No one likes to pay taxes. So we investors perk up our ears if someone says we can generate returns that are really, truly, legally tax-free.
Guess what – we identified not just one, but five ways you can do that.
We’re not talking about shady, “off the radar” methods to avoid reporting income to the IRS. These are completely legitimate ways to earn returns that you’re allowed to keep for yourself at tax time.
What’s the fine print, you ask? (There’s always fine print.) Some forms of tax-free investing generate interest or dividends that are not taxed. You pay tax on capital gains when you sell.
There are a couple of other potential “gotchas,” but don’t worry. We explain them here so you’ll know about them before you invest your money.
Perhaps the most obvious way to earn tax-free returns is to buy tax-exempt municipal bonds (munis). Interest from these bonds is exempt from federal tax. And in some states, the bonds are exempt from that state’s income tax.
This can be a big deal if you live in a high-income tax state. You’ll probably owe state income tax on interest from munis issued somewhere other than your home state. For example, if you live in New York and buy California munis, you’ll owe New York state income tax on the interest from those California bonds. Buy tax-exempt munis issued either by the State of New York or another government entity in order to avoid paying state income tax on your muni income.
You can buy either individual municipal bonds or municipal bond funds (mutual funds or ETFs) that hold a diversified portfolio of munis. A fund’s dividends come from the interest earned on its bonds, so they’re tax-free to investors. Specialized funds hold bonds from only one state, such as California or New York, so the dividends from those funds are “double tax-free” to residents of that state.
Fine Print Alert: However, funds often distribute capital gains at year’s end. All investors who hold the fund as of a certain date will owe tax on those capital gains.
- If you buy a muni below face value, the difference between the face amount and your purchase price may be considered taxable income. There are arcane rules about this, but you might end up owing capital gains tax due to this.
- Interest from some munis is subject to the Alternative Minimum Tax (AMT). AMT affects fewer taxpayers since the 2018 tax bill, but ask your broker before buying if the bond is an “AMT bond.”
- Just because the interest is tax-free doesn’t mean buying munis is “better” than buying corporate bonds. On an after-tax basis, some corporate bonds may offer higher returns.
As long as the money in the account is used to pay for qualified educational expenses, the returns earned in a 529 Plan, including interest, dividends and capital gains, are tax free. If you’re sure your child is college-bound, this is a great option. Or you could use this for a close relative if your kid decides to go in another direction. Start saving as soon as your child is born. That way, those untaxed investment returns can help to pay for a big chunk of those future college costs. In some states, you can now also use 529 Plans for K–12 private school tuition.
Fine Print Alert: Using the money for any nonqualified purpose triggers taxes and penalties.
Here’s a great gift idea: Give a Roth IRA to your kids as soon as they start earning income. It may not be as much fun as electronic gadgetry, but it truly is the gift that keeps on giving. Money in a Roth IRA grows tax-free for the rest of the owner’s life. Even when your kids retire and start pulling out the money to pay for their inter-planetary vacations, it won’t be taxed. This one is usually a no-brainer.
Here At InvestorJunkie, we recommand to let Personal Capital to handle your Roth IRA accounts:
The Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) allow minors to own assets. This technique doesn’t always offer 100% tax-free returns, but it might work for you – or really, for your non-adult children.
This type of account is held in the name of a minor child. So the returns from investments, up to a specified limit, are taxed according to the child’s tax bracket. That often means zero tax is owed since most children do not earn more than the standard deduction.
Fine Print Alert: If your kid is a big earner, income above the specified limit is taxed at the parent’s rate.
More Fine Print: When the child reaches a certain age, he or she gains control over the money. If all goes well, it will be used to pay for college or to help with a down payment on a house. But it could go toward buying a motorcycle or whatever. Please talk to a tax expert before proceeding.
Master Limited Partnerships (MLPs)
A master limited partnership (MLP) is a publicly traded company. You can buy shares of the company on many of the exchanges.
“Limited” means you’re not responsible for running the business; you just collect dividend checks. Sound good so far? Dividends from MLPs are usually tax-deferred. These distributions actually lower the cost basis of the shares. You pay tax when you sell your shares, and the capital gain can be significant, depending on how long you’ve held the MLP.
Fine Print Alert: Owning an MLP complicates filing an income tax return. Also note these are not a good idea for a retirement account, as they can trigger tax liabilities.
A wise old CPA once said, “If you owe taxes, it means you earned money. That’s a good thing.” He had a point. Still, paying taxes is not fun, so legally minimizing them is worth considering.