They say there are two guarantees in life - death and taxes. Today you might learn that that’s not necessarily the case. A good understanding of the tax code presents many opportunities to earn tax-free income from various investments, services, and employee benefits.
Although the end-goal of investing is not to pay as little tax as possible, tax-free income is certainly a piece of a well-diversified portfolio. Not only should one look to diversify their assets across multiple asset classes, but also diversify across various tax classifications. This includes tax-free, tax-deferred, and taxable.
The various tax-free income sources listed below may not be appropriate for everyone, but there are sure to be a few that most individuals can take advantage of (and be grateful for)!
Municipal bond interest. Bonds that are issued by municipalities pay out interest to the bond holders. This income is federally tax-exempt and can be tax-exempt on the state level as well.
14 days of rental income. A little known benefit to short-term rentals is that if you only rent your home for 14 days or less, the income is tax-free. This is a great opportunity for someone that lives in a high-tourist area and can rent their home or an extra bedroom in their home at a high rate.
Roth IRA withdrawals. Contributions to a Roth IRA are after-tax, allowing the contributions and investments to grow tax-deferred and withdrawn in retirement tax-free. The tax-free nature of a Roth IRA makes it a great tool to control taxable income levels in retirement.
Gifts and inheritances. Any gifts or inheritances received by an individual are tax-free, on an unlimited basis.
Child support. Child support payments received are not considered taxable income to the recipient.
HSA medical withdrawals. HSA contributions are tax-deductible, tax-deferred while in the HSA account, and withdrawals are tax-free if used for medical expenses. This is a triple-tax-benefit account.
Insurance proceeds. Insurance policies like disability, life, and workers compensation pay out benefits that are received tax-free. The one caveat is with disability insurance where the premiums have to be paid by the insured for the benefits to be tax-free. If the premiums are paid by an employer, the benefits are taxable.
Employee benefits. The employee benefits signed up for through an employer are considered tax-free income. These payments are for health, life, and other insurance policies that are paid for all or in part by the employer.
Credit card rewards. Any rewards or sign-up bonuses received from a credit card are tax-free. With high travel sign-up offers, this can be an easy way to earn thousands of dollars in free travel every year. Just remember to pay off the credit card bill in full every month!
529 Plan education withdrawals. Similar to a Roth IRA, 529 Plan contributions are made after-tax, grow tax-deferred, and are tax-free when withdrawn. This time, however, withdrawals must be made for higher education related expenses. Due to the Tax Cuts and Jobs Act, 529 Plan proceeds can now be used for K-12 private school tuition (up to $10,000 per year per student).
Scholarships and fellowships. Most scholarships or fellowships received are tax-free income to the recipient, as long as the funds received are used for tuition and other required expenses.
Sale of principal residence. If you’ve owned and lived in your home for two years out of the past five, you receive a sizeable tax exclusion on the capital gain. For single filers, $250,000 of gains is tax-free and married filing jointly filers receive a $500,000 exclusion.
0% Capital Gains bracket. Most investments receive a preferential tax bracket for long-term capital gains. For individuals in the 10% and 12% tax brackets, realized long-term capital gains are taxed at a rate of 0%. For married filing jointly retirees with $0 of earned income, this means up to $77,200 of long-term capital gains and qualified dividends are tax-free.
Standard deduction amount. Starting in 2018, single filers have a Standard Deduction of $12,000 and married filing jointly filers have a Standard Deduction of $24,000. This deduction means income earned up to the respective amounts is tax-free before entering the progressive tax rate bracket.
Do any of these tax-free income sources apply to you? It is wise to evaluate your income sources on a regular basis to make sure you are being as tax-efficient as possible. Furthermore, adding in additional revenue streams (especially when tax-free) is a great way to boost your financial security.