What Really Counts as Tax-Free Income?

When you’re planning ahead for retirement, taxes—and how much they will take from your accumulated wealth—will likely play a large role. But did you know that some types of investments are tax-free?

When an investment is tax-free or tax-advantaged, it is free of all taxes. This includes state and federal taxes, along with inheritance taxes and capital gains tax. An inheritance tax is a tax paid by a person who inherits the money or property of a deceased person, while a capital gains tax is a tax on the profit on the sale of an asset for twelve months or longer. Additionally, money from a tax-free investment does not count as provisional income. This means that it does not contribute to the thresholds that determine taxes on Social Security benefits. For these reasons, seeking out tax-free income can be an advantageous decision for people looking to save money toward retirement.

That said, it can be tricky to determine what truly qualifies as tax-free income. Some vehicles of investment might seem like they are tax-free, but actually still require taxes. For example, municipal bonds—debt security issued by a state, municipality or county to finance expenditures like highway construction—seem like a great source of tax-free income because they are exempt from federal taxes and most state and local taxes. However, municipal bonds are still subject to capital gains tax. Due to this, they are not truly a form of tax-free income.

Traditional individual retirements accounts (IRAs) encounter a similar issue when it comes to determining tax-free income. A traditional IRA is tax-deferred, and deposits made into an IRA have tax-deferred growth. When an IRA owner retires, though, and begins to withdraw from their IRA, they must pay income taxes on all withdrawals. A Roth IRA comes slightly closer to being truly tax-free than a traditional IRA, as deposits to a Roth IRA enjoy tax-free growth and because distributions taken during retirement are also tax-free. However, a Roth IRA does not qualify for tax-free income if the owner takes distribution before reaching the age of 59 ½.

While municipal bonds, traditional IRAs, and Roth IRAs all fall short of being fully tax-free, some investment vehicles are truly tax-free. One of these is a Life Insurance Retirement Plan, or LIRP. LIRPS count toward tax-free income by taking advantage of tax code 7702, which eliminates all taxation of death benefits.

A LIRP is a permanent life insurance policy that provides a death benefit while also building cash value. While having a LIRP means higher insurance premiums than term life insurance and having similar growth to other equities, the build-up of the cash value is tax-deferred, and it serves as a form of tax-free retirement income. Unlike the above examples, LIRPs are free from all forms of taxes, including inheritance taxes or capital gains tax. Additionally, LIRPs do not have limits on age distribution, so people with a LIRP can take out their retirement at any time without any penalties.

Like many other vehicles for retirement planning, LIRPs have pros and cons that should be carefully considered. However, unlike municipal bonds and traditional and Roth IRAs, they are unique because they are a source of truly tax-free income.

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