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Taxes are never fun — especially when they take a chunk out of an otherwise healthy investment return. Here’s how tax-free investments work and how to wield them to your advantage.
Are any investments fully tax-free?
Sadly, a true tax-free investment doesn’t exist. In some form of another, you’ll need to pay taxes on what you earn. Even so-called “tax-free investments” have taxes associated with them — but you end up paying them in a different way or at a later date.
That said, there are tax-efficient accounts and investments that can help minimize the taxes you owe. You might not avoid having to pay taxes entirely, but you may reduce their impact on your bottom line.
Tax-advantaged investment options
There are numerous tax-advantaged accounts and investments that can help maximize your returns.
- What’s the catch? You pay taxes on Traditional 401(k) returns once you retire and Roth 401(k) contributions can only be made with after-tax dollars.
A 401(k) is a tax-advantaged retirement account named after a section of the US Internal Revenue Code. This account is typically offered through your employer and you can make regular contributions to the account through automatic payroll withholding. Some employers match employee contributions, but this isn’t a requirement. The Internal Revenue Service limits annual 401(k) contributions up to a set dollar amount. In 2020, the combined 401(k) contribution limit was $57,000.
There are two types of 401(k)s: Traditional and Roth. What separates these accounts is how they’re taxed. Traditional 401(k)s aren’t taxed on their contributions, but withdrawals are subject to tax. Roth 401(k)s don’t tax withdrawals, but contributions can only be made with after-tax earnings.
Gifts and donations
- What’s the catch? You don’t get to pocket the profits and whoever you give the stock to will eventually have to pay capital gains tax on it — unless it’s a nonprofit.
One way to avoid paying tax on an investment is to give it as a gift to a friend, family member or charity. You won’t be able to cash in on the value of the stock, but you’ll receive a deductible credit for what you spend depending on how long you held the stock.
If you give the gift of a stock you’ve held for less than one year, you’ll receive what you initially paid for the stock as a deductible credit against your annual income. If you give the gift of a stock you’ve held for more than one year, you’ll receive what you initially paid for the stock plus any gains the stock has made as a deductible credit against your annual income.
The downside to this is that the person you give the stock to will eventually need to pay capital gains tax on the investment unless it’s a nonprofit organization.
You should also be wary of gift tax. Any gift over $15,000 needs to be reported, but gift tax isn’t due until the lifetime gift exemption limit is reached. As of May 2020, this limit was $11.58 million.
529 education fund
- What’s the catch? The funds in this account are tax-free as long as they’re used for qualifying educational purposes.
A 529 education fund is a tax-advantaged investment account designed for educational purposes — the funds grow tax-free and can be used to cover eligible educational expenses like tuition, books and supplies. These accounts can be opened through state-run plans or through a Private College 529 plan. State-run plans offer the added benefit of potential state income tax deductions or tax credits.
The funds in this account — including interest, dividends and capital gains — grow tax-free. But if you use account funds for any nonqualifying expense, not only will you be dinged with taxes, but you’ll also pay a 10% penalty.
- What’s the catch? You’ll pay taxes on any bond purchased outside your state. And if you sell a bond before it matures, you’ll owe federal and state capital gains taxes.
Bonds are investment vehicles used by governments and corporations to raise money from investors. When an investor purchases a bond, the cost of the bond is forwarded to the issuing agency. The investor receives interest over the term of the bond until its maturity date, when the bond is repaid in full.
Municipal, treasury and Series I bonds all offer tax advantages. Treasury and Series I bonds are typically free from local and state taxes, while municipal bonds are often exempt from local, state and federal taxes. But if you purchase a municipal bond from a state outside your own, you’ll be met with state taxes. And if you sell a bond before its maturity date, you’ll be expected to pay capital gains taxes on your profit.
Other ways to maximize tax deductions
While pursuing tax-efficient investment strategies may sound like more hassle than it’s worth, it’s far more preferable than skipping out on what you owe. There can be major penalties for failing to pay owed taxes, including garnished wages, property seizure and even jail time. Here are a few more ways to maximize your tax deductions:
- Tax-advantaged managed portfolio. Some investment platforms, like Ally Invest, offer hands-off portfolio management. If you prefer to leave your assets in the hands of a financial advisor, a portfolio can be built around your long-term investment goals guided by tax-advantaged investments.
- Robo-advisor with tax-loss harvesting. Robo-advisors like Betterment and Wealthfront come equipped with tax-advantaged accounts, tax-loss harvesting and automatic portfolio rebalancing to help you minimize what you owe.
- Hire an accountant. If you’re worried about filing and feel more comfortable relying on a professional, consider hiring an accountant. An accountant will help you identify opportunities to maximize your deductions while ensuring your taxes are filed correctly.
What is tax-loss harvesting?
Tax-loss harvesting is an investment strategy that involves strategically selling down investments at a loss to claim against your income. Then, you purchase a new investment in a similar sector or industry to maintain portfolio diversification. The process can help you save on capital gains taxes.
You can engage in tax-loss harvesting on your own, but the strategy requires you to consistently monitor your investments. If you’re uncomfortable executing the strategy, robo-advisors and financial advisers can employ it on your behalf.
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True tax-free investments don’t exist. But there are numerous tax-advantaged accounts and investment options for those looking to cut down on what they owe.
Explore your account options with numerous brokerages to find the platform that best fits your investment strategy.
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