The Seven Best Tax-Free Investments

February 6, 2014 by Douglas A. McIntyre

140411606When it comes to taxes and investments, we have all heard the old saying: “It’s not what you make, it’s what you keep.” Since the founding of the United States, if not before, investors have searchedĀ for ways to keep as much after-tax money as possible.

Tax-free and tax-efficient investments have been around for decades. Some of us remember getting a savings bond as a childhood birthday present, with the explanation its value would appreciate and be relatively tax-free by the time we were grownups. The market for U.S. municipal bonds, which are usually tax-exempt at the federal level and sometimes tax-free at state and local levels, is currently worth around $3.7 trillion, and it has long been dominated by household investors. In fact, according to the Federal Reserve Bank of New York, more than half of that U.S. municipal debt is in the hands of individuals.

Tax-deferred retirement accounts such individual retirement accounts (IRAs) and 401(k)s are also part of our daily financial landscape, and they are growing more common in the American workplace. Similarly, strategies such as 529 plans or UGMA — the Uniform Gift to Minors Act — are low-maintenance and often tax-free ways to create and grow a nest egg for a young person’s future college tuition payments.

There are also less well-known instruments out there that can make a huge difference when planning for a child’s education, preparing for retirement or simply trying to pay the least taxes on your investment returns.

Gonzalo Freixes, a senior lecturer who teaches taxation at the UCLA Anderson School of Management, thinks people do not make use of most of the available tax-saving methods. There are several options, he said, “that have either immediate or future tax benefits [people] should think about.”

With the help of Professor Freixes, 24/7 Wall St. has compiled a list of seven tax-free or tax-efficient investment methods that can help you keep more of what you make.

1. Retirement

Probably the most popular and familiar retirement accounts are the traditional IRAs and the workplace 401(k), which have been around for some time. Money put into a traditional IRA is not taxed until it is withdrawn at your retirement.

There are also Roth IRAs and employer savings plans. Unlike traditional IRAs, money set for investments in these accounts is not tax deductible. But such accounts have other advantages, most notably at retirement age. “[A]ll of the money you’re taking out, including the gain or the growth or the income generated by that money, comes out tax-free,” said Freixes.

There are also Keogh plans, available to business owners. Such plans allow higher contributions at a pretax level. Taxes on any interest, capital gains and dividends earned in a Keogh are deferred until withdrawn.

2. Fixed Annuities

A fixed annuity is essentially a contract between you and an insurance company. You pay the insurance company a lump sum in exchange for periodic payments at a guaranteed interest rate and for a certain time. On top of principal safety and guaranteed income, fixed annuities offer steady, taxed-deferred growth, according to Prudential.

However, annuities can be very complicated, and they have come under public scrutiny in recent years due to performance issues. Fixed annuities are regulated by state insurance commissioners because they are insurance products, so your protections may vary depending on where you live. Also, different annuities offer different protections. Some may have cost-of-living adjustments, while others offer protection from company failure. There are annuities with high commission rates, while others guarantee payment to a surviving spouse.

3. Death Benefits for the Living

Death benefits or life insurance can have tax advantages. “If you receive an inheritance or if you receive money from a life insurance policy as the beneficiary of that policy, it is entirely tax-free,” said Freixes. And corporations, he notes, do not pay taxes on such monies, either. “A lot of people don’t know that corporations take out life insurance policies on their key employees,” he adds. “And the corporation gets the money tax-free when they die.”

When it comes to life insurance, people paying for that insurance may get a deduction if they use the policy in their business. So if you own a business, you may be able to deduct life insurance premiums.

4. Municipal Bonds

Another well-known way to gain tax advantages is by investing in municipal bonds. Lending money to your city or state can benefit you as well. Interest from municipal bonds is tax-free at the federal level and may be tax-free as well in your state and local municipality. There are some downsides to bonds: as an investment vehicle, their return isn’t all that high. They are also coming under increasing federal scrutiny as the government considers ways to limit their tax exemption. Another risk, as Freixes noted, “[O]ccasionally, municipalities go bankrupt.”

5. Harvesting Tax Losses

Use any downturns in your investment portfolio to offset realized gains. For example, said Freixes, if you were to sell stocks A and B at a loss but stocks C and D at a gain, “you can harvest the losses from A and B to offset some of the income you’re going to have to pay — the capital gains income you’re going to have to pay taxes on — from the C and D stock.”

There are also “passive losses,” made in non-stock investments like a limited liability company (LLC) or rental property. While they cannot be offset by active income, they can be deducted against income from any other passive investments you might have.

6. Gifting

If you are trying to put some money aside for your child or grandchild, you are probably familiar with the Uniform Gift to Minors Act. UGMA lets you establish a custodial account for a child. The first $1,000 of unearned income in a UGMA is tax-exempt; the second $1,000 is taxed at the child’s rate (of about 10% for most kids) and anything above $2,000 of unearned income is reportedly taxed at the higher of the child’s or parent’s rates.

Then there is the so-called kiddie tax, imposed on minors under 18 (or full-time students age 24 and under) who receive more than $2,000 in investment income. It is meant to keep parents and others from sheltering their money in a child’s account at a lower tax rate. At the same time, said Freixes, parents can also give up to $14,000 annually to their minor or adult children “without ever having any gift or estate tax ramifications.”

7. College Investing

There are a variety of tax-efficient college saving instruments.

Contributions to a Coverdell Education Savings Account (ESA) are not deductible, but they can grow tax-free until withdrawn, according to the Internal Revenue Service. An ESA lets you set aside up to $2,000 annually, “and then it works like a Roth IRA,” said Freixes. “You don’t get to deduct anything by setting aside this money, but then, when the money is taken out with its interest or gain or income for education, it’s tax-free.”

Similarly, a 529 plan, set up by a state or educational institution, allows a family to set aside funds for a child’s college costs. The IRS says 529 earnings are not subject to federal tax, and they are generally not subject to state tax, either, if used for qualified education expenses. Contributions to a 529 plan, however, are not deductible.

Another instrument is the previously mentioned UGMA, which allows more flexibility compared to a 529 plan. There are no restrictions on the types of investments in a UGMA account. And unlike 529 plans that restrict the use of funds for college expenses, parents can spend UGMA funds on anything for the benefit of the child.

Twelve states also offer a prepaid tuition 529 plan, which allows parents to pre-purchase tuition based on current rates.

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