“It doesn’t matter how much you make, but how much you keep.” Over time, taxes can be a significant drag on returns, especially for those who are in the higher tax brackets. Today, many families are also hit with the 3.8% Medicare surtax on investment income. If you are in the top tax bracket, you could be paying as much as 43.4% (39.6% plus the 3.8% Medicare surtax) for interest income or short-term capital gains.
Even if you are not in the top tax bracket, it can still be beneficial to evaluate your portfolio returns on an after-tax basis. If you take this step, you will quickly realize that a 9% return may only net you 6% after taxes. And that means that a 6% tax-free return would be equivalent to a 9% taxable return, a return that is 50% higher!
In spite of increasing taxes, many investors miss opportunities to invest on a tax advantaged basis. Here are my five favorite ways to find tax-free growth:
1) Roth 401(k) and Roth IRA. The Roth IRA was the original tax-free account. You fund a Roth IRA with after-tax money and then you can withdraw the money tax-free once you are age 59 1/2 and the account has been open at least five years.
In the last couple of years, many employers have added a Roth option to their 401(k) plans, allowing employees to make after-tax contributions that will grow tax-free. The two big advantages of the 401(k) over the IRA are that there are no income restrictions and that you can contribute much more: $18,000 versus $5,500.
In general, most people will be in a lower tax bracket in retirement, so my recommendation is to first fund a traditional tax-deductible 401(k) before investing in a Roth IRA. However, if you are in a lower tax bracket, and aren’t looking for a current tax deduction, then the Roth 401(k) is a great choice.
A third options for some investors is the Back-Door Roth IRA, which has been available since 2010. This is an excellent option if you have already fully funded a 401(k), make too much to contribute directly to a Roth IRA, and do not have any other IRAs. Read details here.
2) Municipal Bonds. Muni bonds offer interest income that is free from Federal Income tax, and may be tax-free on the state level as well. You can buy individual bonds, or invest in a mutual fund, ETF, or closed end fund for diversification and professional management.
Muni bonds have performed strongly, along with most bond categories, in recent years. Although the interest rates today are low by historical standards, muni bonds remain an attractive investment relative to taxable bonds such as Treasuries or corporate bonds.
There are a lot of moving parts when it comes to municipal bonds, and this is not an area that I’d suggest individual investors try to do themselves. If you’re interested in munis, we can help you sort through your options.
3) 529 College Savings Account. A 529 plan works similar to a Roth: you can invest money on an after-tax basis and that money may be withdrawn tax-free when used for qualified higher educational expenses, such as tuition or room and board.
Since the primary benefit of 529 plans is tax-free growth, the best time to open one is when a child is very young. The longer the account has to grow, the more likely there will be growth and a significant tax benefit. If a child is 16, you’d only have two years before college.
My favorite strategy is for Grandparents to open 529 plans for their grandchildren. This is a great way to pass money on to your family, get that money out of your taxable estate, all while retaining some control over the distribution of this money and the investment selection. By being held in the grandparent’s name (as opposed to an account held by the parent’s or student’s name), there may be some benefits when applying for financial aid, as well.
Typically, you can only give someone $14,000 a year without having to file a Gift Tax return. However, 529 plans allow you to give five years at once, for a total of $70,000 per beneficiary. Grandma and Grandpa can give a combined $140,000 per grandchild. And if one child doesn’t go to college, you can change the beneficiary to another relative, even of another generation. The 529 plan is a great way for families to create a legacy that reinforces the importance of education. And given the soaring costs of education today, helping your children or grandchildren minimize their student loans will have a significant impact on their financial futures.
4) Health Savings Account (HSA). The HSA is arguably the best tax-free account, because it is the only one where you get an upfront tax deduction for your contribution AND you can take out your money tax-free (for qualified medical expenses). To be eligible for an HSA, you must participate in an HSA-compatible high deductible health plan.
You can use your HSA to pay for deductibles, co-pays, prescriptions, dental/vision, and other medical expenses. There is no expiration date on money in an HSA, and you can even use it in retirement to pay for your Medicare premiums. Believe me, you will not have any trouble using the money in your HSA in the future. So why not have that money growing in a tax-free account? Otherwise, many retirees have to take withdrawals from their 401(k) or IRA – and pay taxes on those withdrawals – in order to cover their medical expenses.
5) Life Insurance. Death benefits from life insurance are non-taxable to your beneficiary. Life insurance is a great way to leave money for your heirs, to provide liquidity for your estate, or to pay estate taxes, if you own assets that you don’t want your heirs to sell, such as a business or farm.
Life insurance proceeds are income-tax free, but could be subject to the estate tax if your estate is above the $5,450,000 threshold (for 2016). However, we can avoid the estate tax on life insurance by having the policy be owned by an Irrevocable Life Insurance Trust, or ILIT.
We often say that “life insurance isn’t for you”, and we don’t recommend using insurance as a savings vehicle. However, if you have more than enough for your own needs, life insurance can be an appropriate way to create a tax-free pool of money for someone you care about.
Tax-Free investing takes a bit of work, but in the long-run, you may be able to save a significant amount of money. If you’re wondering if any of these ideas would work for you, let’s talk.