Wondering what investments are tax free? These smart, legal options can help you grow your wealth while minimizing taxes and keeping more of your returns.
If you’re looking to build your wealth, and earn passive income, investing can be extremely beneficial if you know what you’re doing. The problem with regular investing, is like most other things in life, anything you make may be subject to taxation, with capital gains tax being the most common. Uncle Sam always wants his cut.
Investing is all about growing your wealth and setting yourself up the future, so it can be demoralizing to have to hand over a percentage of your earnings to the government, especially considering we’re taxed on pretty much everything else. The good news, however, is that there is a perfectly legal way around this.
Tax-free investing, along with tax-efficient investing, has become hugely popular in recent years and if you’re looking to ease your tax burden, you have a number of options at your disposal.
So, what investments are tax free? Here are several tax-efficient and tax-free investments for you to consider adding to your portfolio.
Treasury Bonds
Treasury bonds are basically a loan to none other than the federal government. Despite not being fully tax-exempt, they are still free from state income tax. This is largely due to the fact that they offer yields which are lower than corporate bonds.
Unfortunately, if you do sell your treasury bonds for a gain, your profits will still be eligible for capital gains taxes. If you’re looking to make your portfolio more tax-efficient, however, treasury bonds are a great choice.
Municipal Bonds
Another bond that’s perfect for individuals looking to become more tax-efficient with their investments is a municipal bond.
Municipal bonds are issued by the government and are used to fund local infrastructure such as travel links and accommodation. If you invest in municipal bonds, you’re basically lending the government your money, so that it can fund these various projects.
Municipal bonds are great because you are guaranteed a positive rate of return thanks to interest payments. The icing on the cake? Your interest payments are federal tax exempt. Depending upon your state, they may also be exempt from local or state taxes.
Is there a catch? Of course there is, there always is, and that catch is that interest from some of these investments are still subject to the AMT (Alternative Minimum Tax). They are also vulnerable to inflation, as this may affect your rate of return thanks to changes in interest rates.
2022 – 2023 for example, say record-high rates of inflation and subsequent interest rate hikes. Municipal bonds, which are ordinarily a safe bet, were suddenly deemed fairly volatile.
Tax-Exempt ETFs
Wondering what investments are tax free? Well, if you’re looking for long-term growth over the course of several years, tax-exempt ETFs (Exchange-Traded Funds) are a great option.
ETFs are made up of a collection of different stocks and shares, so rather than buying shares in just one stock, you instead buy fractions of shares in multiple different stocks. ETFs often have lower fund management costs as they may track indexes such as the S&P 500 or the Dow Jones.
You can also invest in ETFs focused solely on municipal bonds, meaning you get to enjoy those same tax breaks and exemptions as standard municipal bonds.
Tax-Exempt Mutual Funds
Tax-exempt mutual funds are very similar to ETFs, except they’re made up of a collection of different securities such as bonds, stocks, or a combination.
They too can track indexes or be managed by a professional fund manager. If you invest in a managed mutual fund, you’ll pay more in management fees than you would with a fund that simply tracked an index.
The good news, is that there are mutual funds out there that are tax-exempt so you don’t pay taxes on any positive returns you may receive. Usually, tax-exempt mutual funds consist of government securities and municipal bonds.
The exact tax exemptions you can enjoy will depend upon which mutual funds you invest in.
Health Savings Accounts
Health savings accounts, or HSAs for short, enable individuals to save money for future medical expenses, with the added bonus of reducing their tax liability.
Any contributions you make to an HSA will benefit from both state and federal income tax deductions. If you use the money in the account to pay for eligible healthcare services and expenses, any withdrawals you make from the account will not be subject to local, state, or federal income taxes.
Just to complicate matters further, some states do not legally recognize HSAs, so any earnings are not free from state income taxes. As of this writing, neither California nor New Jersey recognize HSAs.
529 Accounts
529 college savings plans are designed to help people pay for educational expenses such as college.
529 accounts provide tax deductions and credits, though if withdrawals are used for qualifying educational services and expenses, in some states, tax-exemptions on any earnings also apply. Namely, state, federal, and local income taxes.
Virtually all states offer 529 savings plans, and you can pick and choose whichever plan you contribute to, regardless of where you live.
So, what investments are tax free? Well, for educational expenses, 529 savings accounts are ideal.
*Disclaimer* This is not financial advice. We are not qualified financial advisers. The content of this article is for educational purposes only. Only invest what you can afford to lose and remember that investments can go down as well as up.