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14 best tax-free investments to build an efficient portfolio

The best tax-free investments to help you build a tax-efficient portfolio include tax-exempt mutual funds, exchange-traded funds, municipal bonds, and more.

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September 22, 2023

10 min read

What's Playbook? We're your friendly guide to paying less in taxes (legally!) and putting your money in the right places automatically. Money stuff can feel hard, but we’re here to help along the way.

Key takeaways
  • When it comes to building wealth, tax-free investments are the key to long-term success.
  • These opportunities lower your tax burden so that you can give your money as much room to grow as possible without Uncle Sam taking a scoop off the top.
  • Tax-efficient investing isn’t rocket science. It takes some forethought and planning, as well as a nest egg, to get started.
  • With the right guidance, the tax minimization investment strategies can help you save for retirement more efficiently than other approaches.

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      Tax-efficient investing: What exactly does that mean? 

      Tax-efficient investing is making the right investing decisions to minimize tax liability in favor of long-term portfolio growth. This is often maxing out contributions to retirement accounts like 401(k)s and IRAs, but there are other ways to make tax-saving investments, such as mutual funds, municipal bonds, and more.

      Taxes should be considered before each investment decision, as they will significantly impact your return on investment. Yet, people usually overlook taxes.

      To fully understand the potential of tax-free investments, you need to understand just how many different opportunities there are to lower your tax bill.

      Luckily, we’ll dive right in to explore the best tax-advantaged investments available to most people today. We’ll cover their benefits, contribution limits, and eligibility requirements that determine whether or not you can capitalize on them.

      14 tax-free investment opportunities to juice your portfolio

      We’ll start with the basics and move into more unique options for tax-free investment opportunities like funds, easements, and trusts.

      Roth IRAs, Roth 401(k) plans, or conversions

      Roth retirement plans are a handy financial tool that can help you grow your wealth tax-free. Typically, you’d choose a Roth account over a traditional retirement account if you anticipate that your earnings will be higher when you reach retirement age than they are now – that is, you anticipate paying more taxes in retirement than currently.

      Roth IRAs are the cozy, familiar piggy bank where you squirrel away money for retirement. But the magic here is that you throw in after-tax dollars that take advantage of compound growth – all free of taxes. This means when you retire and head out to sip a margarita on a beach somewhere, the money you pull out (including earnings) is all yours from this tax-free account.

      Roth 401(k) plans are employer-sponsored alternatives to an IRA. You stash your hard-earned cash there and watch your contributions grow tax-free. When you’re ready to retire, the money you take out is tax-free, too. It’s like telling the tax person, “Sorry, not today, pal!”

      Now, Roth conversions are more like a financial makeover. If you have a traditional IRA or 401(k), you can convert it into a Roth account. You’ll pay taxes on the converted amount now, but down the line, all those sweet earnings are tax-free when you retire.

      Roth IRA Roth 401(k)
      Benefits After-tax contributions lead to tax-free growth and withdrawals After-tax contributions lead to tax-free growth and withdrawals
      Contribution limits $6,500 per year (2023) No contribution limit. Can be hit with penalties if withdrawn before age 59½
      Eligibility Earned income more than $0 but less than $153,000 ($228,000 for couples filing jointly) Not all benefit plans offer Roth accounts

      Remember this

      If you touch your money in a Roth IRA or 401(k) before age 59½, your withdrawal will be subject to a 10% penalty if you’ve owned the account for more than five years, and additional income taxes on earnings if you’ve owned it for less. If you withdraw after age 59½ but owned the account for less than five years, you’ll pay taxes on earnings without an early withdrawal penalty. The early withdrawal penalty can be avoided in some cases (such as death, disability, or using the funds for a first-time home purchase) but not the income taxes. So keep this in mind and make sure you have accessible cash on hand elsewhere in case of an emergency!

      Take heed of these tips before diving into the world of Roth accounts.

      1. Start early! Your future self will thank you for it.
      2. Consider your risk tolerance. These are less risky than direct benefits like employee stock options, but don’t go all-in on the stock market if you can’t stomach the rollercoaster ride. You can put bonds in your Roth IRA for a lower-risk investment.

      Municipal bonds

      Municipal bonds are like financial worker bees that help you support your community while making a little green for yourself.

      Imagine you’re at a garage sale, but instead of old junk, you’re buying some of your city’s biggest projects (like bridges, schools, or sparkly new playgrounds). A municipal bond lets you lend money to your state or local government, and in return, they pay you back with interest.

      First, you buy a bond, and the government promises to repay you the initial amount (the principal) plus interest over time. And the cool part? That interest is usually tax-free when it comes to federal income taxes.

      Municipal bonds
      Benefits Tax-free interest (in most cases)
      Contribution limits None
      Eligibility Open to almost all investors

      Tips for success? You got it!

      1. Do your homework and research your municipality’s financial health. You wouldn’t buy a house without first checking its foundation, right?
      2. Remember that bonds can tie up your money for a while unless you purchase them in an ETF, so make sure your financial timelines match up and you’re not in a place where you can’t access cash. You can also sell bonds to free up cash, albeit at a higher cost.
      3. Watch your yield. After-tax yield is priced in to municipal bonds, and the after-tax yield might not actually be higher than the after-tax yield of a different bond.
      4. Keep an eye on interest rates. They can jolt the bond market and leave you with less money in your pocket.
      5. Stay cool when the market dances. Bonds might not be as flashy as stocks, but they can be more stable in the long term.

      Tax-exempt mutual funds

      Picture this: You’ve got a bunch of investors pooling their money into a big pot, and a fund manager takes this cash and invests it in bonds issued by cities, states, or other government entities.

      These bonds are the government’s way of asking for a loan, promising to pay it back with a little extra interest. And here’s the sweet part – the interest from these bonds is usually tax-exempt, rendering it invisible to the tax collector’s gaze.

      Essentially, you buy shares in this tax-exempt mutual fund, and your cash gets sprinkled into a basket of these tax-free bonds. As the bonds pay interest, you get a slice of that pie. It’s like a double rainbow, where you can enjoy tax-free interest and potential investment growth.

      Tax-exempt mutual funds
      Benefits Tax-free interest (in most cases)
      Contribution limits None
      Eligibility Open to almost all investors

      Of course, there are some considerations regarding mutual funds.

      1. Consider your goals. Do you want income or growth? Different funds have different styles.
      2. Know the state of the bond market. It can be as unpredictable as the weather, so stay informed if you can.
      3. Look at net asset value. When compared to ETFs (which we’ll touch on below), mutual funds are less liquid, usually have a higher investment minimum, and can have higher expenses associated with purchasing them.

      Tax-exempt exchange-traded funds (ETFs)

      Tax-exempt ETFs bear some similarities to mutual funds. You buy shares in a tax-exempt ETF, along with other investors, and your money goes toward a stash of tax-free government bonds. As the bonds cough up interest, you get a piece of the action. And, of course, that interest is usually tax-free, too.

      There are a few key differences that distinguish a mutual fund from an ETF:

      Tax-exempt mutual funds Tax-exempt ETFs
      Traded once a day Traded multiple times daily
      Managed actively Managed passively
      Priced once a day, after markets close Priced repeatedly, often fluctuating
      Priced with dollar amounts (NAV) Set at market price
      Available only in full shares Available in portions any dollar amount

      ETF are more liquid than mutual funds, and are one way to diversify your portfolio.

      Tax-exempt ETFs
      Benefits Tax-free interest (in most cases)
      Contribution limits None
      Eligibility Open to almost all investors

      Naturally, we’ve got a few tips for you if you’re intrigued by ETFs.

      1. Understand your investment goals. Whether you’re looking for more income or seeking growth, different ETFs can help you find what you’re looking for.
      2. Watch the markets. Just like mutual funds, ETFs rely on unpredictable bond markets.
      3. Stay patient and don’t look for quick outs. Investing isn’t a sprint but a marathon!

      Health savings accounts (HSAs)

      HSAs are sneaky financial pirates that help you stash loot for medical expenses without that stash incurring taxes.

      Every month, you stash pre-tax dollars in a tax-free health savings account that grows over time. But this stash is only for health-related expenses. Doctor visits, prescriptions, even those pesky co-pays – they’re all fair game.

      You’ll team up with an HSA provider who will give you a debit card for these medical expenses. If you don’t use all the funds this year, they’ll roll over in a never-ending cycle of financial health.

      • Pre-tax contributions
      • Tax-free interest
      Contribution limits
      • $3,850 (2023)
      • Most high-deductible health insurance plan holders
      • Funds must be spent on qualifying medical expenses

      Like any opportunity, this tax-free investment has some tips to best take advantage of it:

      1. Max out your contributions. The more money you stash in an HSA, the more you save on taxes by lowering your taxable income.
      2. Invest your account. Some HSAs allow you to invest your stockpile, letting it grow even more! However, this can come with additional risks, like losing out on your investment.
      3. Keep all your receipts! Even if you pay out-of-pocket at the doctor today, you can reimburse yourself later from your HSA.
      4. Save it for retirement. Once you hit a certain age, you can use your HSA funds for non-medical expenses. However, you’ll need to pay taxes on the funds at this point.
      5. Be prepared – medical expenses are unpredictable. Having a chunky HSA can help you weather unexpected storms.

      529 plans

      If you’re the proud parent of a future academic scholar, 529 plans can make saving for education feel like a walk in the park.

      529 plans allow you to stash after-tax dollars and watch them grow tax-free. The funds are earmarked for your little scholar’s academic future – college tuition, textbooks, even that ridiculous hat they’ll wear at graduation.

      You’ll pick a 529 plan, usually sponsored by your state, and fund it over time. The funds will grow with compound interest and be free from taxes once it’s time to withdraw as long as they’re used for applicable education expenses. If you use them for anything else, you’ll owe taxes and be assessed a penalty.

      529 plans
      • Tax-free interest
      • Tax deductions on contributions in some states
      • Allows room for qualified financial aid since contributions aren’t considered your child’s assets
      Contribution limits
      • Varies by state, but usually pretty high
      • Open to almost all investors, including distant relatives or friends of the child
      • Funds must be spent on qualifying education expenses

      529 plans are pretty straightforward, but these tips will help your child get the most out of it when it comes time for them to head off to school.

      1. Start early. Time is your ally when it comes to compounding interest.
      2. Choose an automatic investment to consistently contribute and keep the growth strong.
      3. Be smart about withdrawals. You can withdraw up to, but not more than, the cost of qualified education expenses before the tax person comes a-callin’.

      Indexed universal life (IUL) insurance

      IUL insurance is like a financial safety net that moonlights as a treasure chest. It offers protection and growth all in one.

      If you’re the captain of your financial ship, then an IUL insurance policy is a map leading you to a safe harbor. You pay into a policy that does two things: First, contributions go toward providing life insurance protection for your loved ones. Then, the rest is invested in a stock market index fund, like the S&P 500.

      If that index gets a little bumpy, you’ll have a safety harness in the insurance policy. When the market surges, you get to share in the spoils, and when it stumbles, your protection kicks in to keep your loved ones safe and sound.

      IUL insurance
      • Life insurance payout
      • Tax-free interest
      Contribution limits
      • None
      • Open to almost all investors, but more suitable for high-net-worth individuals

      There’s no shortage of tips, either, when balancing life insurance with your investment goals.

      1. Consider your net worth. IUL can be expensive with very costly fees, and the money you invest is locked up for a long time with a significant penalty if you need to access it. IULs therefore aren’t suitable for people who aren’t already wealthy.
      2. Know your goals and aim to understand the trade-off between life insurance protection and potential investment growth.
      3. Know your index. The performance of your investment is linked to it, so be sure you can grasp the basics of the ebb and flow.

      Donor-advised funds (DAFs)

      Donor-advised funds are investments that help feed your inner charitable giver.

      You start by contributing to a fund for your charitable donations, and instead of using it all at once, you make grants to your favorite causes as you choose over time. When you contribute to the fund, you get an instant tax deduction.

      DAFs are suitable for large positions with significant appreciation – like company stock. You can lock in the value of the shares and claim your deduction on the assessed amount.

      • Tax-deductible
      • Tax-free interest (in most cases)
      Contribution limits
      • Varies by fund, but usually pretty high
      • Open to almost all investors, but more suitable for high-net-worth individuals

      These tips will help you set off the right path before sending money to different charitable organizations.

      1. Choose your fund wisely. Research fees and investment options so your fund grows at a healthy rate. After all, you want to provide the most impact possible.
      2. Create a giving strategy. Which causes tug most at your heartstrings? Having a set plan can help you make a bigger impact and avoid hesitations about which charity gets what amount of money.
      3. Make grants wisely. Ensure your grants align with your values and that the receiving organizations are credible.
      4. Involve your family! Turn this opportunity into a legacy by teaching your children about the joys of giving.

      Conservation easements

      This tax-free investment option is like donning a superhero cape to save the environment and picking up some tax savings along the way.

      Conservation easements are legal agreements that protect a piece of land as an environmental haven. You have to work with a land trust or government agency to create the easement; they’ll ensure your land is protected even if you decide to sell it. And by helping out Mother Nature, you might also get a tax deduction.

      Conservation easements
      Benefits Tax-deductible
      Contribution limits Varies based on income and assessed value of the easement
      Eligibility Open to almost all investors, but more suitable for high-net-worth individuals

      As with any tax-saving measure that relies on government cooperation, there are a few tips you need to consider before declaring an easement in the name of conservation.

      1. Find the right partner. Work with a reputable land trust or agency to create a solid agreement.
      2. Consider any possible future changes. Make sure the easement aligns with your land’s potential future uses. You won’t be able to develop on the land without amending or extinguishing the easement and paying taxes on the property once again.
      3. Involve your family. If they’ll inherit the land, get them on board with your conservation plans.
      4. Consult an environmental guide. An advisor can help you navigate the ins and outs of creating a successful easement.

      Environmental tax credits

      Environmental tax credits are like a high-five from Uncle Sam for being an eco-friendly champion. You’re not just saving the Earth – you’re saving on taxes, too.

      These credits are rewards for taking eco-smart actions. If you make green upgrades to your home or invest in planet-friendly projects, you might be eligible for a reduced tax bill, almost like a carbon footprint discount.

      These investments include solar panels, energy-efficient windows, or wind turbines. The IRS can, in turn, grant you tax savings for qualifying investments. For example, solar panels can net you a double-digit percentage tax credit, although they’re expensive to install and maintain.

      Environmental tax credits
      Benefits Tax credits for environmental benefit
      Contribution limits Varies by project
      Eligibility Open to almost all investors

      To nab these lucrative tax savings, you need to watch out for a few tips:

      1. Seek environmental guidance. Experts can guide you on the best ways to maximize your credits.
      2. Embrace the long-term. You’ll earn many credits over several years, so don’t expect instant results.
      3. Spread the word! Tell your friends and family about these credits to help them take advantage of the tax savings, too.

      Irrevocable trusts

      Irrevocable trusts are vaults that allow you to lock away assets for a noble cause, whether it’s securing your family’s future, supporting a charity, or passing on your treasures while avoiding a major tax bill.

      You start by choosing assets to shelter in your trust, like investments, property, or even cherished heirlooms like artwork investments. But once the trust is established, it can’t be changed unless specifically mentioned within the rules of the trust or a court is granted authority to do so. It is a vault that seals these assets away for future use – except the vault is also tax-advantaged.

      Once you create the trust, you appoint a trustee to manage it according to your wishes.

      Irrevocable trusts
      • You set the rules
      • Assets can escape estate taxes depending on asset type, value, and location
      • Not accessible by creditors
      Contribution limits
      • None
      • Open to almost all investors

      Since someone else will manage your trust and you can’t change it once it’s established, you need to be very careful about setting it up.

      1. Be crystal-clear with your instructions. Outline your intentions and rules for the trust to avoid any mix-ups.
      2. Choose your trustee wisely; they’ll be responsible for honoring your wishes after you pass away.
      3. Weigh your choices. Decide if the benefits of locking away your assets outweigh the loss of control.
      4. Update your story. Life evolves, so revisit your trust to ensure it aligns with your goals. Though it usually can’t be changed, there are ways to do so, like terminating the trust entirely and starting over.

      Other tax-free trusts

      There are near-countless other ways to make smart, tax-advantaged investments to plan for your and your loved ones’ futures. Here are a few more types of trusts that can help limit your overall tax liability.

      Charitable remainder trusts

      You contribute assets (like investments) to a fund. That fund pays an income stream to loved ones for a set period, after which the remainder goes toward your chosen charity.

      Deferred sale trusts (1031 exchanges)

      You arrange a legal contract to sell your property to a trust for installment payments. These payments can help defer capital gains taxes on property sales.

      Parent-seeded trusts

      Parents can form a trust for their children to pass down assets while avoiding (or lowering) state income, gift, and estate taxes.

      Additional tips for tax-advantaged investing

      These tips will help you plan for general tax-free investing, no matter which of the above options you feel is best for your portfolio.

      1. Diversify. This is the most important way to lower risk and create a more stable early retirement plan. Spread your investments across different funds, accounts, and more to manage risk in case one fails to grow as planned.
      2. Do your research. Ensure your chosen investment aligns with your goals and beliefs, whether it’s environmental upgrades, community improvements, or a Roth account. If you’re investing in a fund, get to know the fund manager and their track record.
      3. Document everything. Keep receipts, contracts, and any other proof of your investments and gains for a squeaky-clean record and minimal headaches come tax season.
      4. Watch out for fees and expenses that will slash the growth of your fund, account, or other investment.

      Start making smarter investments now, not later.

      To save for retirement, you need a strategy that works for you. Sure, there are big ideas to live by, like the 50/30/20 rule to manage your expenses and investments as a percentage of your income. But outside of that, your investment strategy should focus on what will grow your nest egg.

      Playbook helps you take the guesswork out of investing with an automated approach that adapts to your life changes and grows with you. That way, you can spend more time focusing on what matters and less time worrying about taking advantage of the right tax credits.

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      About the author

      Phil Wettersten, Series 7 & 66

      Head of Product Success

      Phil holds both Series 66 and Series 7 credentials and previously served as an Investment Consultant at TD Ameritrade. At Playbook, he's the authoritative voice representing our customers, spearheading product enhancements and strategic planning. Phil's unwavering dedication keeps us ahead in delivering top-notch user experiences.

      Theo Katsoulis, CFA

      Head of Investments

      Theo brings an extensive background in Institutional Asset Management. With a B.A. from Villanova University's School of Business, and having passed the rigorous Series 65 and CFA examinations, he brings significant expertise from portfolio management to understanding intricate financial infrastructures. As Head of Investments at Playbook, he ensures consumers receive exceptional diligence and care for their investment portfolios.

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