What are tax-free investments?

How are investments taxed?

Investments are a great way to grow your income and achieve financial freedom. But when choosing investments, it's essential to consider how taxes impact your investment since you'll pay for them in one way or another.

The tax rate varies based on your tax bracket and the type of investment. Here are some examples:

• Taxes on capital gains: Capital gains are the profits you earn from selling an asset, a business, a piece of land or even a stock. These proceeds are considered taxable income. If you've had the asset for less than a year, you pay taxes based on your ordinary income tax rate. If you've held the asset for over a year, the tax rate will be 0%, 15% or 20%, based on your taxable income.
• Taxes on interest: Interest that you have received in your account and can withdraw without penalty is considered taxable income in the year it becomes available to you. This includes interest on bank accounts, certificates of deposit (CDs), savings bonds, etc. Interest is taxed as ordinary income, meaning the rate depends on your tax bracket.
• Taxes on dividends: Dividends are a share of a company's profit distributed to its shareholders. They are classified into two groups (qualified and nonqualified/ordinary), and they're taxed differently. Nonqualified dividends are taxed like ordinary income based on your tax bracket, while qualified dividends’ tax rates are 0%, 15% or 20%, based on your taxable income.

» MORE: Are personal loans taxable and considered income?

Types of tax-free investments

Taking advantage of tax-free investments can help significantly reduce your tax bill. This is especially helpful if you're currently in a high tax bracket. Lowering the tax you owe maximizes your returns and leaves you more funds to invest and grow your income.

Keeping that in mind, here are some tax-free investments to consider.

Municipal bonds

A municipal bond is a type of debt obligation issued by local, county or state governments. It acts as a loan in which investors are creditors. At the end of the maturity date, creditors are repaid their principal and interest.

Unlike the interest you get from other bonds, interest from municipal bonds is exempt from federal income tax, which makes the investment very attractive for individuals in high tax brackets.

The cherry on top is if you reside in the state where the bond was issued, the interest may be exempt from state and local taxes, too.

Roth IRA

A Roth IRA differs from traditional IRAs, where you contribute before-tax dollars and pay taxes when withdrawing your funds.

A Roth IRA is a retirement account that allows you to contribute post-tax dollars. While Roth IRA contributions aren't tax-deductible, saving after-tax dollars for retirement is a great financial strategy for the future.

Another benefit of investing in a Roth IRA is that you can tap into your contributions without penalties. While you will be penalized if you withdraw your earnings before the age of 59½, there are exceptions to this rule. For example, you can withdraw your contribution and earnings for purchasing your first home penalty-free and tax-free after five years.

» MORE: Traditional IRA vs. Roth IRA

Health Savings Account (HSA)

An HSA is an account you can use to cover various medical costs. It is only available for individuals with a high-deductible health insurance plan.

HSA contributions are tax-deductible, and if you invest the funds in mutual funds or other securities, the earnings continue to grow tax-free. The earnings can be withdrawn tax-free to cover qualifying medical expenses at any time.

“HSAs are one of the best savings vehicles available today, offering prized triple-tax savings, “ said Stephen Kates, principal financial analyst for Annuity.org. “Contributions are made pre-tax, growth is tax-free and withdrawals for qualified medical expenses are also tax-free.”

One of the most significant advantages of HSA contributions is that the funds do not expire. When you turn 65, you can use the money for expenses other than medical costs; in this case, it is considered taxable income, and you'll pay taxes on it.

Flexible spending accounts (FSA) are different in that they have an expiration date, making them only valuable in the short term. If you stay healthy the entire year and end up with a balance in your account, those funds go back to your employer. Some workplaces allow a grace period of up to March or roll over a portion of the money to the following year, but it's not required by law.

529 college savings plan

A 529 plan is a tax-advantaged college savings account that allows you to pay for a beneficiary's qualified education expenses. The rules and regulations around a 529 college savings account have changed for the better, making it a more attractive investment.

Investments made in this account grow tax-free, and if the earnings are used for qualified educational expenses, the withdrawals are still tax-free. In some states, contributions to a 529 account are tax-deductible.

Another advantage of a 529 account is the flexibility. You can transfer the money to another qualified beneficiary if the primary one does not attend college. Also, if the account is at least 15 years old, the beneficiary can roll over up to $35,000 to their Roth IRA (within a five-year period).

Lastly, you can use the distributions for other costs, but they will be considered income tax, so you'll owe tax. You'll also be subject to a 10% penalty on the earnings.

Benefits of tax-free investing

Taking advantage of tax-free investments means maximizing returns on your investment by allowing it to compound without the tax burden. Some tax-free investments are also tax-deductible, so they lower your current tax bill.

Post-tax contributions, such as to a Roth IRA, allow you to save and invest for the future without worrying about paying Uncle Sam during your prime years.

“There is a saying, ‘What’s important isn’t what you make, it’s what you keep’ and that gets to the heart of tax-free investing,” said Kates. “When you invest in a tax-free investment, any income or growth remains 100% yours to use and no cut will be owed for taxes. Firstly, this keeps more money in your pocket, and secondly, it makes planning for income much easier.”

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Bottom line

One way or another, you'll have to pay taxes on your investments. But by taking advantage of tax-free investments, you allow your earnings to compound, maximizing your returns.

Only some tax-advantaged investments are suitable for your portfolio in the long run, so it's important to do your due diligence before any investment.