Eight Ways To Plan For Tax-Free Income

When you’re evaluating potential sources of income, you should also be keeping an eye on their tax consequences.  This is especially important if you’re near a tax bracket that will adversely effect your tax picture in April.  Fortunately, there are alternatives that can lower the tax bite.  Here are some to consider.

Consider a real estate tax shelter.  When you buy income producing real estate for investment purposes, you can take a depreciation write-off for the cost of the property and improvements against your income.  Your taxable rental income will then be reduced by the amount of your depreciation deduction.  This deduction is a tax-sheltered source of income, since depreciation is a non-cash expense.

Shelter business income with tax-deferred retirement plans.  Up to $53,000 a year can be contributed to a defined contribution plan.  A person who is 50 years of age or older may make an additional “catch-up” contribution of $6,000 to a 401(k) and certain simplified employee plans (SEP).  Strategy:  If you are older than age 45, consider setting up defined benefit plans.  Defined-benefit plans may permit larger contributions than defined contribution plans because you fund a specific amount and have fewer years in which to do so.  In some instances, contributions can exceed $200,000 per person.

Plan for tax-free Social Security.  Not all of your social security benefits may be subject to tax.  To determine how much is taxable, you must look to all of your sources of income.  If you and your spouse earn less than $32,000 ($25,000 for an individual),then all of your social security benefits may be exempt from tax.

Open an IRA and contribute to it each year.  Even if you can’t deduct and IRA contribution, income from individual retirement accounts is tax-deferred.  You pay income tax only when you withdraw your funds, usually when you’re retired and in a lower tax bracket.  Meanwhile, the interest from your IRA investments keeps compounding.

Contributions to a Roth IRA are not deductible. However, all Roth IRA withdrawals may be tax free. Provided you are at least 59 1/2 years old, you can take tax-free withdrawals from a Roth IRA after five years.

Use the interest from life insurance.  When you cash in a life insurance policy, you’ll be taxed on the interest that’s been accumulated.  But there is a way to use certain policies to avoid taxes and enhance your cash flow.  Some life insurance policies actually allow you to “borrow” against the annual interest they generate.  For example, $20,000 invested in a life insurance policy that pays 6% a year will generate $1,200 in interest which is available for you to “borrow”.  You will have to pay a modest amount of interest to the insurance company for the “loan”, but the loan proceeds won’t be taxable.

Look at annuities. Another insurance-based option is the tax deferred annuity.  Sometimes called single-premium deferred annuities, these are investments you can make with an insurance company at a specified rate of interest.  Unlike life insurance policies, however, you can’t borrow against this income until you cash in the investment.  But it’s only when you cash in the annuity that you pay tax on the income.

Consider municipal bonds.  There’s no federal income tax on interest earned from municipal bonds, which are usually sold at $5,000 minimum with maturities anywhere between 30 days and 30 years.  If you’re investing a smaller sum, or prefer that experts manage this part of your portfolio, you can invest in municipals, through specialized mutual funds.  If you’re looking for rapid turnover without the risk of long-term changes in the value of your investment, there are mutual funds which invest only in very short-term municipals that mature in 60 days.  You can usually buy into these funds at a lower minimum – between $1,000 and $5,000 – and can often write checks against your account.

Whichever way you invest in municipals, however, you do need to keep an eye on the state tax.  Interest from municipals is exempt from state tax, but only when the bonds are issued in the state where you live.  If you’re in Massachusetts, for example, and invest in DesMoines municipals, you won’t pay federal income tax on the interest, but you will be liable for Massachusetts state income tax.

Buy U.S. Treasury Bonds. When you buy U.S. Treasury bonds, your tax situation is exactly the opposite of the situation with municipal bonds. Regardless of where you live, you’ll have to pay federal tax on the interest from Treasury bonds, but all U.S. Government securities are exempt from state tax.