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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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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.
We’ll start with the basics and move into more unique options for tax-free investment opportunities like funds, easements, and trusts.
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.
Take heed of these tips before diving into the world of Roth accounts.
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.
Tips for success? You got it!
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.
Of course, there are some considerations regarding mutual funds.
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:
ETF are more liquid than mutual funds, and are one way to diversify your portfolio.
Naturally, we’ve got a few tips for you if you’re intrigued by ETFs.
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.
Like any opportunity, this tax-free investment has some tips to best take advantage of it:
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 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.
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.
There’s no shortage of tips, either, when balancing life insurance with your investment goals.
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.
These tips will help you set off the right path before sending money to different charitable organizations.
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.
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.
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.
To nab these lucrative tax savings, you need to watch out for a few tips:
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.
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.
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.
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.
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.
Parents can form a trust for their children to pass down assets while avoiding (or lowering) state income, gift, and estate taxes.
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.
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.