Is there such a thing as a tax-free investment? The short answer is yes — but there aren’t many to choose from. The handful of tax-exempt investments out there are fixed-income securities, like municipal bonds.
But there are plenty of other ways to minimize taxes in your portfolio, including using tax-advantaged retirement accounts and strategically selling investments at a loss in order to offset capital gains.
In short, if you’re trying to skirt federal or state taxes on investments, you have options.
Tax-exempt investments tend to be most beneficial for high-income individuals, so it’s important to consider your specific tax situation when evaluating whether these securities are a good fit for your portfolio.
For example, while municipal bonds often shine for those with high incomes, lower-income investors might find better after-tax returns and diversification in taxable bonds.
(Working with a financial advisor that specializes in tax planning can also be a good way to determine the tax implications of certain investments.)
Here are four of the best investments to minimize taxes.
1. Municipal bonds
Unlike conventional bonds, where interest income is taxed at your ordinary income rate, municipal bonds offer tax-free interest income at the federal level. In some cases, you might also be able to avoid state and local taxes, especially if you invest in bonds issued by your home state or municipality.
Municipal bonds and municipal bond funds, like their taxable counterparts, come with different levels of interest-rate sensitivity and credit quality. For short-term goals, a high-quality, short-term municipal bond fund might be a suitable option. For longer-term goals, a longer-duration or lower-quality fund might be more appropriate.
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2. Tax-exempt money market funds
A money market fund is a type of mutual fund that invests in high-quality, short-term debt securities. They’re generally considered to be very low risk. Money market funds typically produce lower returns compared to other investments, but they also offer greater stability.
A specific type of money market fund — a tax-exempt money market fund — is particularly attractive to investors in higher tax brackets. These funds invest at least 80 percent of assets in municipal bonds, and, as we discussed earlier, interest income from municipal bonds is generally exempt from federal income tax.
Examples of tax-exempt money market funds include Fidelity’s SAI Municipal Money Market Fund (FMQXX) and Vanguard’s Municipal Money Market Fund (VMSXX).
While money market funds offer a safe haven for your cash, they generate lower returns than other investments like stocks, so consider your goals before investing. Factors like the fund’s expense ratio, the types of securities it holds and its credit quality should all be taken into account.
3. Series I bonds and EE bonds
While not as tax-friendly as municipal bonds, Series I bonds and EE bonds offer some attractive tax advantages. The interest earned is typically free from state and local taxes. And if you redeem the bonds to pay for qualified education expenses and your income falls below the IRS thresholds, the interest earned can be entirely exempt from federal taxes as well.
However, there’s a key caveat to qualify for the federal tax exemption on I bonds and EE bonds used for education. According to the Treasury Department, the bond owner must be at least 24 years old when the bond was issued. That means if you received these savings bonds as a child, you won’t qualify for the tax break on educational expenses.
You can purchase I bonds and EE bonds directly from the Treasury Department at TreasuryDirect.gov.
I bonds surged in popularity in 2022 as investors flocked to their attractive yields. Currently, they offer a combined rate of 3.11 percent, which includes a fixed rate and an inflation adjustment rate.
However, it’s important to note that I bond rates have been decreasing over the past year and a half as inflation cools.
4. Treasury bills
Treasury bills, or T-bills, are short-term debt securities issued by the U.S. government. Backed by the full faith and credit of the United States, they’re considered one of the safest investments out there. T-bills are sold in denominations of $100 or more and can be purchased through the TreasuryDirect website or through a brokerage account.
T-bills offer a tax advantage over many other cash equivalent investments, like high-yield savings accounts and certificates of deposit. While T-bill interest is still subject to federal income tax, it’s exempt from state and local taxes. This makes them especially attractive to investors in places with high state tax rates, such as Massachusetts and California.
With maturities ranging from one month to one year, T-bills are yielding more than 4 percent as of November 2024.
How investments are taxed
The Internal Revenue Service (IRS) taxes investment income differently than income from wages. The tax rates and the timing of when taxes are due are both different.
Investments typically generate income (and trigger taxes) in two ways:
- Capital gains: This happens when an asset, like a stock or property, increases in value. Capital gain taxes are generally only owed when the asset is sold.
- Dividends or cash income: This is money received directly from investments, such as dividends from stocks or rental income from real estate. These earnings are usually taxed in the year they’re received.
If you’re looking to minimize your investment taxes, you’ll need to explore accounts, strategies and assets that work around these rules.
Other ways to defer or reduce taxes in your portfolio
While the number of tax-exempt investments available to everyday investors is limited, there are multiple ways to lower the tax bite in your portfolio. Where you keep your assets — in a tax-advantage account or a traditional brokerage account — plays a big role.
Consider an IRA
An individual retirement account (IRA) is a powerful investment account with significant tax advantages. A traditional IRA allows you to contribute pre-tax dollars, reducing your tax burden in the year you make the contribution. Your investments within an IRA grow tax-deferred, meaning you won’t owe taxes on capital gains or dividends until you withdraw the funds in retirement. However, withdrawals in retirement are subject to income tax.
For those seeking more tax freedom in retirement, a Roth IRA is an excellent option. Contributions to a Roth IRA are made with after-tax dollars, so you won’t get an upfront tax break, but qualifying withdrawals after age 59 ½ are tax-free.
When choosing between a traditional and Roth IRA, consider your current tax situation, income level and long-term financial goals. Both types of IRAs have specific contribution limits, income eligibility requirements and withdrawal rules. For example, withdrawing earnings from either account before age 59 ½ are subject to a 10 percent early withdrawal penalty from the IRS.
Practice tax-loss harvesting
Tax-loss harvesting is an investment strategy that can help you reduce your tax burden. By selling underperforming investments and realizing losses, you can offset capital gains on other investments. The IRS allows you to deduct realized losses up to $3,000 per year. Any excess losses can be carried forward to future tax years.
For example, if you have a $10,000 capital gain and an $8,000 capital loss, you can offset the loss against the gain, resulting in a taxable gain of only $2,000.
To avoid a wash sale, which can negate your tax benefits, you must wait at least 30 days before repurchasing a similar investment after selling it.
Keep dividend-paying stocks in tax-advantaged accounts
Dividends and other cash distributions are typically taxable in the year you receive them. To minimize your tax burden on dividends, consider where you hold your investments.
For example, if you own dividend-paying stocks, it might be wise to keep them in a tax-advantaged account, like an IRA. This way, you can defer taxes on the income distributions until you withdraw the funds in retirement. Or, in the case of a Roth IRA, avoid taxes entirely.
While placing all your dividend-paying stocks in an IRA or a similar tax-advantaged account might seem appealing, it’s important to consider whether it makes sense for your portfolio and overall investment goals.
Take advantage of long-term capital gains tax rates
Capital gains are taxed differently than regular income. Long-term capital gains, which are realized after selling assets held for over a year, are often taxed at lower rates than short-term gains.
One of the most attractive features of long-term capital gains is the potential for a 0 percent tax rate. If your income falls below certain thresholds, you may not owe any taxes on these gains.
For single filers earning less than $44,625 — or married couples earning less than $89,250 in 2024 — you can avoid taxes on capital gains and qualified dividends, at least up to a certain threshold. For higher income earners, the tax rate on long-term capital gains can increase to 15 percent or even 20 percent.
By strategically timing your investment sales, you can lower or even avoid capital gains taxes entirely. If you have a year with lower income, for example, you might consider realizing some capital gains to benefit from the 0 percent rate.
Remember: Tax laws are complex and change frequently. You might consider speaking with a financial advisor or tax professional to get personalized advice and ensure you’re taking full advantage of all available tax breaks.
Bottom line
Ultimately, the decision to invest in tax-exempt securities should align with your overall investment strategy and financial goals. If these investments seem like a good fit and help you achieve your objectives, they can be a valuable way to reduce your tax burden.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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