I don’t know if I just didn’t notice it earlier, but lately I keep hearing about how municipal bonds are the perfect investment for retiree. Why? Because they have tax-free interest. That got me thinking. Is tax-free income the holy grail for retirement? Let’s take a look at some scenarios. But before we do, remember that it’s not how much you pay in taxes, it’s how much you put in your pocket.
The allure of municipal bonds is that they are free from federal income tax and if issued by the state where you live, they are not subject to state income tax either. Pretty good deal, right? Let’s look at an example. Like many, you’ve decided to retire to a state without an income tax, so we’ll just look at Federal tax ramifications.
- You can purchase a AAA corporate bond that pays 6% interest or a municipal bond that pays 4%
- You have $100,000 to invest in bonds
- You’re in a 28% tax bracket (likely tax bracket for most readers of this newsletter if TCJA sunsets)
- You pay $0 in taxes on the interest from the municipal bonds each and every year the bond exists
- You pay $1,680 in taxes on the corporate bond interest each year the bond exists
So, obviously the muni wins, right? Not so fast. You’ll receive $4,000 in “after-tax” interest on the municipal bond each year and $4,320 in after-tax income on the corporate bond.
It is important to note that this is an example and real numbers may yield a different result. You’ll need to actually run the numbers. With that said, in my experience the interest rate “premium” on municipal bonds only makes them attractive if you are in a high tax bracket.
While this won’t affect many readers retired Senior Military Officers or NCOs, interest on municipal bonds is included when calculating how much of your Social Security is taxable.
The major advantage of Roth IRAs is tax-free income (growth, dividends, interest), if you meet IRS requirements. But again, tax-free income may or may not be your best option. Let’s look at this example.
- You’ve retired from the military and working on a second career. You plan to work for 15 years
- You don’t like the thought of potential increases in Federal taxes so you’re leaning towards contributing to the Roth portion of your 401(k) instead of the pre-tax
- We’ll assume that you have a set amount of money that you can either contribute pre-tax or pay the tax on the income and contribute the remainder to the Roth portion of your 401(k)
- You’re in a combined 37.75% Federal and State income tax bracket (32% Federal, 5.75% State)
- Over your career you have a total of $200,000 you can contribute pre-tax or pay tax and contribute the remainder to the Roth
- Investment returns are the same in either a pre-tax or Roth account
- Your investments double prior to you starting withdrawals and the withdrawals themselves are spread out over several years so your tax bracket stays constant over the withdrawal period
- You move to a state without an income tax
- Your tax bracket in retirement is 28%
Let’s look at the results.
- Total Contribution = $124,500 ($200,000 – 37.75% taxes)
- Future Value = $249,000
- Tax Owed on distributions = $0
- Money in your pocket = $249,000
- Total Contribution = $200,000
- Future Value = $400,000
- Tax Owed on distributions = $112,000
- Money in your pocket = $288,000
You’ll pay a lot more in taxes with the pre-tax 401(k), but you’ll also put $39,000 more in your pocket.
A couple of considerations though.
- If you stay in a state with an income tax, the calculations could change
- If you move to a state without income tax, your federal tax bracket will have to go up a lot to offset the lack of a state income tax. In this example, your tax rate would need to go up 5.75 percentage points which is an 18% increase in your tax rate/bracket for the Roth to work in your favor.
- Medicare premium increases (IRMAA) could change the calculations and tip the scale towards Roth
The radio adds never mention life insurance. They use names like “Bank on Yourself” or RAFT (Retirement Account Free of Tax). But the idea is that you purchase a cash value life insurance policy and then take loans from the life insurance to fund your lifestyle in retirement. Like any other loan, life insurance loans are tax free (just to be technically correct, you’re taking a loan from the life insurance company, using your policy as collateral). This technique is pretty opaque, but here are some observations.
- If you’re not maxing out your pre-tax options and you’re in a high tax bracket you may be paying 30% or more tax on income, you put into the life insurance policy so that you can take it out and avoid paying 28% taxes on a pre-tax alternative
- Not 100% of your “deposits” become investments. Some go towards the actual insurance and administrative fees
- It is possible for the policy to collapse. If the underlying investments don’t earn the projected return for significant periods of time the policy may collapse and the loan will be deemed a distribution and likely taxable.
Wrapping it up
I was in some continuing education a while ago and the presenter said, “If you’re paying 0% tax rate in retirement, you probably screwed up.” The objective is to pay the lowest average tax rate over your lifespan. Deferring taxes now when you’re working and paying them when you retire, may be the best option. It depends. Just make sure you don’t follow the siren’s song of tax-free.
Military Finances are Different
Most Americans will eventually retire. As a retired Senior Military Officer or SNCO your retirement will look a lot different than your civilian counterparts. At a minimum, your pension sets you apart. That's why we think you should work with a Financial Planner/Advisor that works with your issues each and every day. If you'd like to learn how we work with clients like you, use the button below to schedule a free initial consultation.
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