In some respects, investment taxes are very similar to market risk. Every asset class carries a different level of risk, and investors use asset allocation strategies to tailor the amount of risk they want in their portfolios. Some risks can be minimized to reduce volatility or uncertainty, but risk can never be removed entirely when investing in capital markets.
The same principle applies to taxes. You can’t avoid taxes all together; eventually, the IRS will send you a letter saying, “Kindly pay this amount, or we’ll just start taking it and maybe throw you in jail, too.” However, you can minimize your tax burden. In fact, it is a crucial component of your overall wealth management process. Tax avoidance is illegal; tax minimization is good investment planning.
Tax efficiency is critical for maximizing wealth over time. While few investments are entirely tax-free, a wide range of tax-advantaged choices can help minimize your obligation to Uncle Sam. In this article, we’ll break down the most popular tax-free and tax-advantaged investments, explain how they work, and highlight their benefits and limitations.
What Are Tax-Efficient Investments?
Tax-efficient investments are strategies or products that help minimize the taxes you pay on investment gains. The U.S. tax code permits several different assets and account types with specific tax advantages to encourage Americans to save for retirement, educate their children, and support public projects. If you want to control your tax obligations, you’ll want to consider utilizing some of these products, especially if you’re on a fixed income and can’t afford to overpay.
Selecting the proper tax-advanced vehicles requires some self-scouting. You must consider your goals, risk tolerance, income, and family situation. Some tax-advantaged accounts, like Roth IRAs, have phase-out limits for high earners, so always check with your advisor on the best tax planning practices.
Completely Tax-Free Investment Options
Certain investment options provide the benefit of being entirely tax-free, making them ideal for individuals looking to maximize returns without the burden of federal taxes.
Municipal Bonds
While no one would confuse them with high-flying tech stocks, municipal bonds are safe investments that offer several tax advantages depending on where you buy them. State and local governments issue municipal bonds for general purposes or specific projects like schools or airports. The yield is often lower than Treasuries, but income earned from munis isn’t taxed at the federal level. And if you live in the state or municipality where the bond was issued, you might not have to pay state and local taxes on the income either.
529 Education Savings Plans
If you plan on sending children to college, consider the advantages of a 529 plan. These state-administered investment accounts allow for tax-free growth if the profits are used for qualified education expenses. In 2018, rules were relaxed to enable qualified expenses to include private and religious elementary and secondary schools. Contributions to a 529 plan are not tax deductible, but there are no income restrictions, and you can set up a 529 plan for anyone—child, relative, friend or even yourself.
Tax-Advantaged Investment Options
The next best thing to being tax-free is being tax-efficient. These tax-advantaged investments offer a range of benefits tailored to help you achieve specific financial goals.
Roth IRAs
For many savers, the Roth IRA is the golden goose of retirement planning. Unlike a traditional IRA, Roth contributions aren’t tax deductible. Instead, the tax break comes at withdrawal. Provided you wait until age 59.5 (and have the account open for at least 5 years), your investments grow tax-free in a Roth, and you can withdraw your basis at any time since contributions come from after-tax dollars. Plus, there are no required minimum distributions (RMDs) at age 72!
A few rules apply to Roth IRAs:
- Individual contribution limits for 2024 are $7,000 (or $8,000 if you’re 50 or older).
- Roth eligibility phases out at higher income levels, starting at $146,000 for single filers and $230,000 for married couples in 2024.
Health Savings Accounts
Health Savings Accounts (HSAs) aren’t as popular as Roth IRAs, but they’re often just as beneficial since you get a triple whammy of tax benefits—deductible contributions, tax-free investment growth or interest, and untaxed withdrawals—provided you use the proceeds for qualified medical expenses.
To open an HSA, you’ll need a high-deductible health plan (HDHP) that is not enrolled in Medicare. Contribution limits for 2024 are $4,150 for individuals and $8,300 if you have a family plan. What counts as a "qualified medical expense?" Anything that isn’t an insurance premium: copays, physicals, doctor’s exams, medication, menstrual products, eyeglasses, and more.
Series I Bonds
The US Treasury issues these bonds, which are linked to the Consumer Price Index (CPI) but not in the same way as Treasury Inflation-Protected Security (TIPS) bonds. Series I bonds are basically savings bonds with a dual rate: half the rate is fixed and the other half is variable with biannual adjustments.
Series I Bonds aren’t taxed at the local or state level. Federal taxes apply to interest, but this can be waived if you use the profits for qualified education expenses. These bonds can’t be purchased on any secondary market, only from the Treasury directly. The term is also fixed: a 20-year initial period followed by an additional 10-year maturity period. Investors are limited to $10,000 worth of I-bonds each year, but an extra $5,000 is available if you use your tax refund to finance the purchase.
Specialty Investment Opportunities
For investors looking to diversify their portfolio with unique financial products, there are specialty investment opportunities offering tax advantages alongside additional benefits tailored to specific goals.
Tax-Exempt Mutual Funds and Exchanged-Traded Funds
If you aren’t eligible for a tax-advantaged retirement account like a Roth IRA, you can still earn tax-free investment income through tax-exempt mutual funds and exchange-traded funds (ETFs). Tax-exempt funds are bond or money market funds that hold a variety of low-risk debt, such as municipal bonds. For example, Vanguard offers funds based on states issuing the debt (i.e., California or New York), allowing investors to tailor their holdings by location or yield. Not all funds have the same tax treatment, so be sure to understand the objectives before investing.
Life Insurance Policies
Another tax-deferred product for high earners is a whole (or permanent) life insurance policy. Unlike a term policy, whole life insurance has a cash value that accrues interest over time. The interest grows tax-free on the cash component, and taxes are only paid at withdrawal. However, loans against the policy can be used for additional tax benefits, and whole life contains a death benefit that allows tax-free inheritance to heirs, even if the estate is large enough to trigger estate taxes.
Tax-Advantaged Investments Enhance Your Returns, But Mistakes Can Be Costly
Tax benefits on investments are like giving steroids to your returns. Limiting your obligations will give you more capital for compounding and less stress when the calendar approaches April. Tax planning is year-round, so you’ll need a good rapport with an advisor to maximize the benefits.
But remember, these tax advantages aren’t handed out like Halloween candy. You’ll need to meet certain requirements or use your profits for specific expenses like education or health care. The penalties can be harsh for investors who don’t follow the rules, so a financial advisor is a must-have for anyone with a complex tax situation.
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