Investing can be a powerful way to grow your savings over time, but the downside is that you generally have to pay taxes on your investment gains. The more you pay in taxes, the less of your returns you get to keep.
With the right strategy, however, it’s possible to minimize the amount of taxes you pay on your investments. Certain investments are not subject to taxation, and investments placed in certain tax advantaged retirement accounts will likewise be shielded from some taxes. As you build your portfolio, consider including these seven options for minimizing taxes.
1. Municipal Bonds
Municipal bonds, or muni bonds for short, are bonds issued by local governments that are used to fund various projects, such as improving roads or building schools. When you invest in a municipal bond, you’re effectively loaning money to the government. The benefit to you is that you earn a guaranteed rate of return in the form of interest payments from the bond. Even better, these interest payments are exempt from federal taxes. A tax exemption may also apply to any state or local taxes on interest earnings as well.
Municipal bonds do have certain risks and downsides. Inflation, for instance, can affect the interest rate and your subsequent rate of return. And interest from some municipal bonds are subject to the Alternative Minimum Tax (AMT). But there’s very little risk of default, and the ability to generate consistent income in your portfolio on a tax-free basis makes them a great addition to a fixed-income portfolio.
2. Tax-Exempt Mutual Funds
A mutual fund is a collection of securities; it may consist entirely of stocks or bonds, or include some combination of the two. The fund either tracks an index or is managed by a professional, offering the opportunity for hands-off investing.
Certain mutual funds are assigned tax-exempt status, meaning you wouldn’t pay taxes on the returns these funds deliver. A tax-exempt mutual fund typically holds municipal bonds and other government securities. This type of fund can offer tax benefits, along with simplified diversification across different types of government securities.
Before you invest, consider how much of a return a tax-exempt fund may offer. And don’t forget to check the expense ratio to make sure you’re not losing too much in management fees.
3. Tax-Exempt Exchange-Traded Funds
Exchange-traded funds are similar to mutual funds, but they trade on an exchange like a stock. Many ETFs take a passive management approach, meaning the assets within the fund don’t turn over as often as they would with an actively managed fund. Many ETFs, in fact, just track an index rather than have a fund manager choose securities. This, in turn, can make the fund management costs lower.
Like mutual funds, ETFs can also be municipal bond-focused, which provides the same tax-exempt benefit. There are short-, mid- and long-term tax-exempt bond ETFs you can invest in, depending on your time horizon and goals. Similar to tax-exempt mutual funds, pay attention to the fees you’re paying to invest in a tax-free ETF.
4. Indexed Universal Life Insurance
You may not think of life insurance an an investment, but your policy could yield some tax benefits in your portfolio.
Generally, life insurance benefits are tax-free when paid to the policy’s beneficiaries. If you have a permanent policy that accumulates cash value, such as indexed universal life insurance (IUL), that cash value can earn interest over time tax-free. And unlike retirement accounts, you don’t have to be pushing 60 to withdraw from it, as tax-free loans can be taken out at any age without penalty—all while offering a death benefit.
IUL can be a more expensive insurance coverage option than term life or even whole life policies. But if you’re looking for a relatively risk-free way to earn tax-exempt gains, an IUL policy could be right for you
5. Roth IRAs and Roth 401(k) Plans
A Roth IRA isn’t an investment itself, but a retirement account for tax-free investing. With a Roth IRA, you contribute after-tax dollars to your account, up to the annual limit. For 2019, the limit is $6,000, plus an additional $1,000 catch-up contribution if you’re aged 50 or older.
“After-tax dollars” means that, unlike a Traditional IRA, you can’t deduct your contributions. But the benefit comes when you hit age 59 1/2, at which point you can begin withdrawing money from your Roth IRA tax-free. That includes all the returns your investments have seen over the years, which means that your investments have earned tax-free returns. (The only caveat is that your account has to be open at least five years before taking the distribution.)
You can continue adding after-tax dollars to your Roth IRA indefinitely, as long as you have earned income for the year. And there are no requirements for taking minimum distributions once you reach age 70 1/2. That means you can continue growing your retirement savings tax-free until you need it. And if you don’t use all of your savings, you can pass it on to a spouse or another beneficiary when you pass away.
A Roth 401(k) is also a tax-free way to save for retirement. These plans may be offered by your employer or you can enroll in a solo Roth 401(k) if you’re self-employed. You invest with after-tax dollars and qualified withdrawals are tax-free in retirement. The biggest difference from Roth IRAs is that you’re required to take minimum distributions from a Roth 401(k) beginning at age 70 1/2.
6. Health Savings Account
A Health Savings Account allows you to save for future medical expenses while reducing your taxable income. Anyone with a high deductible health insurance plan can get one. You can make contributions to your account each year, up to the annual limit (for 2019, that’s $3,500 for individuals and $7,000 for family coverage). Some employers may opt to make contributions for you.
HSAs offer a triple tax benefit. Your contributions are taken from your paycheck before taxes (for employer-sponsored accounts) or are tax deductible (for setting up your own), which will lower your tax bill for the year. The money in your account grows on a tax-deferred basis, which is especially important if you have an HSA that lets you invest your savings in mutual funds or other investments. When you withdraw the money in your HSA for qualified medical expenses, the distribution is 100% tax-free.
You can use your HSA funds to cover other, non-medical expenses, but you will pay taxes and a 20% penalty on those withdrawals if you’re younger than 65. Non-health care withdrawals made after age 65 are only subject to regular income tax.
7. 529 College Savings Plan
Paying for college can be a major expense, and tuition growth continues to outpace inflation. 529 savings plans are designed to make planning for it easier. while offering tax-free investment growth and withdrawals for qualifying education expenses. Open one when your child is young, and you’ll take full advantage of both tax savings and compounding interest.
Nearly every state offers at least one 529 college savings plan and you can contribute to any plan, regardless of which state you reside in. The contributions you make won’t qualify for a federal tax deduction, although a handful of states allow for deductible contributions. (See a rundown of the best 529 savings plans here.)
Look for Other Ways to Defer Taxes In Your Portfolio
While these strategies can help reduce your tax liability as you save for retirement and other financial goals, they’re not the only tax-advantaged way to invest.
Steve Azoury, owner of Azoury Financial in Troy, Michigan, says tax-deferred annuities are one way to accomplish this goal.
“Annuities allow the gains on your investment to be tax-deferred until withdrawn,” Azoury says. “Only the gains would be taxed later, so you can build up your account and delay the taxation while you’re working and in a higher tax bracket.”
Annuities don’t have required minimum distributions, but once you reach retirement, you can begin taking regular payments from the annuity to supplement your retirement income.
Other ways to save on a tax-deferred basis include traditional 401(k) plans and traditional IRAs; these don’t allow for tax-free growth, but your initial contribution doesn’t count toward your taxable income for that year.
Exploring all the options can help you create an investment strategy to make your portfolio as tax-efficient as possible.
Tips for Managing Taxes and Your Portfolio
- A financial advisor can incorporate long-term tax planning strategies into your investment and retirement plans. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- While you can use these strategies to set up multiple sources of tax-free retirement income, it’s unlikely that all of your retirement income will be able to dodge taxation. Even Social Security benefits are taxable! The good news is that some states are more friendly to retirement income when it comes to state-level income taxes. Our list of the most and least tax-friendly states for retirees may be able to help you choose a tax-friendly place to retire.
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