your earned income for that year or (b) 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 your 2022 tax year, the Roth contribution limit is $6,000 (or $7,000 if you’ll be age 50 or older on December 31, 2022). This assumes you’re unaffected by the AGI-based phaseout rule explained immediately below.
For your 2022 tax year, eligibility to make annual Roth contributions is phased out between modified adjusted gross income (MAGI) of $129,000 and $144,000 for unmarried individuals. For married joint-filers, the 2022 phaseout range is between joint MAGI of $204,000 and $214,000.
Key point: Your ability to make annual Roth contributions is unaffected by your age. You can keep making annual contributions as long as·
you have enough earned income to back them up, and
your contribution privilege is not wiped out by the phaseout rule.
Method 2. Do a Roth Conversion
A few years ago, an income restriction made individuals with MAGI above $100,000 ineligible for Roth conversions. That 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. But it’s important to remember 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.
Break 2: Tax-free Social Security Benefits
While most folks are taxed on between 50 percent and 85 percent of their Social Security benefits, individuals with modest incomes can receive a bigger percentage federal-income-tax-free—potentially up to 100 percent.
If you’re unmarried with provisional income below $25,000, 100 percent of your benefits are tax- free. With provisional income between $25,000 and $34,000, you’ll be taxed on up to 50 percent of your benefits. With provisional income above $34,000, you could be taxed on up to 85 percent of your benefits.
If you’re a married joint-filer with provisional income below $32,000, 100 percent of your benefits are tax-free. With provisional income between $32,000 and $44,000, you’ll be taxed on up to 50 percent of your benefits. With provisional income above $44,000, you could be taxed on up to 85 percent of your benefits.
“Provisional income” means your adjusted gross income (AGI) from page 1 of Form 1040, plus half of your Social Security benefits, plus any non-taxable 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 such things as deductible contributions to a traditional IRA, self-employed retirement plan contributions, self- employed health insurance premiums, the deductible portion of self-employment tax, and alimony payments made under a pre-2019 divorce agreement.
The point is, at least 15 percent of your Social Security benefits will be federal-income-tax-free—and maybe more, potentially up to 100 percent, 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.
Break 3: Tax-free Ira Withdrawals On Top Of Tax-free Social Security
As we just explained, between 50 percent and 100 percent 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 2022, the basic standard deductions amounts are·
$19,400 (head of household)
$25,900 (married, filing jointly)
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 federal-income-tax-free. Ditto for otherwise taxable withdrawals from your traditional IRA. Nice!
Break 4: Tax-free Home Sale Gains
In one of the best tax-saving deals ever, an unmarried seller of a principal residence can exclude (that is, 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.
After the huge surge in residential real estate prices, which may not be over, this break can be more valuable than ever. Naturally, there are some limitations. You must pass the following four tests to qualify.
- Ownership test. You must have owned the property for at least two years during the five-year period ending on the sale date.
- 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.)
- 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.
- 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 available only if neither you nor your spouse claimed the exclusion privilege for an earlier sale within two years of the later sale.
- Prorated Exclusion
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 (reduced) exclusion 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 two years).
Break 5: Tax-free Capital Gains And Dividends
If you occupy the sweet spot, the federal income tax rate on long-term capital gains and qualified dividends is 0 percent. The surprising truth is, you can have a pretty healthy income and still be within the 0 percent bracket for long-term gains and dividends, based on your taxable income.
Say you’re a married joint-filer with two dependent kids in 2022. You claim the $25,900 standard deduction. You could have up to $109,250 of adjusted gross income, including long-term gains and dividends, and still be within the 0 percent bracket. ($109,250 – $25,900 = $83,350 of taxable income, which is the top of the 0 percent capital gains tax bracket for joint-filers in 2022.)
If you itemize deductions, your AGI (including long-term gains and dividends) could be even higher, and you would still be within the 0 percent bracket for those gains and dividends.
Break 6: Capital Gains Sheltered With Capital Losses Are Tax-free
Have you incurred capital losses from stocks and mutual fund investments held in a taxable brokerage firm account this year? If so, you’re not alone. The stock market has been crazy.
Thankfully, capital losses are not all bad.
If you have a current-year net capital loss and/or a capital loss carryover into this year, you can use it to shelter capital gains plus up to $3,000 of income from other sources (salary, self-employment income, interest income, whatever).
You can carry over any unused net capital loss into next year to shelter gains and income in 2023 and beyond.
Break 7: Tax-free Treatment For Inherited Capital Gain Assets
If you inherit a capital gain asset, such as stock or mutual fund shares or real estate, the federal-income-tax basis of the asset is stepped up to its fair market value as of the date of your benefactor’s demise (or six months after that date, if the estate executor so chooses).
So, if you sell the inherited asset, you won’t owe any federal capital gains tax except on appreciation that occurs after the magic date.
Break 8: Tax-free Section 1031 Real Estate Exchanges
Okay, for you techies: Section 1031 is tax-deferred, not tax-free. But stay with us and you’ll see how we get to tax- free.
Section 1031 of our beloved Internal Revenue Code allows you to postpone the federal income tax bill from unloading appreciated real property by arranging for a Section 1031 exchange, also known as a “like-kind exchange.” This time-honored maneuver is one big reason that some real estate investors have struck it rich over the years, because it keeps Uncle Sam out of their pockets.
Here’s the big tax-saving bonus: If you pass away while still owning real property that you’ve acquired in a Section 1031 exchange, the tax basis of the property is stepped up to fair market value as explained immediately above. Thus, now, the 1031 deferred gain turns into a tax-free gain.
Your heirs can sell the inherited property and only owe federal capital gains tax on appreciation that occurs after the magic date. Wow!
Break 9: Tax-free Small Business Stock Gains
Qualified small business corporations (QSBCs) are a special category of corporation, the stock of which can potentially qualify for federal-income-tax-free treatment when you sell for a gain.
As the tax law currently stands, QSBC shares issued after September 27, 2010, are eligible for a 100 percent gain exclusion, which equates to totally federal-income-tax-free treatment if you hold the shares for over five years before selling.
For details on how this works, see Wow! Pay Zero Capital Gains Taxes on Sale of Small C Corporation.
Break 10: Tax-free Withdrawals From Section 529 College Savings Plans
Section 529 college savings plan accounts also allow earnings to accumulate free of any federal income tax.
The big selling point is that 529 accounts allow folks who can afford to make bigger contributions to get their college savings programs off the ground in a hurry. Then when the account beneficiary (typically your child or grandchild) reaches college age, tax-free withdrawals can be taken to cover higher education expenses. State income tax breaks are often available too.
Contributions to a 529 account will also reduce your taxable estate (if you’re worried about that), because the contributions are treated as gifts to the account beneficiary. Contributions in 2022 are eligible for the $16,000 annual federal gift tax exclusion. Contributions up to that amount won’t diminish your unified federal gift and estate tax exemption.
The unified exemption for 2022 will be $12.06 million, or effectively $24.12 million for a married couple. If you’re feeling more generous, you can make a larger lump-sum contribution and spread it over five years for gift tax purposes. That allows you to immediately benefit from five years’ worth of annual gift tax exclusions while jump- starting the beneficiary’s college fund.
Break 11: Tax-free Withdrawals From Coverdell Education Savings Accounts (cesas)
You can contribute up to $2,000 annually to a Coverdell Education Savings Account (CESA) set up for a beneficiary—typically your child or grandchild—who has not reached age 18. A CESA is an account set up by a “responsible person,” which usually means you, to function exclusively as an education savings vehicle for the designated account beneficiary.
CESA earnings are allowed to accumulate federal-income-tax-free. Then tax-free withdrawals can be taken to pay for the beneficiary’s college tuition, fees, books, supplies, and room and board. If you have several beneficiaries in mind, you can contribute up to $2,000 annually to separate CESAs set up for each one.
Here’s the only catch: your right to make CESA contributions is phased out between MAGI of $95,000 and$110,000, or between $190,000 and $220,000 if you’re a married joint-filer.
This restriction often can be circumvented by enlisting someone who is unaffected. For example, you can give the contribution dollars to another trustworthy adult (maybe a sibling or parent) who can open up the CESA as the “responsible person” and make the contribution on behalf of your intended beneficiary.
But when the “responsible person” is someone other than yourself, you lose any control over the account. Keep that in mind.
The phrase “tax-free” has a nice ring to it. In this article, you saw the following 11 types of tax-free income
- Roth IRAs
- Social Security benefits up to the taxable limits
- Tax-free IRA withdrawals (on top of tax-free Social Security)
- Home sale gains of up to $250,000 ($500,000 if married, filing jointly)
- Tax-free capital gains and dividends when you hit the sweet spot
- Capital gains sheltered with capital losses
- Stepped-up inherited assets
- Section 1031 real estate exchanges when held until death
- Qualified small business tax gains
- Section 529 college savings plans
- Coverdell Education Savings Accounts
I help our client’s keep more money in their pockets by implementing proactive tax strategies. I promise you, working with a CPA and Certified Tax Planner can be much more exciting than crunching numbers and reviewing last year’s taxes.