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How Tax-Free Investments May Benefit You, Your Kids, Charities

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February 12, 2018
Ball in grass: Tax-free investments may help you preserve more of your wealth
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In 1789, Benjamin Franklin famously wrote that “In this world nothing can be said to be certain, except death and taxes.” However, that hasn’t stopped scientists and mystics from trying to unlock the secret to immortality, nor investors from seeking a tax-free return on their money. Immortality is still out of reach, but is there such thing as a tax-free investment? The answer is yes, kind of, and it depends on how you define the word “investment.”

The Pure Tax-Free Play

When most people think of tax-free investment they think of munis—municipal bonds issued by government entities like counties, cities, or states. Muni interest, with a few exceptions, is exempt from federal income tax, and in some cases, state tax as well.

When it comes to a pure play, municipal bonds are really the only tax-free game in town. Sure, you can find tax-free funds in the form of money market funds and bond funds, but they both generate their income from investing in those same tax-free bonds.

In some cases, depending on your circumstances and time horizon, a master limited partnership (MLP) can act as a de facto tax-free investment. Some MLPs offer quarterly dividends, which—thanks to the structure of an MLP—are sheltered by depreciation deductions and considered “return of capital,” which can be non-taxable.

Of course, the sheltering deductions will eventually be exhausted, but sometimes not for many years. If the MLP shares are willed to your heirs, the process resets and they can inherit them at a new, higher cost basis.

An Investment in Name Only

Traditionally, the word investment makes us think of an arrangement in which our money brings us a personal return. But an investment might also be set up at a cost to you, but provide a benefit to others—your children or your chosen charities.

Many people are familiar with 529 plans, designed to help people save for education costs such as college tuition. You and other investors can contribute to the account, and the funds can be allocated across a number of investment options. Withdrawals are tax free when used for the qualified education expenses of your designated beneficiary, such as tuition, fees, books, room and board, and so on. Plus, the new tax law extends the 529 to K-12 tuition expenses. Previously, 529 plans were limited to college-related expenses.

Another investment for children has a tax-free component. Most brokerages can help you set up and fund a Uniform Gifts to Minors (UGMA) account. You control the administration of the account, but the funds and assets are the property of the designated child. And because of that, the first $1,050 of annual income is tax free, and the next $1,050 of income is taxed at the child’s bracket, which in many cases will effectively be zero.

And to stretch the concept of investment a bit further: Life insurance is, in a way, tax free, as the proceeds paid out to your beneficiaries are not taxed.

Now to stretch the term to almost its breaking point: donating stock can give you some tax-free benefit. Suppose you buy $5,000 of stock and it doubles in value. If you have held that stock for at least one year, you can donate it to a qualified charity, and not only will you be exempt from paying taxes on the $5,000 in capital gains, but you can claim the entire $10,000 as a charitable donation.

Home Is Where the Tax Shelter Might Be

Your home. Yes, it’s an investment you make in order to have a roof over your head. But many consider their home to be a financial investment as well. And up to a point, it can be a tax-free one.

The IRS allows you $250,000 in tax-free profits on the sale of your home, or $500,000 if you are married. There are a few requirements: It must be your primary residence, and you must live there for at least two years. But if you meet those requirements, you can take that exemption every two years, as many times as you want. Even better, you can deduct any improvements you’ve made on your primary residence from the proceeds.

So for those who are a little more aggressive in their investing, you could buy a fixer-upper, live in it while you improve it, and if you sell it after two years for a profit, it would be tax free up to the $250,000/$500,000 limit, plus the costs of improvements.

Taxes are a fact of life; they help the government function. But that doesn’t mean you should pay more than your share. Tax-free bonds and other forms of tax-free investments can help take the sting out of your tax bill.

TD Ameritrade does not provide tax advice. Clients should consult with a tax advisor with regard to their specific tax circumstances.

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