Nobody likes to see their investment income eaten up by taxes, and this makes investing tax free very appealing. There are a number of options, but there are catches to each of them. However, with the right understanding, there are opportunities to decrease one’s tax burden.
These are the most obvious and well-known way to invest tax free for Americans. Annual contributions are limited, so it is necessary to start as early as one can and max the yearly contribution if it is at all possible. In addition, for those who want to pass something on to their children, starting Roth IRAs for them when they are young is a way to give them something while lowering investment taxes.
The Uniform Gift to Minors Act
This act, or the Uniform Transfers to Minors Act in some states, makes it possible to set up a brokerage account for children with the first $950 a year in annual income tax free, and the following $950 taxed in the lower tax bracket the child will be in. The drawback is that the child will have full legal control as to how the money is spent from the age of 18 or 21.
Municipal bonds (sometimes called munis) offer perhaps the least limited method of investing tax free, but they do have their drawbacks. These bonds are defined as IOUs issued by state and local governments and their agencies. The money they raise is used to fund public projects from schools to hospitals. These bonds are free of federal taxes and are sometimes free of state taxes too if the investor lives in the state.
Some advantages and disadvantages of municipal bonds
Apart from being free of federal taxes, municipal bonds add diversity to a portfolio. In addition, with comparatively low volatility and tax bases to support them (some types), they are relatively safe.
However, as with all bonds, the principle will be affected by interest rates. Bond prices will generally move in the opposite direction of rates and increase in value when rates are dropping and decrease in value when rates are rising. In addition, there will be penalties for early withdrawal.
Who are municipal bonds suitable for?
The biggest single disadvantage of tax-free municipal bonds is that they will pay lower rates, which may be fixed or variable. Because of this lost interest, as a general rule of thumb, these bonds only make sense for those in the 25% tax bracket or higher. This is the point where the tax savings will more than compensate for the lower interest payments. A formula for deciding if they make sense for any individual investor (for finding the “tax-equivalent yield”) can be found on the following page of T. Rowe Price.
Classes of municipal securities
These bonds are classified by the financial source of their interest payments. With general obligation bonds(GOs), the issuer can back the interest of the bond with tax dollars. On the other hand, riskier revenue bonds are backed solely by the revenue from the projects they finance.
Municipal bond funds
These funds, sometimes called tax-free income funds, invest in municipal bonds and offer an easy and more diversified way of participating in the market. On the downside, since there is no fixed maturity date when investing in funds in contrast to individual bonds, the purchaser of these bonds has less control over when potential capital gains will be taken.
Types of bond funds
To better meet investor needs, there are several types of municipal bond funds based on the length of their maturities and the types of bonds they are invested in. Keep in mind that those funds that offer the longest average maturity and the greatest return are likely to have higher volatility.
- These include national tax-free funds that buy state and local bonds nationwide.
- State-specific tax free-free funds that allow investors to take advantage of the fact that bonds are usually also free of state taxes for residents of the states they are issued in.
- High-yield tax-free funds are invested in bonds that offer higher yields but greater risks.
- Term funds are based on average length of maturity of the funds.
- Insured tax-free funds are covered by insurance to guarantee principal and interest payments will be made on time (this does not protect the bonds from market fluctuations in value).
- Tax-exempt money-market funds invest in high-quality, short-term securities and usually maintain a value of $1, thus preserving investor principle.
Buying tax-free municipal bond funds
- It is first necessary to look one’s tax bracket (federal and state) and investment goals and decide if tax-free funds are the right choice. Then, consider the type of fund that will best meet investment objectives.
- Look for good funds. For those who do not have an investment adviser, there is plenty of information online.
- Look at the funds that spark the most interest more closely by requesting prospects and by checking their risk rating on the Morningstar or similar ratings websites.
Investing tax free offshore
Of course, the way to get the best returns without restrictions is to move the money offshore. While this is not particularly difficult to do in most situations for those willing to spend the time and effort to learn how to do it, there are some drawbacks that always need to be kept in mind.
- Americans are taxed on their worldwide income. Penalties for having unreported accounts and not reporting income are stiff.
- Governments are becoming increasingly sophisticated in tracking money and finding hidden accounts, especially when money is sent or returned from abroad.
- The minimum balances and startup costs of setting up such accounts can be high.
There is no perfect way of investing tax free. However, there are a number of opportunities to reduce one’s tax burden and increase returns.