5 Ways to Pay No Income Tax During Retirement

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Benjamin Franklin said it best: "[I]n this world, nothing can be said to be certain, except for death and taxes."

When you're making the transition into retirement, or you've been retired for years or decades already, the last thing you want to think about is forking over a large percentage of your annual income to the federal government because of taxes. Unfortunately, this is the fate most seniors will endure.

According to The Senior Citizens League, 56% of retirees receiving Social Security will owe federal tax on at least a portion of their benefits during retirement. When compounded with the possibility that Social Security benefits could be cut by up to 21% within the next two decades (based on estimates from the Social Security Board of Trustees), it could leave retirees with far less income during their golden years than they anticipated.

But here's the good news: It's possible to earn income during retirement without having to fork it over to the federal government. Here are five such ways you may be able to completely avoid Uncle Sam during your golden years.

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1. Keep your Social Security income below set thresholds

As noted above, most retirees will wind up paying tax on their Social Security income, and it's really no fault of their own. The Social Security laws governing the taxation of benefits were amended in 1983 and 1993, and they haven't once been adjusted for inflation since they were implemented! In 1983, when the amendment was first passed, it was only designed to affect about 1 in 10 households. Today, it affects more than half of all seniors.

Social Security benefits are taxed once annual individual income reaches $25,000, or the annual income of joint filers reaches $32,000. The simple solution to paying nothing in federal taxes is to earn less than these income thresholds.

Understandably, it makes no sense whatsoever to try to avoid taxes if you have little or nothing saved for retirement. In this instance, waiting to file until age 70 so that your benefit grows as large as possible is probably the best move. However, if you do have plenty of additional income streams and/or a healthy nest egg, then claiming benefits as early as possible (age 62) and taking the reduction in benefits from what you would have received had you waited until your full retirement age may keep you below the $25,000 individual (or $32,000 joint-filer) threshold.

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2. Invest in municipal bonds within your state

Investing in municipal bonds is another smart way that seniors can avoid paying federal (and often state) income tax.

Municipal bonds are issued by cities, counties, or a state, and their purpose is to raise funds to finance capital expenditures, including the construction of schools, bridges, and highways. The general rule with municipal bonds is that interest earned is free of federal taxation. You'll almost always get away with not having to pay any money to the state, either. The one catch is you'll need to invest in municipal bonds within your state to get this tax-exempt status on the interest.

According to data aggregated by WM Financial Strategies of some of the largest municipal bonds in America, the average yield in 2016 is about 3.2%, meaning to generate about $30,000 annually you'd need to invest nearly $1 million. Muni bonds are therefore a smart tax-free choice for investors with large nest eggs.

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3. Contribute to a Roth IRA

One of the most popular solutions for generating tax-free income is to contribute to a Roth IRA.

Roth IRAs are funded with after-tax dollars, and as such are allowed to grow free and clear of taxation as long as no unqualified withdrawals are made. Although there are a few exemptions, such as buying your first home or paying for large medical bills, the general rule with any IRA is that you have wait until at least age 59-1/2 to access your money without any penalty.

The other great thing about a Roth IRA, aside from the fact that withdrawals won't count toward your annual income, is that there's no required minimum distribution. With a 401(k) or traditional IRA, the accountholder is required to begin taking distributions by age 70-1/2, but with a Roth IRA there is no required distribution at any age. Thus, you have the option of letting your nest egg grow for as long as you'd like, and you can withdraw any percentage at any time after age 59-1/2.

One word to the wise: There are income exemptions associated with a Roth IRA that may exclude wealthier individuals, though there are backdoor approaches that can still allow well-to-do people to participate.

4. Hold your investments for the long term (for select tax brackets)

A fourth way you may be able to generate tax-free income during retirement is by investing in stocks or bonds for the long term.

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According to the IRS, short-term assets, or those held for 365 or fewer days and sold, are taxed at a rate equal to your peak marginal tax bracket (between 10% and 39.6%). On the other hand, the long-term capital gains tax rate (for assets held for 366 or more days and sold) has just three brackets (0%, 15%, and 20%), and they're all substantially lower than the short-term marginal tax brackets.

Individuals and joint filers who fall into the 10% and 15% marginal tax brackets will pay a 0% tax rate on their long-term capital gains. This means individual filers can earn up to $37,650, and married filers up to $75,300, without having to pay a cent in long-term capital gains as long as their adjusted gross income stays below these thresholds in 2016. In 2017, these thresholds will increase to $37,950 and $75,900, respectively.

5. Use the home-sale capital gains tax exemption

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Finally, retirees may want to consider selling their home or downsizing and utilizing the home-sale capital gains tax exemption to live off of the proceeds during retirement.

According to the IRS, homeowners who've lived in their home for at least two of the past five years can sell their home and pocket up to $250,000 in individual capital gains, or $500,000 in joint capital gains if you're married, without having to fork a single cent over to the government in federal taxes. Since most Americans won't earn more than $250,000 individually or $500,000 jointly in capital gains when selling their home, they should be able to avoid this tax.

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Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.

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