Benjamin Franklin, one of the founding fathers, once famously said: “… in this world, nothing is certain except death and taxes.” While these words hold some weight, they’re not entirely true, at least where taxes are considered. Contrary to popular belief, there are investments that may offer tax savings and be appropriate to include in your portfolio. In this article, we’ll cover in detail five tax-advantaged investments to consider adding to your portfolio to reduce or avoid paying taxes on certain investments. 

What Are Tax-Advantaged Investments?

Investing is an important way to grow your assets over time, but taxes are a necessary factor to consider in your portfolio structure when choosing which investments to include and how long to hold them. Understanding which investment vehicles are tax-exempt or tax-deferred is the first step to building a tax-efficient portfolio.  

There are three main ways investments are taxed: 

1. Taxes on dividends – dividends are payments companies may make to their shareholders. If you receive dividends from any stock you own, you’ll be responsible for paying the applicable taxes. According to U.S. News, the maximum rate on qualified dividends is 20% for U.S.-based companies. 
2. Taxes on interest – if you earn interest on any investments, you’ll owe taxes at ordinary tax rates, dependent on which tax bracket you’re in.
3. Capital gains taxes – capital gains are taxed when you sell an asset for more than you paid for it. They can be either short-term or long-term, and most tax rates for capital gains are no higher than 15%. Read more about capital gains here.  

Some options provide more tax advantages than others.  

• If you want to avoid paying taxes on your gains, you can invest in municipal bonds, tax-exempt mutual funds, tax-exempt exchange-traded funds (ETFs), and indexed universal life (IUL) insurance.  
• If you want the growth and distributions in your retirement account to be tax-exempt, you might opt for a Roth IRA instead of a 401(k) or traditional IRA. 

Municipal Bonds 

Municipal bonds, also known as “munis,” are debt securities issued by states, cities, counties, and other governmental entities to fund day-to-day necessities and finance projects such as highways, schools, and other essential infrastructure. As an investor, when you buy bonds, you lend your money to a borrower (in this case, the government), and in exchange, you earn interest on the money you loaned. 

There are typically three types of municipal bonds:  

1. General obligation bonds – not secured by any assets; they are backed by the bond issuer, which usually has the power to tax residents to pay investors
2. Revenue bonds – backed by revenues from a project or source, such as highway tolls
3. Conduit bonds – bonds issued on behalf of private entities, such as hospitals or colleges 

Any gains from municipal bonds are usually exempt from federal taxes. This tax exemption may apply to state and local taxes as well, depending on the bond; however, any gains from municipal bonds are subject to alternative minimum tax (AMT). According to the Internal Revenue Service (IRS), AMT “applies to taxpayers with high economic income by setting a limit on those benefits. It helps to ensure that those taxpayers pay at least a minimum amount of tax.” To learn if you’ll be subject to the alternative minimum tax, it’s best to consult with a tax professional.  

Bonds have a low risk of default and may be a good addition to some portfolios, especially for more risk-averse investors or as a method of diversification. It’s also important to understand that all investments have risks. Inflation can impact the bond’s interest rate and the underlying returns you receive. Per Investopedia, if you own a revenue bond, and if the revenue stream dries up for the bond that you own, you can potentially lose your investment, and you will not have a claim on the underlying revenue source. The same goes for conduit bonds. If the conduit borrower fails to pay the bond issuer, the issuer doesn’t have to pay you, and you may lose out on your investment. 

Tax-Exempt Mutual Funds  

Mutual funds are usually invested in a combination of asset classes such as stocks, bonds, ETFs, and other securities. Some mutual funds are actively managed by an investment manager, who tries to beat the return of a market index such as the S&P 500. Other mutual funds are passively managed to track a popular market index and attempt to mirror the return of the index that it’s tracking. Then, there are tax-exempt mutual funds, which are typically invested in government or municipal bonds and usually exempt from federal and state taxes. As an investor, if you have tax-exempt mutual funds in your portfolio, you may not have to pay taxes on your gains in that investment. 

 Like all investments, there’s a risk of loss with tax-exempt mutual funds. Your investment may lose value if the securities the mutual fund is invested in don’t perform as well or go out of business. The mutual fund expense ratio, i.e., the fees you have to pay to invest in the mutual fund, may also impact your return. Be sure to shop around for a mutual fund with a low expense ratio. 

Tax-Exempt ETFs 

ETFs are similar to mutual funds but trade like stocks on an exchange. You can buy and sell them during regular trading hours without much hassle. The advantage of an ETF is that it contains a diversified bucket of securities from various companies, so your risk is spread across many companies. Tax-exempt ETFs are typically invested in tax-exempt municipal bonds and other government securities. However, unlike a mutual fund, which an investment manager actively manages, a tax-exempt ETF is usually passively managed and typically tracks an index, seeking to mimic the benchmark index’s performance.  

Interest rate changes can impact the bond market’s value, which, in turn, can affect the value of your tax-exempt ETF. Also, pay attention to the fees you’ll pay to invest in tax-exempt ETFs; high fees can eat away at your returns. 

Roth IRA  

A Roth IRA is an individual retirement account in which you contribute after-tax dollars, which means the money deposited into the account was already taxed. Unlike a traditional IRA, the gains that are made in a Roth IRA grow tax-exempt; when you withdraw the money in retirement, you don’t have to pay taxes on your withdrawals. With a Roth IRA, you can invest in almost any asset class, such as stocks, exchange-traded funds, options, futures markets, bonds, etc.  

According to the IRS, as long as your yearly salary doesn’t exceed $129,000, you can contribute up to $6,000 per tax year into your IRA Roth account in 2022. To illustrate how Roth IRAs work, suppose you start contributing the maximum amount of $6,000 and continue to do so for 30 years. And let’s say your Roth IRA is invested in the S&P 500—which has returned 10.7% per year over the past 30 years, according to The Motley Fool. Using these variables and the SEC’s compound interest calculator, after 30 years, your account can grow to $1,254,143.71*—and you don’t have to pay taxes on any of the growth. Take that, Uncle Sam!*Calculations were made using $6000 as the initial investment value, $500 for monthly contribution (to total $6000/year), 30 years as the length of time, and 10.7% as the estimated interest rate. The calculation was set up to compound annually. 

Also, if you’re above the age of 50, you can contribute up to $7,000 per year. This maximum yearly contribution could increase in the future, which means you could have even more money in your account to invest and grow tax-exempt.  

To withdraw from your Roth IRA tax and penalty-free, you must have had the account for at least five years and be age 59 ½ or older. Unlike other retirement plans, such as Social Security, there’s no required minimum distribution for a Roth IRA. You can continue to let the money grow tax-exempt for as long as you wish. Also, upon your death, your heirs can inherit your Roth IRA (if you’ve set it up this way), though they do have to follow different withdrawal rules than the original account holder. Read more about Roth IRAs here. 

Indexed Universal Life Insurance (IUL)  

Life insurance benefits are generally not taxed when distributed to beneficiaries upon the policyholder’s death. However, an IUL insurance policy has two components: a death benefit and a cash value. The growth of the policy’s cash value is tied to a market index’s performance instead of growing at a fixed interest rate. This cash component will grow tax-exempt. In the event of your death, the death benefit, a lump sum of money, will be given to your beneficiaries tax-exempt. 

The advantages of IULs include no limitation on how much you can contribute towards your IUL policy, no age requirement to start withdrawing money, and you can borrow against the policy tax and penalty-free. 

One downside of an IUL is that your returns can be capped. If the market index the IUL is invested in has a great year, you may not reap the full benefits as you would with other investments like mutual funds or ETFs, as your returns will be capped at whatever amount stipulated in your policy. For example, if your gains are capped at 8% per year and the market returns 20%, you’ll miss out on all gains above 8%. However, if the same market index has a negative year and loses value, it may not affect your investment, as the insurance company will absorb the losses. This means the worst your investment can do is not make any gains on the years that the index your policy is tied to has a negative return. 

Another consideration to keep in mind is that an IUL policy will likely be more expensive than term or whole life insurance policies. Your policy can also be canceled if you stop making your monthly premium payments. If you’re going to invest in an IUL, you have to be sure that you’ll be able to keep up with the premium payments and adhere to the agreed-upon terms with your insurance provider. 

Takeaway 

We’ve covered five tax-advantaged investments you may want to consider for your investment portfolio. A Roth IRA and an IUL can provide tax-exempt investments for your retirement. If you don’t want to wait until retirement age, you may want to consider investing in municipal bonds, tax-exempt mutual funds, and tax-exempt ETFs; however, these options may not be right for everyone. Whether you choose to invest in one or a combination of the tax-exempt investments covered in this article will depend on your investment needs and financial situation, so always consult a financial professional to ensure your investment portfolio is aligned with your investment objectives and financial goals. 

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Standard Disclosure

This blog expresses the author’s views as of the date indicated, are subject to change without notice, and may not be updated.  The information contained within is believed to be from reliable sources.  However, its accurateness, completeness, and the opinions based thereon by the author are not guaranteed – no responsibility is assumed for omissions or errors.  This blog aims to expose you to ideas and financial vehicles that may help you work towards your financial goals. No promises or guarantees are made that you will accomplish such goals.  

This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein, any risks associated therewith and any related legal, tax, accounting or other material considerations. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, prospective investors are encouraged to contact Liberty Wealth or consult with the professional advisor of their choosing 

Any indices and other financial benchmarks shown are provided for illustrative purposes only, are unmanaged, reflect reinvestment of income and dividends and do not reflect the impact of advisory fees.  Investors cannot invest directly in an index.  Comparisons to indexes have limitations because indexes have volatility and other material characteristics that may differ from a particular hedge fund.  For example, a hedge fund may typically hold substantially fewer securities than are contained in an index. 

Past performance is no guarantee of future results, and any expected returns or hypothetical projections may not reflect actual future performance or outcomes. All investments involve risk and may lose money. Nothing in this document should be construed as investment, tax, financial, accounting, or legal advice. Each prospective investor must evaluate and investigate any investments considered or any investment strategies or recommendations described herein (including the risks and merits thereof), seek professional advice for their particular circumstances, and inform themselves about the tax or other consequences of any investments or services considered.   

Investment advisory services are offered through Liberty Wealth Management, LLC (“LWM”), DBA Liberty Group, an SEC-registered investment adviser.  For additional information on LWM or its investment professionals, please visit www.adviserinfo.sec.gov  or contact us directly at 411 30th Street, 2nd Floor, Oakland, CA  94609, T: 510-658-1880, F: 510-658-1886,  www.libertygroupllc.com. Registration with the U.S. Securities and Exchange Commission or any state securities authority does not imply a certain level of skill or training. 

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References

Kuepper, Justin. (November 04, 2022). Indexed Universal Life Insurance (IUL) Meaning and Pros and Cons. Investopedia. https://www.investopedia.com/articles/personal-finance/012416/pros-and-cons-indexed-universal-life-insurance.asp 

Investor.gov. (n.d.). Bonds. https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products/bonds  

Investor.gov. (n.d.). Compound Interest Calculator. https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator  

IRS. (October 14, 2022). Topic No. 556 Alternative Minimum Tax. https://www.irs.gov/taxtopics/tc556 

IRS. (November 17, 2021). IRS announces changes to retirement plans for 2022. https://www.irs.gov/newsroom/irs-announces-changes-to-retirement-plans-for-2022 

Speights, Keith. (November 8, 2022). S&P 500 Index Fund Average Annual Return Rate. The Motley Fool. https://www.fool.com/investing/how-to-invest/index-funds/average-return/ 

Vanguard. (n.d). Vanguard Tax-Exempt Bond ETF. https://investor.vanguard.com/investment-products/etfs/profile/vteb#overview 

Zinn, Dori. (August 25, 2022). What Is Indexed Universal Life (IUL) Insurance? SmartAsset. https://smartasset.com/retirement/indexed-universal-life-insurance-iul