When investors cash out a successful long-term investment, they're sometimes dismayed to realize they have to share a chunk of their earnings with Uncle Sam, which sends some people searching for tax-free investments. Some of the most common types for U.S. investors are tax-free municipal bonds, which you can invest in directly or through municipal bond funds. You can also use tax-deferred retirement funds such as individual retirement accounts and 401(k)s or Roth accounts, which let your investments grow tax-free. Federally issued Treasury bonds are also exempt from state taxes.
But don't let special tax rules stop you from doing your due diligence: Exactly which approaches are best for you, or whether you can see better earnings after taxes from a taxed investment, depends both on your tax bracket and your appetite for risk.
Tax-free municipal bonds are considered fairly safe investments that are usually exempt from federal, state and local income tax. Remember, though, that tax status is just one of the factors affecting returns on your investments and that you may make more money even after tax on a taxed investment.
Tax-Free Municipal Bonds
Tax-free municipal bonds are likely the most well-known tax-free investment option in the U.S. These are issued by local entities like cities and school districts to borrow money to fund construction projects, highways, schools and other public goods. As with other bonds, they can be bought and sold by investors who receive interest over the life of the bond.
These bonds are usually exempt from all income taxes, including federal, state and local taxes, but you should make sure a bond you're considering won't be subject to tax in your jurisdiction. Some bonds are also subject to the federal alternative minimum tax, which is generally paid by high income taxpayers. Municipal bond defaults, meaning situations where a local government stops payments on its bonds, are rare, so they're considered relatively safe investments. You will likely still want to do some research into the agencies issuing a particular bond you're considering, including publicly available credit ratings.
Benefits of Municipal Bonds
Bonds in general are often favored by investors who are looking for a stable, low-risk investment with predictable returns. Many financial advisers suggest investors shift their portfolios from stocks and other more volatile investments toward bonds and other fixed-income offerings like bank certificates of deposit as they get older and near retirement. Investors with more time before they retire or more appetite for risk in general will likely keep a smaller percentage of their savings in bonds.
The tax advantage of municipal bonds is naturally greater for investors in higher marginal tax brackets and those in places with higher state and local income tax rates. If your income shifts between tax brackets or you move to a new jurisdiction with different rates, you might want to reconsider how much of your income to put in such securities.
Tax-Free Bond Funds
As with other types of investments, you can either hold tax-free municipal bonds directly or through an investment fund. Many brokerages and other financial institutions offer their own tax-free bond funds that you can invest in. For legal reasons, some target investors in particular states where the underlying bonds are issued, so that they can be exempt from state and local taxes where they're based.
You can work with a brokerage or financial advisor, or you can simply do research online to find a fund that offers tax-free returns where you live. Also look at the fund's historic returns, fees charged and other information that's available to understand if it's a good investment for you. You'll likely want to compare the fund's return after taxes to other opportunities with a similar level of risk, including investing directly in municipal bonds.
Treasury Bonds and Taxes
Bonds issued by the federal government are known as Treasury bonds. Like other bonds, they pay interest over time at a fixed rate. They're considered one of the safest investments in the world, since the federal government has never defaulted on its debt, although that naturally means they can pay less interest than other debt securities.
One advantage of Treasury bonds is that they're not taxed at the state or local income tax level, though they are taxed like other interest payments on your federal taxes. How much that benefits you depends on your state and local tax rates. If you live in a jurisdiction with no state or local income tax, it likely won't benefit you at all. Short-term federal debt is issued in instruments known as Treasury bills, which function the same way for tax purposes.
You can generally invest in federal government bonds through a brokerage, bank or by buying directly from the Treasury Department through its TreasuryDirect program. Compare different opportunities to see which one offers the fees and convenience you want.
Investing Through an IRA
Many people looking to save for retirement will put some money into an individual retirement arrangement, or IRA. These are special accounts that allow you to deduct the money you put into them from your income tax the year you transfer the funds into the accounts. While the limits can change annually, you can generally put up to $6,000 of your earned income per year into IRA accounts, but you can put up to $7,000 if you are 50 or older. You can open IRAs with brokerages, banks and other institutions and invest in a wide variety of opportunities, including stocks, bonds, managed mutual funds and index funds.
You don't get to avoid paying tax on money in an IRA forever. When you withdraw money from the account, you pay tax at your ordinary income rate on the money you take out. If you take money out of the account before you turn 59 1/2, you also pay an additional 10 percent tax penalty to the Internal Revenue Service unless certain conditions apply.
Withdrawing From an IRA
You can withdraw money early for various hardship reasons, such as paying for health insurance while you're unemployed, paying for certain medical expenses or becoming disabled, as well as for positive reasons like spending up to $10,000 in IRA money toward a first home or paying for yourself or a relative to go to college. You generally still owe income tax even if the penalty is waived, and in some cases you may face tax withholding on what you take out of the IRA. Make sure you understand the ins and outs of the IRS rules around early withdrawals if you plan to take one so you don't face a surprise penalty.
Once you turn age 70 1/2, you generally must withdraw a certain minimum amount from your IRAs and other tax-deferred accounts, such as 401(k) and 403(b) accounts offered through your job, or you will face a hefty tax penalty. The penalty is generally 50 percent of the amount you failed to withdraw as required, which is more than any federal tax bracket rate, so it's essentially never worth it to skip a required minimum distribution, as the mandatory withdrawals are called in tax jargon. Special rules also apply if you inherit an IRA or another tax-deferred account.
Understanding Roth IRAs
Roth IRAs are a variation on IRAs with separate tax rules. You pay tax on money you put into a Roth IRA in the year you earn it, as with other funds. However, when you withdraw from a Roth IRA after age 59 1/2, you don't pay any additional tax, including on your investment earnings. That means that your investments in a Roth IRA essentially grow tax-free. If you're anticipating being in a high income tax bracket when you retire or earning a lot on your investments, a Roth IRA can be a good alternative to a traditional IRA.
Both Roth and traditional IRA contributions count toward the total $6,000 or $7,000 per year limit. Roth IRAs don't have required minimum distributions, but separate rules do apply if you inherit one.
- Consulting a tax lawyer can help you save money in taxes with complex investments.
- Although risks are typically low, most tax-free investments are not FDIC-insured.
Video of the Day
- Investopedia: Taxation Rules for Bond Investors
- TreasuryDirect: Home Page
- Investopedia: Tax-Free Savings Accounts and Other Places to Save Tax-Free
- Charles Schwab: Not Always Tax-Free: 7 Municipal Bond Tax Traps
- Fidelity: Fidelity Tax-Free Bond Fund
- Franklin Templeton: Franklin California Tax-Free Income Fund
- IRS: Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)
- IRS: Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)
- IRS: 401(k) Contribution Limit Increases to $19,000 for 2019; IRA Limit Increases to $6,000