Non-Taxable Income in Retirement: 5 Sources You Should Know About
When it comes to retirement income, not all dollars are treated equally. Some are fully taxable, others partially taxable, and a select few are entirely tax-free. Understanding the difference is critical to building a retirement income plan that protects your nest egg from unnecessary taxation, especially in a high-inflation, high-cost-of-living environment.
In this article, we break down five sources of non-taxable income in retirement, how they work, and how to strategically use them to lower your tax bill and preserve long-term wealth.
1. Roth IRA Withdrawals
A Roth IRA offers one of the most powerful tax benefits available to retirees — tax-free growth and qualified tax-free withdrawals.
To qualify, withdrawals must occur after age 59½ and at least five years after your first contribution or Roth conversion. If both conditions are met, all distributions (contributions and growth) are 100% tax-free.
Why it matters:
Withdrawals from pre-tax retirement accounts like Traditional IRAs and 401(k)s are taxed as ordinary income, which can push you into a higher tax bracket, increase Medicare premiums, and reduce the portion of your Social Security benefits that are tax-free. With Roth IRAs, none of those problems exist.
Planning strategy:
Many retirees choose to complete Roth conversions during low-income years (such as early retirement) to move pre-tax funds into a Roth IRA while controlling their tax rate. This allows them to create a future pool of tax-free income while reducing Required Minimum Distributions (RMDs) down the line.
2. Health Savings Account (HSA) Distributions for Medical Expenses
HSAs are the only account type that offers triple tax advantages:
Contributions are tax-deductible
Growth is tax-deferred
Withdrawals are tax-free if used for qualified medical expenses
Qualified expenses include Medicare premiums, prescriptions, dental and vision care, long-term care insurance premiums (subject to limits), and more.
Why it matters:
Healthcare is often one of the largest expenses in retirement, and using HSA funds tax-free for these costs allows retirees to preserve their other taxable accounts.
Planning strategy:
For clients who are still working and enrolled in a high-deductible health plan, the strategy may be to contribute the maximum amount to an HSA and pay current medical expenses out-of-pocket. This allows the HSA to grow and be used as a supplemental retirement account for tax-free medical reimbursements later in life.
3. Social Security (Partially Non-Taxable)
Up to 85% of Social Security benefits can be taxable at the federal level, depending on your provisional income (which includes half of your Social Security benefits, taxable income, and tax-exempt interest).
However, if a retiree has very little income other than their social security, it’s possible that they may not pay any tax on their social security benefits.
Why it matters:
Retirees who rely heavily on Roth IRA withdrawals or return of principal from brokerage accounts may be able to keep their provisional income low enough to shield some or all of their Social Security benefits from taxation.
Planning strategy:
By building a tax-efficient distribution plan in retirement, retirees can often reduce the amount of tax paid on their Social Security benefits and improve net income in retirement.
4. Municipal Bond Interest
Interest from municipal bonds is generally exempt from federal income tax. If you reside in the state where the bond was issued, that interest may also be exempt from state and local taxes.
Why it matters:
For retirees in high tax brackets, municipal bonds can provide steady, tax-advantaged income without adding to provisional income or triggering taxes on Social Security.
Planning strategy:
Retirees in high-income tax brackets may hold municipal bonds in taxable brokerage accounts, while keeping higher-yield taxable bonds inside IRAs or 401(k)s where the interest won’t be taxed annually.
5. Return of Principal from Non-Retirement Accounts
Withdrawals from taxable brokerage accounts can be structured to return your cost basis first, which is not subject to tax. Only the gains portion of a sale is subject to capital gains tax — and long-term capital gains may be taxed at 0% if your taxable income is below certain thresholds.
Why it matters:
This allows retirees to tap into their investments in a low-tax or no-tax manner — especially when drawing from principal rather than interest, dividends, or gains.
Planning strategy:
Coordinate asset sales to manage taxable gains, and consider drawing from principal early in retirement to reduce future RMDs or pay the tax liability generated by Roth conversions in lower-income years.
Final Thoughts: Build a Tax-Efficient Retirement Income Plan
Most retirees understand the importance of investment performance, but few give the same attention to tax efficiency, even though taxes can quietly erode thousands of dollars in retirement income each year.
By blending these non-taxable income sources into your withdrawal strategy, you can:
Reduce your tax liability
Lower Medicare surcharges
Improve portfolio longevity
Increase the amount of inheritance passed to the next generation
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Frequently Asked Questions (FAQs):
What types of retirement income are tax-free?
Common sources of tax-free retirement income include qualified Roth IRA withdrawals, Health Savings Account (HSA) distributions for medical expenses, a portion of Social Security benefits, municipal bond interest, and the return of principal from non-retirement investments. These sources can help retirees reduce overall taxable income and extend portfolio longevity.
Why are Roth IRA withdrawals tax-free in retirement?
Roth IRA withdrawals are tax-free if you’re over age 59½ and the account has been open for at least five years. Because Roth withdrawals don’t count toward taxable income, they won’t increase your tax bracket, affect Medicare premiums, or reduce the tax-free portion of your Social Security benefits.
How can a Health Savings Account (HSA) provide tax-free income in retirement?
HSAs offer triple tax advantages: contributions are tax-deductible, growth is tax-deferred, and withdrawals are tax-free for qualified medical expenses. Retirees can use HSA funds to pay for Medicare premiums, prescriptions, and other healthcare costs without generating taxable income.
Are Social Security benefits always taxable?
No. Depending on your provisional income, up to 85% of Social Security benefits may be taxable, but some retirees owe no tax on their benefits. Keeping taxable income low through Roth withdrawals or return of principal from brokerage accounts can help reduce or eliminate Social Security taxation.
How are municipal bond earnings taxed?
Interest earned from municipal bonds is typically exempt from federal income tax and, if the bonds are issued by your home state, may also be exempt from state and local taxes. This makes municipal bonds a valuable source of tax-advantaged income for retirees in higher tax brackets.
What does “return of principal” mean for taxable accounts?
When you sell investments in a taxable brokerage account, the portion representing your original cost basis is considered a return of principal and isn’t taxed. Only the gains portion is subject to capital gains tax, which may be as low as 0% for retirees in lower income brackets.
How can retirees use non-taxable income to improve their financial plan?
Strategically blending tax-free and taxable income sources can lower your overall tax burden, reduce Medicare surcharges, and improve long-term portfolio sustainability. This approach helps preserve wealth and increase the amount that can ultimately be passed to heirs.
