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Investing is a key component to building wealth, though certain types of investments are much more tax-favorable than others. Fortunately, there are a number of investment options that aren’t subject to taxes at all, and even more that, at least, minimize the taxes that they do incur.
This article covers everything you need to know about tax-friendly investments, including those that do not tax gains you make from your investment, those that allow you to contribute pre-tax dollars and those that allow you to make tax-free withdrawals.
Tax laws can be complex, a financial advisor can help you maximize your tax breaks -- Connect with a financial advisor today.
There are an array of tax-friendly investments that could have a place in your portfolio. Those investments include the following:
What it is: Municipal bonds are debt securities that can be issued by states, cities, counties or other government entities. When you invest in a municipal bond, you are lending money to the issuer — which is often used to finance local infrastructure — and in exchange, you will get regular interest payments in addition to the return of your initial investment.
Tax treatment: Typically, the interest income you receive from your municipal bond is exempt from federal income tax, and can also be exempt from state and local taxes.
“Generally speaking, for folks in high enough income tax brackets, municipal bonds make sense as they increase their after-tax return,” said Brian Fischer, a senior financial advisor and certified financial planner (CFP) at Evensky & Katz/Foldes Financial Wealth Management in Coral Gables, Fla.
Fischer added that your municipal bond might be subject to the federal alternative minimum tax — although that’s less likely since the 2017 Tax Cuts and Job Act. Additionally, he reminds investors that non-taxable interest is included when calculating the taxed amount of one’s Social Security benefit.
What it is: You can invest directly in municipal bonds that can garner tax-exempt income, but you can also invest in tax-exempt mutual funds. Mutual funds are a popular type of investment in which investors pool their money to purchase a bundle of securities that will serve as their portfolio. In the case of tax-exempt mutual funds, the securities included in the fund are largely made up of municipal bonds and other government securities — which, in turn, can give you tax-exempt income. While tax-exempt mutual funds typically generate lower returns than other types of investments, they might be a good fit for those looking to save on taxes.
Tax treatment: With mutual funds, you are not typically required to pay federal taxes on the earnings you make from tax-exempt municipal bonds. A number of states also offer similar tax exemptions on that money.
What it is: Similar to tax-exempt mutual funds, tax-exempt exchange-traded funds (ETFs) are made up of nontaxable investments, such as municipal bonds and U.S. government bonds. ETFs are similar to mutual funds and are baskets of securities that can include several asset classes. Unlike mutual funds, however, ETFs are bought and sold on a stock exchange, similar to company stock.
Tax treatment: Like individual municipal bonds and municipal-bond-focused mutual funds, ETFs that are made up of municipal bonds and other government securities can be exempt from federal, state and local taxes, depending on the particular investment.
What it is: Roth IRAs are tax-efficient investment vehicles that you can use to save for your retirement years. With Roth IRAs, you contribute after-tax dollars to an investment account that you can withdraw from once you reach the age of 59½. However, your eligibility to contribute to your Roth IRA depends on your adjusted gross income, and you can only contribute up to a certain amount every year.
Tax treatment: The investments in your Roth IRA grow tax-free and the withdrawals you make in retirement from your Roth IRA won’t be taxed, either (as long as those withdrawals are qualified). Additionally, your Roth IRA can be passed along to your beneficiary, and they won’t be required to pay taxes on withdrawals (as long as they are withdrawn within 10 years). However, the contributions you make to your Roth IRA are not tax-deductible.
It’s worth highlighting a similar, tax-efficient option for saving for retirement: Traditional IRAs. With a traditional IRA, you receive the opposite tax treatment, in which your contributions are tax-deductible, but your withdrawals may be subject to federal income tax.
What it is: Health savings accounts (HSAs) are a tax-efficient way to save for future medical expenses. With an HSA, you get a tax break on the funds you use for qualified medical expenses, such as deductibles, copayments and coinsurance. To qualify for an HSA, you must be enrolled in a high-deductible healthcare plan. The money in your HSA can either sit as cash or be invested in ETFs, mutual funds or other types of investments.
Tax treatment: In terms of tax benefits, HSAs are a triple threat. First, they allow you to contribute pre-tax dollars, which, in turn, lower your taxable income for the year. Then, the earnings in your HSA grow tax-free, and, finally, your distributions — when used to pay for qualified medical expenses — are also exempt from taxes.
What it is: 529 plans are tax-efficient investment vehicles that are designed to be used for future education expenses. They offer tax-free growth and tax benefits for withdrawals that are made and used on qualifying educational expenses.
Tax treatment: While 529 plan contributions are made with after-tax dollars, income taxes do not apply to earnings that are made in a 529 plan, and withdrawals also may not be subject to federal income tax (and often state income tax, too) as long as they are used to pay for qualified educational expenses. Additionally, many states offer tax benefits for 529 plan contributions — such as allowing you to deduct your contributions from your state income tax.
What it is: Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) are custodial accounts that share similarities with 529 plans. These tax-efficient accounts offer ways to save for a minor’s future expenses and are controlled and held by an adult until the minor reaches the age of majority. However, with UGMA and UTMA accounts, distributions do not have to be used for qualified education expenses. The funds in a UGMA or UTMA account can be invested in an array of different types of assets.
Tax treatment: While UGMA and UTMA accounts offer tax advantages, they aren’t as tax-friendly as 529 plans. Typically, the first $1,100 of unearned income from a UGMA or UTMA account is exempt from taxes, while the next $1,100 is taxed at the child’s rate. Additionally, these accounts are funded with after-tax dollars, as opposed to pre-tax dollars.
What it is: Indexed universal life (IUL) insurance is a type of permanent life insurance policy that not only offers a death benefit but a cash account that pays out interest at a rate that is based on the performance of the stock market. With an IUL, part of your payment goes toward your life insurance benefit, while the other portion is used to build cash value through interest earned.
The cash value portion of your policy can be borrowed for other expenses — such as retirement funds or to pay for emergencies — and is considered a tax-free investment because the cash value portion comes with a plethora of tax benefits.
Tax treatment: The money in your IUL account grows tax-free, and like other life insurance policies, offers a tax-free death benefit. Additionally, the cash that you are able to borrow from your IUL account can be borrowed through tax-free loans and withdrawals.
“For high-income earners who have a life insurance need, an efficiently designed cash value insurance policy may have a strong fit in your financial plan,” said Henry Hoang, a CFP at Bright Wealth Advisors in Newport Beach, Calif.
“Life insurance products can be complex and challenging to understand, so it is crucial to have a knowledgeable advisor with a fiduciary responsibility to provide objective advice,” he said.
While there are a number of tax-free investments that might benefit from a spot in your portfolio, there are also simple ways you can minimize the taxes you pay on your other investments. If you’re aiming for a lower tax bill on your investments, consider the following:
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