Are You Taking Advantage of Tax-Free Income Opportunities?

Two things in life are certain: death and taxes. While you can't live forever, there are still some ways to collect tax-free income. Here's a list of common federal-income-tax-free opportunities for individuals. 

Roth IRA Distributions

You may decide to set up a Roth IRA by making annual contributions or converting a traditional IRA to a Roth IRA. (See "How to Get Money into a Roth IRA," below.) Either way, these accounts offer two big tax advantages over traditional IRAs:

1. Tax-free withdrawals. Qualified Roth IRA withdrawals are federal-income-tax-free and usually state-income-tax-free, too. What's a qualified withdrawal? It's one that's taken after you've met the following requirements:

• You've had at least one Roth IRA open for over five years, and
• You're 59½, disabled or deceased.

With proper planning, your heirs can take federal-income-tax-free qualified Roth IRA withdrawals after you die.   

2. Exemption from RMD rules. As the original owner of a Roth account, you aren't burdened with the obligation to start taking annual required minimum distributions (RMDs) after reaching age 72 or face a stiff 50% penalty. Therefore, you can leave a Roth account untouched for as long you live. This important privilege, along with the aforementioned tax-free withdrawal privilege for heirs, makes the Roth IRA a great asset to set up, maintain and eventually leave to your heirs—to the extent you don't need the Roth IRA money to help cover your own retirement living expenses.

How to Get Money into a Roth IRA

A Roth IRA can be a tax-savvy retirement saving tool. Contributing to one makes sense if you believe you'll pay the same or higher tax rates during retirement. You can avoid higher future federal income tax rates on Roth account earnings because qualified Roth withdrawals are federal-income-tax-free. The downside is you get no deductions for Roth contributions.

Note: If you expect to pay lower tax rates during retirement, you might be better off making deductible traditional IRA contributions (assuming your income is low enough to permit deductible contributions), because the current deductions may be worth more to you than tax-free withdrawals later on.

How do you get money into a Roth IRA? One slow-and-steady option is making annual Roth contributions. The absolute maximum you can contribute for any tax year to a Roth IRA is the lesser of:

• Your earned income for the year, or
• The annual contribution limit for the year.

Basically, earned income includes wage and salary income (including bonuses), self-employment income and alimony received under a pre-2019 divorce decree.

For 2022, the Roth contribution limit is $6,000, or $7,000 if you'll be 50 or older as of year end. This assumes you're unaffected by the income phase-out rule. For 2022, eligibility to make annual Roth contributions is phased out between modified adjusted gross income (MAGI) of: 

• $129,000 and $144,000 for unmarried individuals, and
• $204,000 and $214,000 for married couples filing jointly.

Important: Your ability to make annual Roth contributions is unaffected by your age. You can keep making annual contributions as long as 1) you have enough earned income to back them up, and 2) your contribution privilege isn't phased out due to high income.

Alternatively, you can get money into a Roth IRA through a "Roth conversion." Years ago, an income restriction made individuals with MAGI above $100,000 ineligible for Roth conversions. That restriction is gone—even billionaires are eligible for Roth conversions. That's important, because conversion contributions are the only way to quickly get large amounts of money into a Roth IRA.

However, it's important to remember that a conversion will trigger taxable income. So, you'll need to consider the federal income tax hit that will accompany a conversion. It may affect a state income tax hit, too. Consult your SSB tax advisor before using this option to fund a Roth IRA.

Social Security Benefits

Most people are taxed on between 50% and 85% of their Social Security benefits. However, individuals with modest incomes can receive a bigger percentage federal-income-tax-free—potentially up to 100%.

For example, if you're unmarried with provisional income below $25,000, 100% of your benefits are tax-free. With provisional income between $25,000 and $34,000, you'll be taxed on up to 50% of your benefits. Above $34,000, you could be taxed on up to 85%.

Likewise, if you're married and file jointly with provisional income below $32,000, 100% of your benefits are tax-free. With provisional income between $32,000 and $44,000, you'll be taxed on up to 50% of your benefits. Above $44,000, you could be taxed on up to 85%.

What's "provisional income?" This refers to your adjusted gross income (AGI) plus half of your Social Security benefits and any nontaxable interest income (typically from municipal bonds). AGI equals the sum of your taxable income items reduced by the sum of your "above-the-line deductions," including:

• Deductible contributions to a traditional IRA,
• Self-employed retirement plan contributions,
• Self-employed health insurance premiums,
• The deductible portion of self-employment tax, and
• Alimony payments made under a pre-2019 divorce agreement.

At least 15% of your Social Security benefits will be federal-income-tax-free and maybe more, potentially up to 100%, depending on your provisional income. As a bonus, some states exempt all or part of your Social Security benefits from state income taxes. For example, Colorado exempts the first $24,000 from state income tax.

Important: There's more good news for people with modest incomes: You might be able to shelter all or part of otherwise taxable withdrawals taken from your traditional IRA from federal income tax with your standard deduction. For 2022, the basic standard deduction amounts are:

• $12,950 for single and married filing separately taxpayers,
• $19,400 for heads of households, and
• $25,900 married couples who file joint returns.

If you're 65 or older as of year end, the standard deduction amounts are slightly higher. 

Home Sale Gain Exclusion

An unmarried seller of a principal residence can exclude (pay no federal income tax on) a gain of up to $250,000 ($500,000 for a married joint-filing couple). With the recent surge in residential real estate prices, this break can be more valuable than ever.

You must pass the following four tests to qualify for this break:

1. Ownership. You must have owned the property for at least two years during the five-year period ending on the sale date.
2. Use. You must have used the property as a principal residence for at least two years during the same five-year period. But the periods of ownership and use don't need to overlap.
3. Joint filer. To be eligible for the larger $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.
4. Previous sale. If you excluded gain from an earlier principal residence sale, you generally must wait at least two years before taking advantage of the gain exclusion deal again. If you're a married joint filer, the $500,000 exclusion is only available if neither you nor your spouse claimed the exclusion for an earlier sale within two years of the later sale.

If you don't pass all the preceding tests, you may still qualify for a prorated (reduced) exclusion if you had to sell your home for job-related or health reasons or for certain other IRS-approved reasons. For instance, say you're married and file jointly. You and your spouse lived in a principal residence for only one year before having to move for job-related reasons. In this situation, you'd qualify for a prorated exclusion of $250,000. That's half the $500,000 maximum allowance for a joint-filing couple, based on passing the ownership and use tests for only one year instead of for two years.

Tax-Free Capital Gains and Dividends

For 2022, the federal income tax rate on long-term capital gains and qualified dividends is 0% for people with taxable income below the following levels:

• $41,675 for single and married filing separately taxpayers,
• $55,800 for heads of households, and
• $83,350 married couples who file jointly.

The surprising truth is you can have a pretty healthy income and still be within the 0% bracket for long-term gains and dividends, based on your taxable income. For instance, the Rodriquez's are a married couple who file jointly. They have two dependent kids and claim the $25,900 standard deduction in 2022. They could have up to $109,250 of AGI, including long-term gains and dividends, and still be within the 0% bracket. ($109,250 minus $25,900 is $83,350 of taxable income, which is the top of the 0% bracket for joint filers in 2022.)

If you itemize deductions, your AGI, including long-term gains and dividends, could be even higher, and you'd still be within the 0% bracket for those gains and dividends.

Capital Gains Sheltered with Capital Losses

Have you incurred capital losses from stocks and mutual fund investments held in a taxable brokerage firm account this year? If you have a current-year net capital loss and/or a capital loss carryover into this year, you can use it to shelter capital gains plus up to $3,000 of income from other sources, such as salary, self-employment income and interest (up to $1,500 if you use married filing separate status).

You can carry over any unused net capital loss into next year. This will allow you to shelter gains and income in 2023 and beyond.    

Section 529 Plan Withdrawals

Section 529 college savings plan accounts allow earnings to accumulate free of federal income tax. These accounts allow people who can afford to make bigger contributions to get their college savings programs off the ground quickly. Then, when the account beneficiary (typically a child or grandchild) reaches college age, tax-free withdrawals can be taken to cover higher education expenses. State income tax breaks are often available, too.

Contributions to a Section 529 account will also reduce your taxable estate because the contributions are treated as gifts to the account beneficiary. Contributions in 2022 are eligible for the $16,000 annual federal gift tax exclusion. Contributions up to that amount won't diminish your unified federal gift and estate tax exemption. The unified exemption for 2022 is $12.06 million ($24.12 million for a married couple). If you're feeling more generous, you can make a larger lump-sum contribution and spread it over five years for gift tax purposes. That allows you to immediately benefit from five years' worth of annual gift tax exclusions while jump-starting the beneficiary's college fund. 

For example, Amy is unmarried and sets up a Section 529 plan for her grandson. For 2022, she can make a lump-sum contribution of up to $80,000 ($16,000 times 5) to the account. If she were married, Amy and her spouse could together contribute up to $160,000 ($80,000 times 2).

Lump-sum contributions up to these amounts won't diminish your unified federal gift and estate tax exemption. If you want to help several children or grandchildren, you can contribute for each one.    

CESA Withdrawals

You can contribute up to $2,000 annually to a Coverdell Education Savings Account (CESA) set up for a beneficiary—typically a child or grandchild—who's under 18. A CESA is an account set up by a "responsible person" to function exclusively as an education savings vehicle for the designated beneficiary.

CESA earnings are allowed to accumulate federal-income-tax-free. Then tax-free withdrawals can be taken to pay for the beneficiary's tuition, fees, books, supplies and room and board. If you have several beneficiaries in mind, you can contribute up to $2,000 annually to separate CESAs set up for each one.    

But there's a catch: Your right to make CESA contributions is phased out between modified adjusted gross income (MAGI) of $95,000 and $110,000 (between $190,000 and $220,000 if you're married and file jointly). This restriction may be circumvented by enlisting someone who's unaffected. For example, you can give the contribution dollars to another trustworthy adult (maybe a sibling or parent) who can open up the CESA as the "responsible person" and make the contribution on behalf of your intended beneficiary. But beware: If the "responsible person" is someone other than yourself, you lose control over the account.

Other Sources of Tax-Free Income

Here are some other types of income that Uncle Sam isn't currently able to tax:

Inherited capital gain assets. If you inherit a capital gain asset—such as real estate or stock—the federal-income-tax basis of the asset is stepped up to its fair market value as of the date of your benefactor's death or six months after that date if the estate executor chooses. So, if you sell the inherited asset, you won't owe any federal capital gains tax except on appreciation that occurs after that date.  

Section 1031 real estate exchanges. Internal Revenue Code Section 1031 allows you to postpone the federal income tax bill from selling appreciated real property by arranging for a 1031 "like-kind" exchange.

Important: If you pass away while still owning real property that you've acquired in a Section 1031 exchange, the tax basis of the property is stepped up to its fair market value as of the date of death (or the six-month alternate date). So, your heirs can sell the inherited property and only owe federal capital gains tax on appreciation that occurs after that date.

Small business stock gains. Qualified small business corporations (QSBCs) are a special category of corporation. If you sell QSBC stock for a gain, it can potentially qualify for federal-income-tax-free treatment.

As the tax law currently stands, QSBC shares issued after September 27, 2010, are eligible for a 100% gain exclusion. This equates to totally federal-income-tax-free treatment if you hold the shares for over five years before selling. Consult your SSB tax advisor if you're considering a small business stock investment that might be eligible for the QSBC gain exclusion. When available, it can be a huge tax-saver.

For More Information

While income and gains are generally taxable, you can collect federal-income-tax-free income and gains in a number of different ways. Don't assume that you'll owe taxes just because you came out ahead in a transaction. With proper planning, you might be able to get more than you think tax-free. Contact your SSB tax advisor before entering into any transaction that could have significant tax consequences.