Tax Efficient Investing: Which Investment Types Are the Most Recommended Ones?

Advertising Disclosure This article/post contains references to products or services from one or more of our advertisers or partners. We may receive compensation when you click on links to those products or services

No one likes paying taxes, but not paying them tends to lead to very big problems, from an IRS audit to possible imprisonment. It's not recommended. What you can do is postpone paying taxes or reduce what you owe. There are a number of perfectly legal ways to do this. Here are the most tax efficient investing strategies to choose from.

1. Municipal Bonds

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.

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.

Other “gotchas”:

  1. 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.
  2. 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.”
  3. 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.

One way to make sure investing in municipal bonds make sense for both your portfolio and your taxes is to have your portfolio reviewed by a licensed professional, such as Personal Capital.

2. Invest Through a Roth IRA

This is probably the best way to permanently reduce your tax burden, because the returns you earn in a Roth IRA are never taxed. Never! 100% of your withdrawals from a Roth IRA are tax free. Even though you pay tax up front on the money that goes into a Roth, the ability to earn tax-free returns on that money, compounded for many years, is unbeatable. The maximum you can contribute to a Roth IRA for 2019 is $6,000, so it's not a huge amount of money, but year after year, it adds up.

Some people will argue, “But I have to pay tax upfront on the money I invest in a Roth IRA. Contributing to a traditional IRA or 401(k) lowers my taxable income, so it reduces my tax today.” True, but that's like saying you'd rather buy a nice dinner tonight than enjoy years and years of feasting after you retire.

With a traditional IRA, you avoid paying a relatively small amount in tax when you put money into the account, but you pay tax on all of the money, including years and years of investment returns when it comes out. Unless you're only a couple of years away from retiring, the Roth is the better deal. You can begin withdrawals after age 59½, but note that a Roth IRA must be in place for at least five years before you can take withdrawals, regardless of your age.

There are income limitations for contributing to a Roth IRA. If you are single, your modified adjusted gross income (MAGI) must be under $137,000 for 2019, and contributions are reduced starting at $122,000. If you are married filing jointly, your MAGI must be less than $203,000, with reductions beginning at $193,000. If you exceed the limit, there is a legal “backdoor” way to convert a regular IRA to a Roth IRA that you may want to consider.

3. Contribute to an Employer-sponsored 401(k)/403(b) Plan

Most employers will match your contributions to a 401(k) or 403(b) plan, up to a specified amount. Your contributions are pre-tax, so they lower your taxable income for the year. And your employer's contribution is free money. You pay tax on 100% of the withdrawals, which you can begin at age 59½.

A growing number of employers now offer a Roth 401(k), which is similar to a Roth IRA but allows you to contribute up to $19,000. If you're 50 or above, that increases to $25,000. Obviously, this is much more than the $6,000 limit for a Roth IRA. The limit applies to your total 401(k) contributions, whether to a traditional 401(k), a Roth 401(k), or both. Employer matching contributions always go into a regular (non-Roth) 401(k) account.

One downside to these employer-sponsored plans is that you are limited to the investment options the plan offers. Most offer low-fee index funds, but watch out for any that have high fees, and be sure to diversify. If your plan offers limited choices of only high-fee funds, you may want to invest only up to the amount that earns you the highest matching contribution from your employer.

4. Contribute to a Traditional IRA

A traditional IRA is similar to a 401(k)/403(b) but without a matching employer contribution. Your contributions reduce your taxable income the year they are made, but you pay tax on that money and on your investment returns when you take withdrawals (no sooner than age 59½, no later than age 70½). Still, postponing those tax payments for 10, 20 or possibly 30+ years before you take withdrawals is a big benefit.

With an IRA, you have virtually unlimited flexibility in your investment options, which can be good or bad, depending upon how comfortable you are with directing your own investing. You may want to seek advice on that.

If you max out your 401(k) contributions and still want to save more, you can contribute to a traditional IRA, but not pre-tax. So, keep careful records to avoid paying tax on that money again when you take withdrawals from the account.

Want to learn more about how taxes work on investments, and how to save on your taxes this year? Check out Cofield's Concepts, an educational site from financial advisor Carter Cofield. In his tax course, you'll learn everything you need to know about how to take advantage of deductions and how taxes on investments work.

5. Save for College With 529 Plans

If you have children and plan to pay for some or all of their college expenses, or if you plan to pursue a degree for yourself in the future, open a 529 plan. Open an account for each child (even if they're not born yet!) and start saving as soon as you can, even if it is only a small amount per month. Investment returns accumulate tax free in 529 accounts, and as long as the money is used for any qualified educational expenses (not just tuition), withdrawals are tax-free. Some states even offer a tax deduction for money invested in that state's 529 plan.

If you are a grandparent, aunt, uncle, or other caring individuals who want to help pay for a child's college education, it is usually better for you to contribute money to the account owned by the child's parent than establish a separate account that you own. We won't go into details, but it affects financial aid eligibility.

Most financial advisors recommend you save for retirement before putting money aside for a child's education. You can't borrow to pay for your retirement, and a child has many more years to earn money to repay a student loan than you have to save for your retirement. But not everyone agrees with this perspective.

6. UGMA/UTMA 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.

7. Pay Medical Expenses With a Health Savings Account

A health savings account (HSA) allows you to get a tax deduction for medical expenses with the benefit of tax-efficient investing. It's almost like an IRA-linked to a high-deductible health plan. Instead of saving for retirement, the account is used to pay for present qualified medical expenses.

The amount you put into the account is tax-deductible, which lowers your tax bill at the end of the year. Any interest earned on the funds is tax-deferred, and withdrawals are not taxed as long as the money is spent on approved medical expenses. Unlike a traditional flexible spending account (FSA), the funds in an HSA are not use-it-or-lose-it.

Money in the account continues to earn interest until you use it for medical expenses, and the funds are completely under your control. This is a great option for people who choose high-deductible health plans.

Once your HSA reaches a certain dollar amount (usually $2,000 or more), you can open an HSA Investment Account and invest the money in a variety of mutual funds. This type of HSA can supplement your overall retirement savings while protecting you with the health insurance coverage you need.

8. Buy U.S. Series I Savings Bonds

This is an often-overlooked but great way to earn a return indexed to inflation. Earnings are not taxed by your state or local government, and federal taxes are deferred while you hold the savings bond. Series I Savings Bonds can be used for higher education tax-free (although 529 plans usually offer superior returns). The maximum amount you can buy is $10,000 per Social Security number, and you can choose to use up to $5,000 (per Social Security number) of any IRS refunds owed to buy more. You can consider them part of your retirement savings, but you don't need to hold them in an IRA or 401(k) to defer taxes on your interest earnings.

When deciding whether to invest in Series I bonds, compare today's rates with other investment opportunities. The U.S. Treasury publishes updated rates on the Treasury Direct website. At a minimum, the rate will keep up with inflation (CPI).

9. Master Limited Partnerships (MLPs)

Master limited partnerships (MLPs) are a way to get some cash flow while deferring most of the return for many years. “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.

A disadvantage of MLPs is they are quite complex to deal with when filing your taxes and usually require help from a professional tax preparer or CPA.

Summary

Being tax-aware with your saving and investing can make a big difference in how much of your hard-earned income (including investment income) you keep versus the amount you have to pay in taxes. As long as it's legal, we're all in favor of keeping your tax payments to a minimum. Oh, you can put your hand down now.

Related Articles

18 Comments

  1. Larry, Thanks for your posting, right what I was looking for. I have a question regarding Trad IRA’s and Roth IRA’s. My wife and I currently max out our employer matched contributions for 401K, and everything else we keep in a combination of cash and taxable investments, we file jointly and our AGI prevent us from taking advantage of Traditional IRA’s deductions or Roth IRA contributions. Would it make sense to still open Traditional IRA accounts for each with max contribution (after-tax) and then immediately convert to Roth IRA’s?

    1. Hi Daniel,

      We, unfortunately, cannot give out personal advice. In addition, don’t have enough info to make give a correct answer to your question.

      What I can say is overall I recommend mixing account types so you can diversify and have more control over your tax situation when you retire and how/when you want to withdrawal money.

  2. Thanks for this post! I have a couple of questions: 1 Where do other investment vehicles fit into this list such as life insurance and annuities? 2. If a family member wanted to set something up as a one-time deposit for their grandchild, what has the most bang for the buck (Roth, 529, etc)?

    1. Permanent life insurance policies with cash values if they are non-MEC could be considered similar to #4. Though I would almost always max out traditional retirement plans first before say a whole life plan. I eventually will be creating an article on whole life policies and their use as an investing vehicle. Though you should almost always do them last in this list because there are so many other options available.

      Annuities are really too many different types to be classified into this. Though deferred annuities I would consider low on the list as well.

  3. Any input for starting an investment account for my 15 year old? I don’t want to do a 529 because we have a good college plan for her already. My goal is for her to have an asset that is growing through compounding interest, that she can watch grow and contribute to, but also can be accessed through her life, not just for school or retirement. But also something that won’t tax her to death.

    1. If your 15 year old works (meaning they get a W2), they then can put the same amount in income into an IRA up to the $5,500 limit. Though it doesn’t have to be the money they earned, you can gift the $5,500 and deposit it for them. You will need to contact a brokerage that allows you to setup a custodian account for a minor. I know that Fidelity for example, does not allow minors to hold accounts.

      In most cases this puts most into the 0% tax bracket so a Roth IRA makes the most sense.

  4. Fantastic analysis. Personally I prefer ISAs (Individual Savings Accounts) mostly because I can use them to save cash, or invest in stocks and shares. Moreover I don’t have to pay any tax on the interest or dividends I receive from an ISA and any profits from investments are free of Capital Gains Tax.

  5. Thanks for the list!
    For high tax-bracket families, how would your list change? Roth IRA is inaccessible at those income levels. Govt bonds are up to the 10K limit per person. How would you rank the muni and MLP versus buying investment (e.g. rental) properties and depreciating them ?

    1. Reinvesting in yourself? You mean higher ed? It's in there. Business and real estate can be great with taxes. It really depends upon your specific situation and hard to put on a list like this and then put in a specific order.
      For example, real estate has a 1031 exchange in which you won't pay capital gains if you upgrade to a bigger investment property.

      Also as you mentioned before a SEP IRA (an IRA within a business) could be placed #1 with 401k/403b because it's pre-tax of business or personal income.

  6. This is a good summary of the tax advantages of each of these accounts. Over time, I have become less enamored of most of these accounts due to all of the strings attached to get the tax advantages. Right now I primarily invest in taxable accounts. The range of investments in taxable accounts is large and many of these have tax advantages of their own.

    Keep in mind that 401Ks and 403bs are not a free lunch every dollar is eventually taxed. If you have a large enough estate, you get hit twice first with the face value of the account for the estate, then you pay taxes on the proceeds. In my mind tax deferral is not enough of a carrot.

    Roths are really a free lunch. It has the tax deferral plus tax free withdraws. Not only that you can withdraw your contributions at any time. Very flexible.

    Mike

    1. "withdraw your contributions at any time." Technically you must be older than 59 1/2, but there are other exceptions.

      You are correct about tax advantages and becoming less enamored with them. I also have a decent amount in taxable accounts as it's much more flexible for other purposes.

      The Roth IRA free lunch, not sure how long it will last with government deficits. Hopefully they will ONLY start with new money, not existing Roth IRAs. If they did somehow make Roth IRAs taxable, the general public would be pissed though.

      1. Your response is incorrect.. Mike is correct. You can withdraw Roth *contributions* at any time, regardless of age. Earnings you have to wait until 59 1/2.

Leave a Reply

Your email address will not be published. Required fields are marked *

Back to top button