The ultimate tax-advantaged investment option might be life insurance, because any proceeds paid out due to the death of the insured are not taxable and don't have to be reported with the beneficiary's gross income. The only problem is you have to die before it pays off. Fortunately, there are other types of tax-advantaged investment options that you can benefit from while you are still in the land of the living.
Your employer might offer you the option of participating in a company-sponsored retirement plan that allows you to contribute money on a pretax or after-tax basis. The funds in your company-sponsored plan are allowed to grow tax-deferred until you withdraw them upon reaching retirement age. The U.S. Congress authorized individual retirement accounts in 1974 as a means of allowing individuals to prepare for their retirement years by setting aside a portion of their earned income in a tax-advantaged account. IRAs have the same tax-deferral benefit as company-sponsored plans.
The interest paid by certain debt securities issued by the U.S. Treasury, such as Treasury bonds, bills and notes, have the advantage of being free from state and local income taxes, although the interest is fully taxable on your federal income tax return. U.S. savings bonds give you the option of paying taxes on the interest annually or upon maturity. If you use the proceeds from your U.S. savings bonds to pay for qualified educational expenses, the interest is free from federal income taxes.
Municipal bonds are debt obligations of government organizations at the state level or below. The interest on most municipal bonds is free from federal income taxes, and might be free from state and local income taxes for individuals who reside in the state of issue. Once a municipal bond is issued, its market price will fluctuate in the secondary market, based primarily on movements in prevailing interest rates. If prevailing interest rates drop, the market price of your bond will typically increase. If you sell your municipal bond in the secondary market for a profit, you will owe capital gains taxes, even though the interest on the bond was tax-free.
You might not think of stock as being a type of tax-advantaged investment but it is. If you purchase a bank certificate of deposit with a three-year maturity, you must pay taxes on the interest earned by the CD each year. You can purchase stock and own it for as long as you like without ever paying taxes on its appreciated value. You only pay capital gains taxes on your stock when you sell it, and if you have held the stock for more than one year you get the added benefit of having your profits taxed at the more advantageous long-term capital gains tax rate. You will have to pay taxes on any dividends the stock pays out.
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- Internal Revenue Service: Publication 590, Individual Retirement Arrangements
- The Securities Industry and Financial Markets Association: Taxation of Municipal Bonds
- Prudential: Tax Strategies: Other Tax-Advantaged Investments
- Internal Revenue Service: Publication 550, Investment Income and Expenses
- Internal Revenue Service: Life Insurance & Disability Insurance Proceeds
- Jupiterimages, Creatas Images/Creatas/Getty Images