Reducing taxes through ‘tax free investments’ may be a good idea when one wants to increase financial leverage of one’s income and/or lower taxable income for a given year via a lower tax bracket ex 15% instead of 25%. Moreover, the income that would have been taxed that is invested, can also increase either free of tax or tax deferred through the tax free investments. A few of the investments commonly used as a hedge against taxes are described below.
Tax Free Mutual Funds:
Money invested in tax free mutual funds is not taxed because the mutual funds themselves invest in tax free investment vehicles. Depending on which type of investments the mutual funds the income earned in this type of investment instrument is not taxable as the federal level and sometimes the state and local levels.
Individual Retirement Accounts (IRA’s):
There are several types of IRA’s including spousal, individual, and Roth IRA’s. Some of these are tax deductible while others are tax free investments. Either way, investment in retirement accounts is a way to avoid taxes either in the present or future.
Municipal bonds are bonds issues by States and local governments. Income earned from these investments is often free of Federal tax but they may also have a lower interest yield than other forms of investment.
The Federal government also issues bonds, at least two of which can earn tax deferred income. The series I and E/EE bonds are not taxed until redemption making them a possible investment option for those seeking to lower short term taxable income on investments.
Life Insurance Policies:
Money invested in life insurance policies accumulates and increases in value without tax. Examples of such policies include universal and whole life policies through which an account value is added to over and above the monthly premiums paid on the policy. In certain instances the distribution of life insurance after the policy holder’s death may be tax free and should the holder survive the maturity of the policy, the proceeds are then subject to tax i.e. tax deferred.
While personal residences are subject to property tax regulations, gains on the sale of homes after 2 years of residence are tax free up to a certain dollar amount. If the home value is above 250K, capital gains on it are taxable if there is only one owner. This tax cap amount doubles for homes with more than one owner/resident.
While education is not an investment that pays solid returns, the investment made into and education is tax deductible on the Internal Revenue Service form 1040 as of the date of this article. The tax deduction may be enough to lower one’s taxable income into a lower tax bracket.
There are many ways to invest and avoid paying taxes on those investments. In many of the cases the tax benefit is tied to a provision the money will not be used for an extended period of time or it is only taxed upon withdrawal. Whatever the investment one makes, the benefits can add up either as tax deferred income growth and/or increased financial leverage via a higher tax return or money saved through a lower taxable income.