Let’s be honest. While we don’t like paying taxes, we pay them anyway. If we kept our money instead, it would lead to even bigger problems. The Internal Revenue Service isn’t a friend to those who try to skip out on paying their taxes.
It is possible, though, to delay or lower your income taxes by taking advantage of tax-advantaged accounts. When a person pays the least amount of taxes required by governments or a state, that is called tax efficiency. This is perfectly legal and something to consider in your overall investment strategy. So, what are tax-free investments and how exactly do they work? Let’s take a closer look in this guide.
Benefits of Tax-Free Investments
It’s obvious to say that the benefit of adding tax-advantaged accounts to your portfolio is to pay fewer taxes. But let’s look at an example to paint a picture of what this could mean.
Let’s assume you put $10,000 into an investment that earns a 4% interest rate. You are in the 30% tax bracket. In a taxable investment, you’ll earn $400 which you’ll have to pay $120 in taxes, for a net gain of $280. On the other hand, in a tax-free investment, you will keep the full $400.
That’s a net increase of $120 which is about 43% more than the taxable investment. This is the taxable equivalent of 5.71%! The tax benefit will definitely make it work adding these investments.
Tax-Free Funds to Consider
Tax considerations for the right type of accounts will depend on your retirement and financial goals. Your income may also limit your investment options. When considering the right tax-free investment products, make sure you have all the information to make the right decision. Seeking advice for a tax advisor or financial planner could also help.
Municipal Bonds
Buying tax-exempt municipal bonds is a straightforward way to save money on taxes. You are exempt from paying federal tax on the interest earned from them. In some states, you might even be tax-exempt from paying state income tax.
In a high-income tax state like New York or California, this could be a huge benefit. For example, if you buy municipal bonds from California, but live in New York then you would pay taxes on the interest earned. However, if you purchased bonds from New York instead, you avoid paying tax.
You could buy these bonds individually or purchase bond funds (ETFs or mutual funds) that have a diversified portfolio of municipal bonds. The dividends from these bond funds are the interest that was earned on these bonds, which means investors don’t pay taxes on them.
Before investing in municipal bonds, you should know there are some tax “gotchas”. It’s common for funds to distribute capital gains at the end of the year. Investors who hold these funds to a specified date must pay tax on those capital gains.
Some municipal bonds are subject to the Alternative Minimum Tax (AMT). Ask your brokerage account manager before investing to check if it is an “AMT bond.” Purchasing bonds or bond funds isn’t necessarily a “better” option than corporate bonds because they are tax-free. Make sure to calculate your returns after tax, as some corporate bonds may earn you more money.
Treasury Bonds
Tax-free from state income tax, treasury bonds are loans that you make to the federal government. You will still have to pay federal income tax on these investments. Capital gains taxes also apply if they are sold for a gain, just like municipal bonds. The bottom line is that you will want to look at possible capital gains and federal income taxes that you may pay before making a purchase.
Treasury bonds are typically considered a good investment to those who are close to retirement or young investors that want to add stable returns to their portfolio. Adding steady returns to your portfolio can offset riskier investments that cause volatility.
When investing in treasury bonds, you put up an upfront amount to the initial investment. This is called the principal. The interest rate on these debt securities is really paid back on a fixed, periodic interest payment from when the account was started.
Savings Bonds
The returns on savings bonds are indexed to inflation. You don’t pay tax by your state or federal governments and while you hold the bonds, your federal taxes are deferred. Investing in these bonds is often overlooked by investors.
You can use Series I Savings Bonds to pay for tax-free higher education. These investments aren’t going to offer the returns possible on 529 accounts, but it’s a great way to increase your education savings.
You can buy up to $10,000 on these tax-advantaged investments per Social Security number. Another $5,000 per Social Security number of an IRS return can be used to purchase more. The money can be considered part of your retirement savings without actually being in your retirement plan (IRA or 401(k) for them to be tax-deferred on your interest-earning.
The interest rates that you’ll earn are published on the U.S. Treasury’s website. Compare these bond prices to information about other possible investments to determine whether these tax-exempt bonds work for you. Your investment returns should at least keep up with inflation.
529 Accounts
Paying for education expenses these days takes a lot of money. One great way to offset these costs is to open a 529 plan. With these tax-deferred accounts, you can start your investment before your child is even born. Contributions are maxed after taxes and arent’ deductible. However, some of the accumulated tax is deferred.
The investment returns will grow free of tax as you accumulate your savings. As long as the money in these accounts is used for qualified educational expenses, there is no tax on the withdrawals. You might even get some tax benefits depending on the state. Contributions made to a state’s 529 accounts may offer a tax deduction.
Before opening a 529 account, make sure you compare information based on your location and how you plan to use the funds. You must pay income tax on any money that’s used for a non-qualified expense. Additionally, there’s s a penalty on earnings.
The money in these accounts is not as liquid as other investments. You’ll likely face penalties that will eat away at the tax benefits if those funds aren’t used properly. The tax benefit is also a moot point if your beneficiary chooses not to go to college. Luckily, you can transfer the beneficiary to someone else if this happens.
IRA Accounts
If you want to start a retirement account, the tax-advantaged IRA accounts are a great choice. There are two types of accounts that one should consider: The traditional IRA and the Roth IRA.
Both of these accounts have contribution limits of up to $6,000. If you’re over 50 years old, you get an additional catch up contribution of $1,000 beyond the contribution limits. If you open one of these accounts, it is recommended to do this catch-up contribution to maximize your investment funds.
When searching for IRA products, make sure you pay attention to the expense ratio. These are investment services that are managed by others (Fidelity for example) and a high ratio will cut into the returns on your portfolio. More information about these accounts are found below:
Traditional IRA
Tax-advantaged traditional IRA accounts are similar to a 401(k) or 403(b), which we will cover later. Contributions that are made will reduce your taxable income, thereby reducing your income taxes for that year. You must pay tax on that money and investment returns once you start taking withdrawals.
Still, being able to postpone these taxes for decades is a big benefit. Since the money that’s used is before taxes, it grows tax-deferred until withdrawals are made. Plus it reduces your tax burden in the present state.
There are some drawbacks in using this retirement device to fund your retirement. For example, there are mandatory disbursements that must occur once you reach a certain age. And if you want access to your money before you reach the age threshold, you are subject to penalties. These implications may outweigh the tax advantages so you may consider investing in a Roth account instead.
Roth IRA
The difference in a Roth IRA account is that it uses after-tax money to fund contributions. Upon retirement, these investments are also free of tax. Since these dollars are after paying taxes, you can’t deduct your contributions.
The other good news is that once you are the right age, you can start withdrawing money from these funds without paying a dime of tax. All the returns on your investments are also tax-exempt. The exception is if the account has been opened for less than five years before taking distributions.
You must meet certain income eligibility requirements to open these accounts. So if your gross income falls above these maximums, you can’t open these tax-advantaged accounts.
Unlike a traditional IRA account, you don’t have to start taking minimum distributions once you hit a certain age. So you can continue to grow your tax-free investment gains for as long as you like.
Health Savings Account
Reducing your taxable income could help put you in one of the lower tax brackets. And a Health Savings Account can help you do just that. These accounts allow you to save for future medical expenses.
There’s a limit to how much you can invest into an account each year that’s set annual for individuals and family cover. There are three tax benefits of setting up this tax-exempt fund. First, the money is taken out of your paycheck before taxes (if they are employer-sponsored) or are tax-deductible (if you set it up yourself). That lowers your tax bill for the year.
If you have an HSA that allows investing in mutual funds or other securities, this is another advantage. That’s because the money grows on a tax-deferred basis. The distribution is also tax-free when it’s withdrawn to use towards a qualified medical expense.
If you use your HSA funds to cover a non-medical expense, you will have to pay tax on that money. Additionally, there is a 20% penalty on those withdrawals if you less than 65 years old. You’re also subject to regular income tax on these withdrawals after the age of 65.
Tax-Exempt Mutual Funds
A mutual fund may consist of all stocks or bonds, or a combination of the two. Mutual funds are a collection of securities that may track an index, managed by a professional, or a robo-advisor that uses data to make investment decisions.
This allows your investors to enjoy hands-off investing so they can just watch their securities grow. Some mutual funds have tax-exempt status so you won’t pay tax on capital gains these securities deliver.
These tax-exempt mutual funds usually hold bond products like municipal bonds and other government securities. Be sure to look at information like the expense ratio to make sure that you’re not paying high management fees. Another important data point to look at is how much it will return.
Tax-Exempt Exchange-Traded Funds
Similar to mutual funds, ETFs are traded on the exchange like a stock. Many ETFs will track an index instead of allowing a fund manager to be actively investing in the assets. They can be municipal-bond focused so by investing in a government bond, they can forgo paying taxes. That’s without having the internal revenue service breathing down your neck.
You can invest in bond ETFs that are short, mid, and long-term in nature. Determine what’s right based on your goals and time horizon. Pay attention to the bond returns on these investments and compare them to other options. Don’t make the error of not looking at information about the fees on these accounts either.
401 (K) and 403 (b) Employer-Sponsored Retirement Plan
If you’re looking for a great way to grow your retirement savings, a 401 (k) or 403 (B) plan is the perfect device. These plans are typically managed by an investment firm like Fidelity on behalf of the employer.
Your contributions are taken out of your payment. This lowers your adjusted gross income (AGI) which could make you fall to a lower income tax bracket too. A benefit that many companies offer is matching your contributions up to a certain amount. Investing in a 401(K) will allow you to accrue money tax-free as it grows.
403 (b) are like 401(k) accounts except that they’re meant for employees of nonprofit organizations. They also use pre-tax dollars that grow tax-deferred. Most nonprofits don’t offer matching contributions, however. The administration expenses of these accounts are generally lower than they are for a 401 (k).
Roth 401 (k) is an option for those who are self-employed and want to invest in retirement. These plans are also sometimes offered by certain employers. The difference between Roth 401(k)s is that you must take minimum distributions starting at 70 and a half years old.
Bottom Line: Tax-Free Investments
At the end of the day, whether investing in these tax-advantaged investments over ones that are susceptible to taxes (i.e. capital gains) is dependent on your goals. You shouldn’t rule out real estate investment trusts or other investments simply due to tax reasons. Your investment strategy needs to be on the same page too.
The good news is that there are various resources like Investopedia that can give you information on what type of investments are out there and which make the most sense for you. Look at the state of your portfolio and explore all the options available to find the most tax-efficient solution possible. ower ways to
