What is a tax-free investment?
A tax-free investment is a type of investment that doesn’t require you to pay taxes on it.
These can include ordinary income taxes, capital gains taxes, dividend or interest income, and other types of taxes.
There are only a few types of investments that fit this criteria; however, there are a wide variety of tax strategies that can minimize or eliminate your tax liability from investments.
You’ll hear these called “tax-efficient” investments or strategies, and we’ve included these strategies in our list of the best tax-free investments.
What are the best tax-free investments?
The best tax-free investments help you keep more money in your pocket.
There are several investments and strategies that can help you reduce your tax liability.
Municipal bonds and municipal bond funds
Most municipal bonds are exempt from federal taxes, which makes them one of the best tax-free investments. If you purchase a municipal bond from your state of residence, you’ll also likely avoid paying state taxes.
Municipal bonds are loans issued by state or local governments to raise money for large projects, such as the building of schools, roads, government buildings, and other infrastructure. Governments repay the investor, but also have the authority to tax citizens to help repay the loan, making them a very secure investment.
While the returns may not be as high as those of other investments, they could make sense for an earner in the higher income tax bracket due to the federal income tax deduction.
In a similar vein, municipal bond funds are portfolios comprising a variety of municipal bonds issued across the nation. They have low expense ratios, helping keep more money in your pocket while increasing exposure to a diverse mix of municipal bonds. However, you may need to pay state income tax on these types of funds.
I and EE Bonds
EE and I Bonds are Treasury savings bonds that are exempt from state and local taxes.
If you’re able to use the distributions for education-related expenses and your income falls below the threshold, you can also avoid federal income taxes.
I Bonds pay a fixed rate plus an inflation adjustment. EE Bonds pay a fixed rate for 20 years. They can be bought directly on TreasuryDirect.gov, but investors are limited to $10,000 in I Bonds per year.
HSA
Health savings accounts offer a triple tax-advantaged place for investments: contributions are made tax-free, growth is tax-free, and qualified distributions are made tax-free.
Essentially, all investments held in an HSA may reduce your tax liability.
Roth IRA and Roth 401(k)
A Roth IRA is a type of account where taxes are paid upfront on investments, allowing for tax-free growth and tax-free distribution in retirement.
It’s a bet investors make that taxes will likely be higher in the future, or that their income will be higher in retirement.
Contributions are limited to $7,000 ($8,000 if you’re over 50). There are income limits as well.
A Roth 401(k) is a similar account where taxes are paid upfront for tax-free growth and distribution later. They may be available from your employer and have a higher contribution limit of $23,500.
Investments that grow and are distributed tax-free make Roth accounts a powerful option.
Traditional IRA & employer-sponsored 401(k)s
Traditional IRAs and 401(k)s offer a tax deduction from the outset of the investment.
That is, you contribute pre-tax money to these types of retirement accounts. The growth is tax-free, but it is taxed when you make a withdrawal in retirement.
Theoretically, most retirees have lower incomes and a lower tax liability in retirement.
Treasury securities
Treasury securities are considered one of the safest investments in the market.
These include Treasury Bills, Treasury Notes, Treasury Bonds, Treasury Inflation-Protected Securities (TIPS), and Floating Rate Notes (FRNs).
They aren’t the most exciting investments, but you won’t owe state and local taxes on them.
529 College Savings Plans
A 529 account is set up for the purpose of saving money for future educational expenses.
Contributions are made in after-tax earnings and grow tax-free. Qualified distributions for education expenses are also tax-free.
Translation: Any investment in this type of account is tax-free after the initial contribution. It’s also possible to roll over these types of accounts into a Roth account after a certain number of years, allowing the investment to continue its tax-free nature.
How can I reduce tax on my investments?
There are several strategies for reducing your tax on investments.
- Use a tax-advantaged account. By opening a tax-advantaged account, such as an IRA or your employer’s 401(k), you’ll be able to defer taxes to retirement. If you expect to make less money in retirement, this move could make sense. This option should be evaluated against other accounts, such as Roth accounts, 529s, and HSAs.
- Hold onto your investments. Individual stocks held more than a year avoid the top capital gains tax you’re levied when you sell stocks held less than a year. You’ll pay capital gains taxes at a lower rate by holding them for more than a year.
- Strategic tax-loss harvesting. You can use losses to offset gains to reduce the amount of tax you owe.
Get expert financial advice
Creating tax-efficient investments helps keep money in your pocket. You can do more with your money by being efficient with where you invest it.
Understanding the tax implications of every investment can be challenging. If you need help creating a portfolio with tax-free and tax-efficient investments, getting expert financial advice is the best first step.
Unbiased can help you find an advisor and get expert financial advice for all your complex questions.