The Best Tax-Free Investments for Smart and Efficient Investing

One of the most fundamental aspects of wealth management and growth is the managing of your taxation through smart investment strategies. With long term investments it's crucial to retain every percentage point of profit especially in investments with compounding interests. This is why all experienced investors focus on tax strategies that focus on keeping more of what they earn.

Focusing on tax-efficient investing is a way to maximize after-tax returns by understanding how to legally avoid or reduce your tax liabilities. By carefully selecting the right types of account, timing and assets, you can greatly maximize your returns while reducing tax liabilities.

The Types of Tax Exposure in Investing

There are many common types of investing accounts subject to varying taxation rules. Some are taxable while others can be tax-advantaged. 

Taxable accounts like brokerage accounts allow you to invest in the stock market and purchase and sell stocks, ETFs, mutual funds, etc.. These accounts don’t come with imposed limitations on withdrawals or contribution limits but require that you settle your tax payments when you make a profit. Profit can be gained and taxed in the following manner:

• Capital Gains Tax: Capital gains are profits that you’ve made by selling an asset for more than you’ve paid for it. Usually, long-term gains tend to get preferable rates as opposed to short-term gains, but other factors also contribute to the amount you have to pay. Have a look at the calculations used for capital gains by the IRS to determine how much you may owe.
  
  
• Dividend Tax: Dividends are payments paid out by companies to shareholders, usually at regular intervals, as a share of the profits made by the company. Certain dividends are taxed at the same rates as capital gains while others may be taxed as ordinary income.
  
  
• Interest Income: If you receive earnings from bonds, savings accounts and similar assets, these are usually taxed as regular income.

Taxation Methods for Tax-Advantage Accounts

There are two types of tax-advantaged accounts, tax-deferred and tax-exempt. Tax-deferred accounts allow you to continue investing pre-tax dollars into something like an IRA or 401 (k) and not worry about paying tax until you decide to withdraw the money. Given that contributions to these accounts are tax-free, they can reduce your taxable income for the year and then when you're ready to withdraw, preferably when you're in a more favorable withdrawal bracket such as in your retirement, you can do so without losing so much through taxes. 

Tax-exempt investments are made with after-tax dollars and their major benefit is that some qualified withdrawals can be completely tax-free. These accounts include things like your Roth 401 (k) and Roth IRA. In these types of accounts your money can grow tax-free and be qualified for withdrawal in retirement, exempt from taxes.

The Best Tax-Free Investment Options

1. Roth IRA

As a tax-advantaged account option, a Roth IRA lets you contribute already taxed money to your retirement. This model allows you to grow your wealth over a long period of time and enjoy tax-free withdrawals in your retirement. A Roth IRA can be one of the best options for long-term, relatively passive, wealth preservation and growth mechanisms, especially for younger investors.

2. Health Savings Account (HSA)

Usually skipped over by investors, a HSA can be a highly tax-efficient investment option. A HSA lets you make tax-deductible contributions while helping your funds grow tax-deferred. Withdrawals for medical expenses are also tax-free, and after the age of 65 you can even withdraw funds for non-medical purposes without a penalty, although these funds will be taxed like a traditional IRA.

3. Municipal Bonds

Issued by state and or local governments, municipal bonds or “munis” are debt securities that provide tax-exempt interest growth at the federal level. You could even expect state and local level municipal bonds if you live in the issuing state.

These bonds are issued to fund development projects at the local level and are a great way to invest, especially for high earners looking for a steady, predictable income stream. Returns however tend to be lower than traditional taxable bonds but sometimes the savings in taxes can make them a more appealing option.

4. 529 College Savings Plans

Setting money aside for education is best done through a 529 plan as it can be one of the best tax-free investment options for this purpose. You can make contributions with after-tax dollars and your earnings will grow tax-free all the while education-related withdrawals stay tax-free.

Tax Efficient Investing Through ETFs and Index Funds

A key investing vehicle for those looking at tax-efficient and tax-free investment options is the exchange traded fund ETF and other low-turnover, passive funds such as the Vanguard index funds.

Compared to traditional mutual funds, ETFs outperform on the tax front thanks to their inherently tax-efficient investment vehicle that facilitates redemption transactions. Generally, holding ETFs in a taxable account tends to generate less tax liabilities than investing into a mutual fund with a similar structure.

As far as the IRS is concerned the tax treatment for both mutual funds and ETFs has no inherent difference. Both types of funds are subject to the capital gains tax and to the taxation of dividend income, as discussed above. The difference comes from the way these funds are structured and managed. 

In essence, ETFs come with less “taxable events” and are only taxed after the ETF is sold and capital gains occur. This final taxation of the ETF is much less than what an investor would have paid as part of a mutual fund since mutual funds are continuously re-balanced through the sale of securities.

Key Tax Advantages of ETFs

Here’s a quick overview of how the ETF structure helps with the retention of capital through better tax management.

• Fewer Distributions of Capital Gains: Capital gains occur less frequently on ETFs compared to mutual funds and are thus taxed less often.
  
  
• Tax Deferral: You could hold on to your ETF investments for years and pay taxes only once you sell.
  
  
• Dividend Reinvestments: Most ETFs let you reinvest your dividend payments which is not only a smart investment decision long-term but also a tax break since those reinvestments will only be taxed once you sell your ETF holdings

Tax-Advantaged Accounts Overview

Below we’ve created an overview of the most common types of tax-advantaged accounts along with their tax benefits and contribution limits for this year.

Advice for High Earners

High-income individuals should take extra steps to ensure efficient wealth management. Apart from managing their finances through a qualified professional high earners should consider the following:

• Maximize tax-advantage accounts: Your Roth IRA, 401 (k), HSA should be fully funded.
  
  
• Consider municipal bonds in taxable accounts: When available, consider municipal bonds as they can be a stable wealth preservation mechanism, as discussed above.
  
  
• Hold high-growth investments for longer: Avoid realizing gains prematurely, invest for longer periods of time.
  
  
• Consider tax-loss harvesting: You could offset your tax bill by offsetting your gains with losses to reduce taxable income.

Commonly Asked Questions About Tax-Free Investing

Is There Such Thing as a Truly Tax-Free Investment Option?

Yes, but not in the traditional market space. Stock market trading and investing is almost always taxed, however options such as municipal bonds, Roth IRAs and HSAs are a way to invest your money and preserve your wealth long-term and potentially tax-free.

What is the Difference Between Tax-Deferred and Tax-Free Investments?

Tax-Deferred means that taxes will be paid at a later date, usually at the time of sale when profits are made while tax-free means that an investment is completely exempt from taxation.

Can I Avoid Taxes on Investments?

Realistically, if you’re investing in the stock market, no. As discussed in our article, taxation models vary depending on the type of investment. Depending on your investment strategy you can drastically reduce how much you end up paying in taxes through things like tax-advantaged investment accounts, tax-efficient fund choices, and strategic planning, but in the traditional sense of the word, investing is not, for the most part, tax-free.

Bottom Line

Through smart investment decisions and careful planning you can greatly mitigate the amount of investment income you lose through taxes. Wealth management usually comes down to preferable funds, careful selection of investment avenues, the maxing out of things like your Roth IRA, HSA, 401 (k) and the utilisation of tax-deferred mechanisms.

You can prioritize these things first and then focus on municipal bonds, ETFs and strategies like loss harvesting, asset location and buy-and-hold investing through products such as the Vanguard index funds and low-cost ETFs.

With these strategies you should expect to keep more of your wealth as it’s a smarter way to allocate your financial resources for long term growth.