Tax-free investments may sound too good to be true. Not only do you have the potential for a return, but you’re able to avoid taxes as well.
While there are benefits to tax-free investments, not all of them are created equal. Some have tax benefits across federal, state, and local taxes (called triple-tax-free) while others do not. There are usually restrictions to follow so that the tax shelter remains in place.
Tax-free investing is often confused with tax-deferred investing. These are two very different things. With a tax-free investment, you actually avoid paying related taxes. With a tax-deferred investment, taxes must still be paid, although at a later date.
We start this article off by identifying tax-deferred investments that are often thrown into the tax-free bag. Then we move into true tax-free investments.
Tax-deferred investments are not the same as tax-free investments. Mainly, the difference is that contributions to tax-deferred investments go in untaxed. But when money is withdrawn, the principal and growth are taxed. With tax-free investments, the contribution goes in taxed, but withdrawals are tax-free, including principal and growth (if the withdrawal is qualifying). There might be slight differences depending on the investment, but most follow this general guideline.
There are also some ways to withdraw money from these tax deferred accounts without triggering penalties.
The following are tax-deferred investments. At some point, you’ll have to pay taxes on them (based on your tax bracket).
- 401(k) and 403(b) employer-sponsored retirement plans
- Traditional IRA
- 1031 exchange
- Opportunity Zone investments
Some may consider a charitable donation a tax-free investment. However, giving is not the same as investing. When you invest, you expect a monetary return or some material return. When you donate, you do not expect a return. That said, many donations are tax-deductible.
The following list has true tax-free investments.
With a Roth IRA, you make contributions with after-tax money, but after that point, everything is tax free. You can contribute to a Roth IRA as long as you meet certain income qualifications. There are also Roth IRA contribution limits you have to follow.
But the benefits of a Roth IRA are huge - tax free growth and tax free withdrawals! That's huge.
See our list of the best IRA accounts here.
Don’t confuse a Roth IRA with a Roth 401(k). While they are similar, there are some important differences. One thing both have in common is that growth and withdrawals are not taxed. Contributions go in tax-free. So why choose one over the other?
The main reason to go with a Roth 401(k) is that it doesn’t have income limitations. Income cutoffs for a Roth IRA are a modified adjusted gross income (MAGI) of $137,000, or for married filing jointly, MAGI must be less than $204,000.
Additionally, you can only access a Roth 401(k) as an employee. In other words, if your employer doesn’t offer a Roth option within your 401(k), you can’t contribute to a Roth 401(k).
The contribution limit for a Roth 401(k) is $19,000; or if you’re over 50, you can add an extra $6,000. The contributions limit can also be split across the Roth IRA and Roth 401(k).
Health Savings Account (HSA)
HSAs are available to high-deductible health insurance plans. The HSA is a mixed bag — contributions go in pretax, and eligible withdrawals are tax-free, but earned interest is tax-deferred.
HSAs are also subject to contribution limits each year. See the current limit here: HSA Contribution Limits.
The trick to an HSA is that you should consider it like an IRA - and NOT use it for healthcare expenses. That's where the real power of using an HSA comes in. Check out this guide: Using your HSA as an IRA.
Municipal bonds are issued by a state, country, or city. These bonds are considered safe investments since they are backed by the issuing government. Returns are generally on the lower side.
Earnings are exempt from federal, state, or city taxes, depending on where you live and the type of bond. Some municipal bonds are triple-tax-free, meaning they are exempt from all three government entities.
While a triple-tax-free municipal bond might sound appealing, you may be surprised to learn that similar taxable investments offer a better return, net of taxes.
Tax-Free Bond Exchange-Traded Funds and Bond Mutual Funds
Similar to municipal bonds, certain bond ETFs and mutual funds are tax-free. These funds are generally easier to buy and sell than municipal bonds. Being funds, they often contain several different types of bond investments with varying tax-free shelters.
Just like individual bonds, you need to make sure you are buying a fund that has bonds in your state so you get the tax exemption.
For example, if your live in California, you want to invest in California municipal bonds. An example ETF would be the California Municipal Bond iShares (CMF).
529 Education Fund
Contributions to a 529 are after-tax and cannot be deducted on your Federal income taxes (however, some states do offer state tax deductions for contributions).
Growth is exempt from federal taxes when funds are used for eligible expenses. Eligible expenses include tuition, books, computers, and fees. Using the funds for non-qualifying expenses will result in a 10% penalty. See this guide to qualified 529 plan expenses.
529s are very state-dependent in regards to taxes and available investments. Most states allow up to $300,000 in contributions. There are no income limitations.
Find the best 529 plan for your state here:
U.S. Series I Savings Bond
Earnings on Series I bonds are not subject to state or local taxes. However, federal taxes must be paid.
The great thing about I Bonds is that you can opt to not pay any taxes on the interest until you redeem them. This makes keeping track of your bonds easier.
Many websites tend to use “tax-free” and “tax-deferral” interchangeably. As we’ve seen, the two terms are very different. Knowing these differences can help you make better-informed decisions about which type of investments to choose.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him here and here.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.