How to Earn Tax-Free Income (Really)

There are still ways to earn tax-free income. With the tax increases that took effect at the beginning of this year, such opportunities are more valuable than ever. This story is the first of our two-part series on some of the best federal-income-tax-free deals. Here goes.

Tax-Free Home Sale Gains

In one of the best tax-saving deals ever, an unmarried seller of a principal residence can exclude (pay no federal income tax on) up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000 of gain. Naturally, there are some limitations. You must pass the following tests to qualify.

Ownership Test: You must have owned the property for at least two years during the five-year period ending on the sale date.

Use Test: You must have used the property as a principal residence for at least two years during the same five-year period (periods of ownership and use need not overlap).

Joint-Filer $500,000 Exclusion Test: To be eligible for the maximum $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.

Previous Sale Test: 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 are a married joint filer, the larger $500,000 exclusion is only available if neither you nor your spouse claimed the exclusion privilege for an earlier sale within two years of the later sale.

Prorated Exclusion

If you don’t qualify for the maximum $250,000/$500,000 gain exclusion due to failure to pass all the preceding tests, you may still qualify for a prorated exclusion (reduced) amount 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 a married joint filer. You and your spouse used a home as your principal residence for only one year before having to move for health reasons. You would qualify for a prorated exclusion of $250,000 (half the $500,000 maximum allowance for a joint-filing couple).

Tax-Free Roth IRAs

Roth IRAs are still a great tax-saving deal. Roth accounts have two big tax advantages.

First Big Advantage: Tax-Free Withdrawals

Unlike traditional IRA withdrawals, qualified Roth IRA withdrawals are federal-income-tax-free (and usually state-income-tax-free too). What is a qualified withdrawal? In general it is one that is taken after the Roth account owner has met both of the following requirements:

You had at least one Roth IRA open for over five years.

You reached age 59 1/2, are disabled, or dead.

Second Big Advantage: Exemption from Required Minimum Distribution Rules

Unlike with a traditional IRA, the original owner of a Roth account (the person for whom the account is originally set up) isn't burdened with the obligation to start taking required minimum distributions (RMDs) after age 70 1/2 or face a stiff 50% penalty. Therefore, you can leave a Roth account untouched for as long you live. This important privilege makes the Roth IRA a great asset to leave to your heirs (to the extent you don’t need the Roth IRA money to help cover your own retirement-age living expenses).

Making Annual Roth Contributions

The idea of making annual Roth IRA contributions makes the most sense for those who believe they will pay the same or higher tax rates during retirement. Higher future taxes can be avoided on Roth account earnings because qualified Roth withdrawals are federal-income-tax-free (and usually state-income-tax-free too).

The downside is you get no deductions for Roth contributions.

So 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.

The absolute maximum amount you can contribute for any tax year to a Roth IRA is the lesser of (1) your earned income for that year or (2) the annual contribution limit for that year.

Basically, earned income means wage and salary income (including bonuses), alimony received (believe it or not), and self-employment income. For 2013, the Roth contribution limit is $5,500 or $6,500 if you’ll be age 50 or older as of year-end. This assumes you’re unaffected by the AGI-based phaseout rule explained immediately below.

For 2013, eligibility to make annual Roth contributions is phased out between modified adjusted gross income (MAGI) of $112,000 and $127,000 for unmarried individuals.

For married joint filers, the 2013 phaseout range is between joint MAGI of $178,000 and $188,000.

Key Point: If your MAGI is too high for annual Roth contributions, consider converting a traditional IRA into a Roth account, as explained below.

Making Roth Conversions

A few years ago, an income restriction made individuals with MAGI above $100,000 ineligible for Roth conversions. The restriction ceased to exist in 2010. Now, even billionaires are eligible for Roth conversions. That is an important break, because conversion contributions are the only way to quickly get large amounts of money into a Roth IRA. However, it is important to keep in mind that a conversion will trigger taxable income. So you need to consider the federal income tax hit that will accompany a conversion. There may be a state income tax hit too. Consult your tax adviser before pulling the trigger on a conversion.

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How to Pay No Federal Income Tax

During the recent presidential election, tax reform was a hot-button issue. Billionaire investor Warren Buffett and Republican presidential candidate Mitt Romney both ignited fiery debates -- Buffett when he claimed the richest 1 percent of the population is not paying its fair share of taxes and Romney when he said nearly half of Americans pay no federal income tax.

According to the Tax Policy Center, 46.4 percent of Americans paid no federal income tax in 2011, a percentage that may sound alarming. But other taxes, such as those levied on property, cigarettes, gas, liquor, payroll, Social Security, and state and local taxes, ensure that virtually no one gets off scot-free.

Even so, the significant number of Americans who pay no federal income tax raises the question: How can a taxpayer reduce federal income tax liability down to nothing?

"It depends on the type of income as well as the deductions and credits you can apply," says Bob D. Scharin, senior tax analyst for the tax and accounting business Thomson Reuters.

Nontaxable income
"Not all income is taxable," Scharin says. Here are a few examples.

Municipal bonds provide tax-free interest. Many wealthy investors will allocate a good portion of their portfolio to municipal bonds to significantly lower their federal income tax liability, says Michael Knoll, professor at University of Pennsylvania Law School and co-director of the Center for Tax Law and Policy. But there's a trade-off: "Economists like to say you're paying an implicit tax because you're getting a lower return on these bonds than you would get on taxable bonds."Disability benefits could be income-tax-free if the policy premiums were paid by the individual, not the employer, says Scharin.Some Social Security benefits are tax-free, or partially taxable, depending on your income, Scharin says. But on the flip side, Knoll points out, everyone who works pays into Social Security through a payroll tax deduction, although some people argue whether it is actually a tax or a forced insurance and savings program.Foreign income is federally tax-exempt up to a maximum of $96,100 if you are employed by a multinational company and work abroad for an entire year, Scharin says. Even if you have to pay taxes to the foreign country where you live and work during this time, you may be able to get a credit for them on your U.S. tax return, he adds.Income from long-term capital gains is not taxed as federal income, but at a lower capital gains rate. That rate can actually be zero for those in the lower tax brackets, Scharin says. A married couple with adjusted gross income below $70,700 and single taxpayers below $35,350 will pay no tax on capital gains.
Deductions and credits
In addition to the types of income a person receives, the use of deductions and credits can reduce or eliminate federal income taxes. The standard deduction and personal exemptions alone can eliminate federal income tax owed, Knoll says. For example, a married couple filing jointly with two children can earn $27,100 and reduce their federal tax liability to zero just by applying the standard deduction of $11,900 and personal exemptions of $3,800 each. That's not even counting any credits, he adds, such as the earned income tax credit, which could further reduce the tax bill. And, depending on where you live and whether you're self-employed, Knoll says, you can deduct property taxes and health insurance premiums outside the standard deduction without itemizing.Credits, such as the earned income credit, are usually aimed at assisting taxpayers with modest incomes, says Scharin. The credit, up to a maximum of $5,891, is available for working adults with children who fall into the lower income brackets.Other credits include the American opportunity credit, which offers a maximum of $2,500 per year for qualified students; the saver's credit for low and moderate income taxpayers who want to save for retirement; and the child and dependent care credit for expenses paid to a care provider.For wealthier taxpayers who itemize, a qualified charitable contribution can provide an immediate federal income tax deduction of up to 50 percent of that year's adjusted gross income. Even if an individual donates a higher amount, the remainder can be carried over and deducted in subsequent tax years. For example, if someone with an income of $2 million donates $10 million one year, he can deduct $1 million on the current tax return and carry over $9 million to deduct in future years.Qualified medical expenses that exceed 7.5 percent of adjusted gross income can be deducted if the taxpayer itemizes. In a year that might include expensive capital improvements to a home to accommodate an illness or injury, for example, the tax savings could be significant, Scharin says. (The 7.5 percent threshold is for the 2012 tax year. In 2013, medical expenses must exceed 10 percent of the taxpayer's adjusted gross income.)There are other ways the ultrawealthy can reduce or avoid federal income taxes, including the use of certain trusts that will pay the income tax and pass on the assets to future generations, Knoll says. Other wealthy individuals who own a business may have a significant gross income, but because of business expenses, will reduce their taxable income to close to nothing.
Of course, the possibility of reducing taxes to zero has always been a concern for revenue raisers. That's why the alternative minimum tax, or AMT, was enacted in 1969 as a way to ensure that in most cases at least some tax is paid. A portion of income is excluded before the AMT kicks in, and the American Taxpayer Relief Act enacted this year now indexes those amounts to inflation to protect lower- and middle-income workers from this parallel tax.

Tax reform and fairness will likely always be a debatable issue because of the nature of our progressive system, in which the amount of tax owed increases according to the taxable amount, says Knoll.

In general, Scharin says, those who are making the most drastic reductions to their federal income tax liability are taking advantage of deductions and a variety of credits aimed primarily at the elderly and the poor. At the other end of the spectrum, the wealthy are giving away assets, thereby reducing their wealth.

"Nothing is simple in the tax code," says Scharin. "Often in the name of fairness, the tax code gets more complex."

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