The Best Tax-Free Investments

Investing is one of the best ways to accumulate wealth over the long term. In most cases, the federal government and some state governments take a portion of your investment earnings through income tax. To encourage investment activity, some investments are designed to lessen your tax burden. Investing your money in a prudent manner involves understanding the best tax-free investments. Once you understand how these investments work, you can develop a strategy to save money and increase your income.

Step 1

Invest in financial securities issued by the federal government through Treasury Direct. Government securities include T-bonds, T-bills and T-notes. According to Treasury Direct, you do not pay state and local income tax on the interest earned from your investment. You are required to pay federal income tax. Not only do you benefit from certain tax exemptions, but Treasury securities are virtually risk-free because they are backed by the U.S. government.

Step 2

Buy municipal bonds through your state, city or local municipality. Municipal bonds are one of the best tax-free investments available, because interest earned on the bond is exempt from federal income tax. You can also save money in state and local taxes if your buy a municipal bond issued by the state where you live. Other benefits of investing in municipal bonds are regular income payments and low risk of default by the issuer.

Step 3

Contact a life insurance company to purchase a policy. Tax advantages venture farther than your lifetime. Life insurance plans allow you to leave tax-free money in the form of a death benefit to your heirs once you die. Ask the insurance company about private-placement life insurance policies. You can benefit from this plan by placing taxable securities, such as stocks and bonds, within the life insurance policy. Gains, interest and the death benefit are tax-free.

Step 4

Start a Coverdell Education Savings Account with a brokerage firm, if eligible. Your modified adjusted gross income must be less than $110,000 if single and $220,000 if married and filing a joint return, as of 2012. Contribute up to $2,000 a year. The withdrawals taken from the account are also tax-free if you use them for eligible education expenses, such as tuition, fees, books and supplies.

Step 5

Open a health savings account. Enroll in a high-deductible health plan to qualify for an HSA. Contribute up to $3,100 in 2012 for self-coverage and $6,250 for family coverage. Deduct your contributions on Form 1040, even if you choose not to itemize. Your funds grow tax-free, and you can withdraw the money on a tax-free basis to use for eligible medical expenses.

Tip

  • Consulting a tax lawyer can help you save money in taxes with complex investments.

Warning

  • Although risks are typically low, most tax-free investments are not FDIC-insured.

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