What Investments are Tax Free?
April 3, 2013
What investments are tax free? Probably at least a few more than you think. Especially when you consider that where you have your money easily has the biggest impact on what is free of taxes and what is not.
Let’s look at tax-free investments in the usual – and not so usual – places.
1. Municipal bonds and municipal bond fund interest.
Talk about tax-free anything, and municipal bonds are the default conversation. They are tax free for federal income tax purposes, and also from state income taxes if you live in the state that issues them. Note: They are not tax free for state income tax purposes if you do not live in the state where the bonds are issued.
Municipal bonds are debt securities issued by states, counties, municipalities, and the various agencies of each. They can be issued for all kinds of purposes, including building roads and schools, developing or improving utility projects, or even the issuance of very low interest mortgage loans by the states to their residents.
It’s important to understand that while the interest earned from municipal bonds is tax free, any capital gains from the sale of the securities will be subject to taxation. However, they’ll be subject to more favorable capital gains tax rates if they are held for more than one year prior to sale.
Municipal bonds are also held in mutual funds and exchange traded funds (ETF’s). Any interest paid to you through the fund will be tax free, however the capital gains will be reported to you as taxable gains in the year of sale.
2. Treasury securities are tax-exempt for state income tax purposes.
Interest earned on United States government treasury securities is fully taxable for federal income tax purposes, however they are exempt from income tax at the state and local level.
This might not mean much if you live in a state with very low marginal income tax rates, but in those states with rates in the 10% (or higher) level, the tax savings can be substantial.
3. Anything in a retirement plan – well, tax-deferred anyway.
Virtually any investment held in a tax-sheltered retirement plan – an IRA, SEP, 401(k), 403(b) or 457 plan – will accumulate income on a tax-deferred basis. This isn’t quite the same as tax free, but it will allow you to grow your investments until you reach retirement and you begin withdrawing funds.
The advantage here is that, at least in theory, by the time you retire you’ll be in a lower income tax bracket, and the tax bite on your withdrawals will be substantially lower than the amount of tax you saved on the contributions and income accumulations.
Again, strictly speaking it’s not quite tax free, but it’s the next best thing!
4. Investments held in a Roth IRA.
Income earned from investments held in a Roth IRA will be tax-free, if you’re at least 59 ½ at the time you begin taking withdrawals, and you have been in the plan for a minimum of five years.
You won’t get a tax reduction as a result of contributing to a Roth IRA, but any income you earn on the investments held in the account can later be withdrawn completely tax free if you meet the above criteria. This makes a strong case for putting at least some of your retirement money into a Roth IRA. You can think of it as a form of income tax diversification for retirement planning.
5. The sale of your principal residence – mostly.
Most people don’t typically think of their principal residence as a tax-free investment, but if the value has risen substantially since you purchased it, the profit on the sale of the home could be largely shielded from income taxes when you sell.
The IRS allows the first $250,000 in gains from the sale of a principal residence to be exempt from taxation for singles, and $500,000 for married couples. Since states generally figure your tax based on taxable income for federal income tax purposes, the gain will also be exempt at the state level.
You won’t get an income from your principal residence in the way that you will from traditional investments, however you will get a big fat tax break when you finally sell the home. A big gain on the sale of your principal residence will result in a very large tax-free windfall.
Are there other tax-free investments that you know of that are available to the average person? Leave a comment!
All posts by Kevin Mercadante
More and more “tax free” income is being included in computations that determine fees (such as Medicare etc). So, it still pays to checkout the investment, as it applies to you, versus its taxable cousin!