How to Take Advantage of Tax-Free Investments
Tax-free investments are often associated with controversial figures who go out of their way to find less-than-ethical loopholes to paying taxes. Yet while we wouldn’t recommend anyone to set up an offshore account in a tax haven, there are plenty of legitimate ways to invest in a way that optimizes for taxes. Here are a few ways to do exactly that.
Whether you look at tax as a necessary contribution to society or a burden on your income, they’re a fact of life—and even the most moral among us would struggle to say that seeing your tax bill isn’t a little painful. You can’t eliminate taxes altogether, but you can certainly turn to tax-free investments to boost your take-home revenue and build your wealth to the max.
Does that sound like something you’d be interested in? Of course it does. We’ll run through some of the best ways to pursue tax-free investing, including both tried-and-tested methods such as 401(k)s and a few more creative strategies.
Tax-free investments: Are they ethical?
First of all, let’s acknowledge the elephant in the room. Isn’t seeking out tax-free investments illegal, or at the very least immoral? Not really.
Tax evasion is an unlawful practice that involves purposely misleading or evading the authorities that want you to pay tax. This could be something as extreme as going off-grid so the IRS has no idea where you even are. Go down a notch and we have tax avoidance, which is usually the one that hits the news—it’s not quite illegal, but it is highly frowned upon. This basically involves going out of your way to avoid paying taxes and find technically-legal loopholes, which most of us would agree is immoral.
Tax-free investments are a 100% legal and completely reasonable way to avoid paying unnecessary taxes. In fact, they often involve using initiatives the government itself has set up, including something as benign as an IRA (more on this shortly). Hardly a criminal act.
In other words, we’re not encouraging anybody to avoid tax here—we’re just showing you ways to be more tax-efficient with your investments while staying within the law. So, feel free to go crazy with the suggestions below.
Tax-free investment strategies
Now we’ve cleared that up, we can get to the good stuff: How to venture into the world of tax-free investments.
In most cases, this will mean either taking advantage of a tax-advantaged account (which is specially built with features that allow you to reduce your tax burden) or investments structured in a way that makes them subject to fewer taxes. This first category focuses on reducing your income tax, while the second one focuses on capital gains tax.
Let’s take a closer look.
The first tax-advantaged account we’ll be examining is the tax-deferred account. This allows you to deduct your contributions to the account from tax. For instance, you could put $2,000 into a tax-deferred account and then subtract the entire amount from your tax return at the end of the year.
This is tax-efficient, because you’ll get an upfront tax break—but it’s not tax avoidance since you’ll be deferring the taxes rather than evading them completely. You’ll still have to pay taxes when you withdraw the money in retirement (assuming you earn enough). IRAs and 401(k) plans fall into this category.
Then there are tax-exempt accounts, which work in the opposite way. Contributing to these accounts won’t reduce your tax bill initially—you’ll still have to pay the same amount of tax—but you will get a perk later on in life. When it comes to withdrawing the money you’ve added in retirement, you won’t have to pay any taxes. Save enough into a tax-exempt account and you could have a tax-free income for life. Roth IRAs and Roth 401(k)s fall into this category.
So, which type of account should you choose? The answer ultimately comes down to your best guess about whether you’ll earn more now or in retirement. If your earnings are high now and you expect to have a lower salary in retirement, you’ll probably be better off taking advantage of the tax deductions now. But if you’re expecting to save a lot in your accounts and withdraw it in big chunks later on, the reverse is true.
Tax-exempt and tax-deferred accounts are a great way to achieve tax efficiency, but unfortunately, there are IRA limits on how much you can contribute. You can add up to $6,000 to your IRA or up to $19,500 to a 401(k) each year (although these numbers are slightly higher if you’re aged 50 or older).
So, what should you do instead? Most of the time, if you’re not investing in a tax-exempt or tax-deferred account, it means you’ll be investing in a taxable account—meaning that you can’t reduce your tax bill upfront and you also have to pay tax if you withdraw the money later on. Even worse, you may have to pay capital gains tax on the money you earn through investing.
However, some investments are subject to a greater amount of capital gains tax than others—so if you’re smart, you can at least be efficient here.
One of the best ways to reduce your capital gains tax is through bonds. There are a few different types of bonds to consider, with perks that work slightly differently:
- Municipal bonds: Interest isn’t subject to federal tax, and sometimes is exempt from state and local tax too.
- Treasury bonds: Exempt from state and local taxes.
- Series I bonds: The same as treasury bonds.
- Corporate bonds: The least tax-efficient and subject to all types of taxes.
Exchange-traded funds (ETFs) don’t involve as much capital gains tax as other types of stock market funds. Why? Officially, less capital gains will be happening if a fund distributes earnings as dividends to investors rather than registering them as capital gains, and ETFs do well on this front.
ETFs are a type of passive fund that tracks a specific index—for example, the S&P 500. As a result, they stick to the same assets over time and don’t involve much buying or selling of investments (something that triggers a lot of capital gains). This means they’re more tax-efficient than active funds, which are managed by professionals and therefore trigger a lot more capital gains.
Invest with MyConstant
Once you’ve exhausted your main options for tax-free investments, one of the best things you can do for your portfolio is diversify across various kinds of investments.
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