Good investing includes minimizing taxes wherever possible. If you’ve followed me or the blog for long you’ve probably picked up on the fact that I’m a big fan of the Roth IRA for this exact reason. You pay income tax on the dollars you contribute to the account, but you never pay them afterward.
I’ve written about Roth IRAs quite a bit. Musings here on the blog have covered how to execute a back door Roth IRA conversion, a mega back door Roth IRA conversion, and when & how to convert your tax deferred savings during your retirement gap years.
Roth IRAs aren’t perfect though, and they’re not for everyone. So what other options are out there for investors trying to avoid taxes? This post will cover five.
The first tax free investing vehicle that comes to mind are municipal bonds. Municipal bonds are issued by counties, municipalities, cities, or states for the purpose of funding their operations or projects. Like other bonds, investors are typically paid interest every six months. When the bonds mature investors are repaid their principal investment, interest payments stop, and the deal is over.
Municipal bond returns come from two sources: interest and capital gains. Interest is tax free at the federal level, and almost always tax free at the state level – for bonds issued in your home state. Municipal bonds issued in other states are still tax free at the the federal level, but you’ll likely owe state income tax on the interest received.
Capital gains will be realized if you sell a municipal at a gain before it matures. If you do, the you’ll owe capital gains tax (either short term or long term, depending on how long you’ve held it) at the federal and state levels.
There are other nuances you’ll want to be clear about (the de minimis rule, and their effect on the alternative minimum tax), but municipal bonds can make a lot of sense for investors in high income tax states. Just remember that since their interest is tax free to investors, states and counties don’t typically have to pay as high a yield in the bond market.
For example, a AA rated 5 year corporate bond may need to pay 4.5% per year in interest based on the current state of the bond market. A municipality with an identical credit rating may only need to pay 3.5%. It could still make sense for high income investors in states like California, New York, New Jersey, Connecticut, etc. But for those in the lower brackets or in a state without income tax, traditional corporate bonds may be a better option.
Health Savings Accounts
Health Savings Accounts (HSAs) are just about my favorite investing vehicle these days. Yes, I like them even more than Roth IRAs. HSAs allow you to make a deductible contribution (with pretax dollars), invest the funds with tax free gains, and then take withdrawals for qualified medical expenses tax free sometime down the road.
The catch with HSAs is that you may only contribute to them if you’re enrolled in a high deductible health plan. The qualification standards for these plans vary year by year, but the idea is that they offer lower premiums and higher deductibles. They incentivize people and families to focus on preventive care to keep themselves out of the doctor’s office in the first place, rather than continually pester their providers when things go wrong.
If you have a high deductible health plan and qualify to contribute to an HSA, there are a growing number of custodians you can use. HSA Bank, Optum Bank, and Lively can all help you open & maintain an account. I can’t endorse them, as I haven’t heard enough feedback to prefer one over another. When choosing one, make sure to review the fees and investment options. HSAs providers typically offer a set of investments to choose from, so you’ll want decent, low cost funds.
529 Education Savings Accounts
Along the same lines as HSAs, 529 plans allow for tax free investing for educational purposes. While your contributions to 529 plans are not tax deductible, any and all investment gains are. The catch is that you may only withdraw funds from 529 accounts for qualified educational expenses. If you pull money out for any other reason, you’ll owe income taxes on the gains plus a 10% penalty.
529 plans are administered by state agencies, and some states’ plans are better than others. While you’re free to use any states’ plan, some states will give you a deduction (or even a tax credit) on your state income taxes for using your home states’ plan. Here is the current list.
If your state doesn’t give you a deduction on contributions (or if you live in a state without income tax at all), I’d suggest using Utah’s plan. Their plan is set up very well, is very low cost, and offers a strong selection of DFA and Vanguard fund options.
For the charitably inclined, there are a number of tax advantaged investing options. One of the most popular is what’s called a donor advised fund, which is basically a savings account for charitable contributions.
I’m a fan of donor advised funds because you have some discretion over when your contributions are disbursed. In years you need a tax deduction you can make a deductible gift to a donor advised fund, and then pick & choose when to release the funds to charitable causes of your choice. You’re free to donate basically anything too: cash, stocks, bonds, artwork, collectibles, etc.
Qualified Opportunity Zones
One of the byproducts of the Tax Cuts & Jobs Act of 2017 is qualified opportunity zones. When the bill was passed, legislators wanted to incentivize investment in low income areas around the country. To do so, the bill includes language that provides substantial tax benefits for investments made in low income zip codes around the country. There are three main tax incentives:
- Temporary Deferral. Investors in qualified opportunity zones receive temporary deferral of capital gains reinvested in opportunity zones. This means that if you have stocks, bonds, real estate, or other assets you’re holding at a gain, you may sell that position free of capital gains tax – if you reinvest the proceeds in a qualified opportunity zone.
- Step Up in Basis. Not only do you receive a deferral on gains, you also receive a 10% step up in basis if you hold an investment in a qualified opportunity zone for at least 5 years, and another 5% step up for holding an additional 2.
- Permanent Exclusion. On top of all this, investment gains in qualified opportunity zones are 100% tax free if the investment is held for 10 years. Tax. Free. This doesn’t apply to deferred gains when reinvesting in opportunity zones, but it works for any gains in opportunity zone investments.
Pretty killer tax deal, no? There is a land rush right now to develop funds and other investment opportunities in qualified opportunity zones. Several such partnerships & opportunities have come across my desk, but the costs and minimum investment requirements are significant. I haven’t recommended any to my clients yet, but I may in the future given the right circumstances. Qualified opportunity zones are probably a good topic for a future post, but for now I’m waiting for better opportunities to develop.