Here’s a rhetorical question: who doesn’t want to reduce their tax bill? The famous saying is “death and taxes,” but while no one has found a way to cheat death, there are a couple of ways to cheat the Internal Revenue Service. By cheat, we mean skirt in totally legal ways, because believe it or not there are ways to invest tax-free that the IRS approves of. Or, at least, the IRS tolerates certain tax-free investments in the spirit of incentivizing financial activity it approves of, such as investing in local and state government bonds and saving for retirement (although most retirement savings are tax advantaged, not completely tax-free.)
Before we dive in to a couple of options, there are two big issues to put on the table. The first is fairly self explanatory, but is sometimes overlooked: don’t make tax-exempt investments in a tax-advantaged retirement account like an IRA. This kind of defeats the purpose. Second, it is sometimes only worth the effort to make tax-exempt investments if you are in a higher income bracket because they generally have lower returns.
The general reasoning is straightforward: the higher your tax rate, the more you stand to benefit from dodging that tax rate where possible. For example, at a 25 percent tax rate, a tax-free investment yielding 5 percent is better than an equivalent taxable investment yielding 6.5 percent. With that said, here are a couple of options to consider.
1. Muni, muni, muni
The government likes to provide tax incentives for good financial behavior — and if you’re Uncle Sam, what’s good for you is citizens investing in local and state government debt. Municipal bonds (munis) are generally tax exempt for people who reside in the places that issue them. So if you live in Boston, Massachusetts and you buy a Boston bond, the income you make from interest could be tax exempt across the board. If you live in Texas, however, and still decide that you really want a piece of that Massachusetts debt, it’s unlikely that your local government will let you get away with earning that money tax-free.
If investing directly in the debt of a particular municipality doesn’t float your boat, municipal bond focused mutual funds do exist. As with any investment, municipal bonds do carry some risk, including interest-rate risk, and a mutual fund can help protect against it.
Read More: The ABC of Investing in Bonds
2. Go to school
A 529 plan — named after the section of the Internal Revenue Code it’s found in — is a special savings plan designed for those saving for college. Contributions are not tax deductible, but investments grow tax deferred and any distributions used to pay for the beneficiary’s college costs come out tax free at the federal level. In same cases, distributions may also be tax-free at the state level.
3. Invest in others
Investing isn’t always about how much you can increase your own wealth. Thanks to the power of compounding interest and tax laws surrounding gifting, a savvy investor can give their spouse and/or children a head start on a retirement or a huge leg up in life. Investing in a Roth IRA for a child gives them not just the value of the principal, but the amazing returns that compounding interesting can provide over a lifetime.
In general, gifts to a spouse are not taxed, and parents can gift up to $14,000 to a child without paying taxes on it. Remember that this is an annual tax exclusion that applies to each recipient individually. There are lifetime gift tax exemption limits, but most people don’t have to worry about hitting this.