The 4 best investments to minimize or avoid taxes

Is there such a thing as a tax-free investment? The short answer is yes, but there aren’t many to choose from. There are only a handful of tax-exempt investments fixed income securitiessuch as municipal bonds.

But there are plenty other ways to minimize taxes in your portfolioincluding using tax-advantaged retirement accounts and strategically selling investments at a loss to offset capital gains.

In short, if you’re trying to avoid federal or state taxes on investments, you have options.

Tax-exempt investments are usually most beneficial for high-income earners. So it’s important to consider your specific tax situation when assessing whether these securities are a good fit for your portfolio.

For example, while municipal bonds often excel for high-income earners, lower-income investors may find better after-tax returns and diversification in taxable bonds.

(Work with a financial advisor who specializes in tax planning can also be a good way to determine the tax implications of certain investments.)

Here are four of the best investments to minimize taxes.

1. Municipal bonds

Unlike conventional bonds, where interest income is taxed at your normal income rate, municipal bonds offering tax-free interest income at the federal level. In some cases, you may also be able to avoid state and local taxes, especially if you invest in bonds issued by your home state or municipality.

Municipal bonds and municipal bond fundslike their taxable counterparts, have different levels of interest rate sensitivity and credit quality. For short-term goals, a high-quality, short-term municipal bond fund may be a suitable option. For longer-term objectives, a fund with a longer term or lower quality may be more suitable.

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2. Tax-exempt money market funds

A money market fund is a type of investment fund that invests in high-quality short-term debt securities. They are generally considered very low risk. Money market funds typically generate lower returns compared to other investments, but also offer more stability.

One specific type of money market fund – a tax-exempt money market fund – is particularly attractive to higher-end investors tax brackets. These funds invest at least 80 percent of their assets in municipal bonds, and as we discussed previously, interest income from municipal bonds is generally exempt from federal income taxes.

Examples of tax-exempt money market funds include Fidelity’s SAI Municipal Money Market Fund (FMQXX) and Vanguard’s Municipal Money Market Fund (VMSXX).

Although money market funds provide a safe haven for your money, they generate lower returns than other investments such as stocks. So think carefully about your objectives before investing. Factors such as those of the fund expense ratiothe types of securities it holds and their credit quality must be taken into account.

3. Series I Bonds and EE Bonds

Although not as tax-friendly as municipal bonds, Series I Bonds and EE bonds offer a number of attractive tax benefits. The interest earned is generally free of state and local taxes. And when you pay off the bonds pay for qualified education expenses and your income falls below the IRS thresholds, the interest earned may also be completely exempt from federal taxes.

However, there is an important caveat to qualifying for the federal tax exemption on I bonds and EE bonds used for education. According to the Treasury Department, the bond owner must be at least 24 years old when the bond was issued. This means that you have received it savings bonds As a child you are not eligible for the tax benefit on education expenses.

You can buy I bonds and EE bonds directly from the Ministry of Finance at TreasuryDirect.gov.

I-bonds became increasingly popular in 2022 as investors flocked to their attractive returns. They currently offer a combined rate of 3.11 percent, which includes a flat rate and an inflation adjustment rate.

However, it is important to note that I-bond yields have fallen over the past year and a half as inflation cools.

4. Treasury bills

Treasury bills, or T-billsare short-term debt securities issued by the U.S. government. Backed by the full faith and credit of the United States, they are considered one of the safest investments available. T-bills are sold in denominations of $100 or more and can be purchased through the TreasuryDirect website or through a brokerage account.

T-bills offer a tax advantage over many other cash equivalent investments, such as savings accounts with a high return And certificates of deposit. Although interest on T-bills is still subject to federal income tax, it is exempt from state and local taxes. This makes them especially attractive to investors in places with high state tax rates, such as Massachusetts and California.

With maturities ranging from one month to one year, government bonds will yield more than 4 percent from November 2024.

How investments are taxed

The Internal Revenue Service (IRS) taxes investment income differently than wage income. The tax rates and when taxes are due are both different.

Investments generally generate income (and trigger taxes) in two ways:

• Added values: This happens when an asset, such as a stock or real estate, increases in value. Capital gains tax is generally only due when the asset is sold.

• Dividends or cash income: This is money received directly from investments, such as dividends from shares or rental income from real estate. This income is generally taxed in the year in which it is received.

If you want to minimize your investment taxes, you should explore accounts, strategies, and assets that avoid these rules.

Other ways to defer or reduce taxes in your portfolio

While the number of tax-free investments available to ordinary investors is limited, there are several ways to reduce the tax burden in your portfolio. Where you keep your assets – in a tax-advantaged account or a traditional investment account – plays a major role.

Consider an IRA

An individual retirement account (IRA) is a powerful investment account with significant tax benefits. A traditional IRA allows you to contribute pre-tax dollars, reducing your tax burden in the year you make the contribution. Your investments within an IRA are tax deferred, meaning you won’t owe taxes on capital gains or dividends until you withdraw the money in retirement. However, income tax is due on withdrawals at retirement.

For those looking for more tax freedom in retirement, a Roth IRA is an excellent option. Contributions to a Roth IRA are made with after-tax dollars, so you won’t get an upfront tax benefit, but eligible withdrawals after age 59½ are tax-free.

When choosing between a traditional and Roth IRAconsider your current tax situation, income level, and long-term financial goals. Both types of IRAs have specific contribution limits, income requirements and withdrawal rules. For example, if you withdraw earnings from either account before age 59.5, you will be charged a 10 percent early withdrawal penalty from the IRS.

Practice tax loss harvesting

Harvesting tax losses is an investment strategy that can help you reduce your tax burden. By selling underperforming investments and realizing losses, you can offset capital gains on other investments. The IRS allows you to deduct realized losses up to $3,000 per year. Any excess losses can be carried forward to future tax years.

For example, if you have a capital gain of $10,000 and a capital loss of $8,000, you can offset the loss against the gain, resulting in a taxable gain of only $2,000.

To prevent one washing salewhich could wipe out your tax benefits, you should wait at least 30 days before repurchasing a similar investment after selling it.

Store dividend-paying stocks in tax-advantaged accounts

Dividends and other cash distributions are generally taxable in the year you receive them. To minimize your tax burden on dividends, consider where you keep your investments.

For example, if you own dividend-paying stocks, it may be wise to keep them in a tax-advantaged account, such as an IRA. This way you can defer taxes on income distributions until you withdraw the money in retirement. Or, in the case of a Roth IRA, avoiding taxes entirely.

While it may seem appealing to put all your dividend-paying stocks into an IRA or similar tax-advantaged account, it’s important to consider whether this makes sense for your portfolio and overall investment goals.

Take advantage of long-term capital gains tax rates

Capital gains are taxed differently than ordinary income. Long-term capital gainsrealized after the sale of assets held for more than a year are often taxed at a lower rate than short-term gains.

One of the most attractive features of long-term capital gains is the potential for a 0 percent tax rate. If your income falls below certain limits, you may not owe taxes on these winnings.

For single filers earning less than $44,625 – or married couples earning less than $89,250 in 2024 – you can avoid taxes on capital gains and qualified dividends, at least up to a certain threshold. For people with higher incomes, the tax rate on long-term capital gains can rise to 15 percent or even 20 percent.

By strategically timing your investment sales, you can reduce or even equalize sales figures avoid capital gains taxes completely. For example, if you are having a lower income year, you may want to consider realizing some capital gains to take advantage of the 0 percent rate.

Remember: tax laws are complex and change frequently. You might consider talking to A financial advisor or tax professional to receive personalized advice and ensure you take full advantage of all available tax benefits.

In short

Ultimately, the decision to invest in tax-exempt securities should align with your overall investment strategy and financial goals. If these investments are a good fit for you and help you achieve your goals, they can be a valuable way to reduce your tax burden.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.