Many physicians are heavily taxed, so it is no surprise you are looking for ways to invest that do not increase your tax burden. However, it is critical that you pay attention not just to the taxes paid but to the after-tax return on the investments. Sometimes it makes sense to pay more in taxes “now” if it leaves you with more later.
In this column, originally published at ACEPNow, I discuss 10 ways to invest without paying any taxes at all. Naturally, with each method there is a way you could owe taxes if you are not careful, but for the most part, these investments are tax-free, at least at the time of writing.
Tax-Free Investment Options
#1 Municipal Bonds
Municipal bonds are a loan to a state or municipality. Municipal bond interest is federal income tax–free (although some bonds do produce interest subject to the Alternative Minimum Tax). A municipal bond from your state is also often state income tax–free. Of course, if you sell a bond or bond mutual fund for a gain, capital gains taxes would apply.
#2 Treasury Bonds
Treasury bonds are a loan to the federal government. While not free from federal income tax, they are free from state income tax. This is one reason their yields are generally lower than those of corporate bonds. Like a municipal bond or bond fund, if sold for a gain, capital gains taxes apply.
#3 Savings Bonds
Savings bonds, whether the standard type EE or inflation-adjusted, are like treasury bonds in that they are always free of state and local income tax. Federal income taxes are deferred until the bond is redeemed, perhaps decades later. If the proceeds are used for education, they are free from federal income tax, too.
#4 Anything in a Roth Account
The dollars you contribute to a Roth IRA, Roth 401(k), Roth 403(b), or Roth 457(b) have already been taxed, but all earnings from these accounts, no matter the investment, are free from federal, state, and local income taxes. There are two notable exceptions: First, income from leveraged real estate in a self-directed Roth IRA may be subject to Unrelated Business Income Tax. Second, if you withdraw money from the account prior to age 59½ and do not have a viable exception such as disability, a first home, or early retirement under the Substantially Equal Periodic Payments Rule, there will be a 10 percent penalty on earnings.
#5 Anything in a 529 Account
529 contributions may provide a state tax credit or deduction at the time of contribution, but if the proceeds are used for approved educational expenses, there are also no federal, state, or local income taxes due on the earnings.
#6 Anything in a Health Savings Account
Contributions to a health savings account (HSA) also provide a federal and state income tax deduction. If used to pay for approved health care expenses, there are no federal, state, or local income taxes due on withdrawals from the account. Note that New Jersey and California do not recognize HSAs, so contributions there are not state income tax deductions and earnings are not free from state income tax.
#7 Basis
Many people forget that you never owe income taxes on your “basis” (ie, the purchase price, excluding commissions and other expenses) since it has already been taxed when you earned it. Basis is the amount the IRS considers you to have paid into an investment. For example, if you paid $10,000 for stock and then sell it when it is worth $15,000, you only owe capital gains taxes on $5,000. The initial basis is income tax–free. This characteristic allows many retirees to dramatically lower their tax bill in retirement.
#8 Equity Real Estate Covered by Depreciation
Depreciation can be an important tax break, and the bonus depreciation enabled by the Tax Cuts and Jobs Act, which went into effect in 2018, offers significant savings. The income from equity real estate is often completely offset by this deduction, providing tax-free income. If you or your spouse qualifies for real estate professional status, that depreciation can even be used to offset your earned income. While depreciation is recaptured when you sell a house, it is recaptured at a maximum of 25 percent and can be deferred by doing “1031 tax-free exchange” of a property instead of selling it. If you do not sell prior to death, the depreciation recapture is eliminated for your heirs by the step-up in basis at death (ie, when the basis of an appreciated asset is adjusted to current market value when it is inherited).
#9 Non-Dividend-Paying Stocks
Qualified stock dividends are eligible for lower tax rates, but if the stock does not pay dividends at all and you do not sell the stock, then the investment grows tax-free. If left to your heirs, the heirs will also benefit from the step-up in basis at death and receive an income tax–free inheritance. Of course, the risks and lack of diversification with picking individual stocks may outweigh this benefit, but a growth stock index fund with a yield under 1 percent is still tax-efficient.
#10 Whole Life Insurance
Cash-value life insurance policies such as “whole life” grow in a tax-deferred manner. Partial surrenders of the policy allow you to access your basis first, which is tax-free. The death benefit is also always income tax–free. In addition, you can borrow against the value of your policy tax-free (just like you can borrow against your house, car, and investment portfolio tax-free), albeit not interest-free. Even with that tax treatment, it is hard to recommend whole life insurance to someone who doesn’t have the permanent need to have a benefit paid upon their death. The low returns (negative for the first five to 15 years) and high insurance costs make this a niche product that is appropriate for only a few physicians.
Do not be afraid to pay more taxes if it means you come out ahead after tax. For example, if a municipal bond fund yields 1.5 percent and a taxable bond fund yields 2.1 percent and you are in the 24 percent federal tax bracket, you can quickly see that 2.1 percent – (24 percent x 2.1) = 1.6 percent. In that case, you would be better off with the taxable bond fund than the municipal bond fund. Minimizing taxes is an important part of being an investor, but do not let the tax tail wag the investment dog.
What tax-free investments do you use to lower your tax burden? Comment below!
A great run down!
I think an important consideration is thinking about the returns each of these is likely to yield. Unfortunately, the tax free nature of more of these comes with some strings in the form of poor investment characteristics, like WLI, or low returns, like bonds.
To me, real estate at #8 is an outlier where it can be tax free and also returns can be quite high. It also has the least restrictions about how and when the money can be used compared to HSA/529/Roth.
The post is just about taxes, not about after-tax returns, much less risk-adjusted after tax returns.
As you know, many times it’s better to pay a lot of taxes because you still come out ahead after doing so.
#7 seems like kind of a stretch to include… I’m guessing it was just done to get to an even number for the list
Picky picky.
I thought it was an important point to make because lots of people forget that you only pay taxes on gains. If basis is 80% of an investment and you’re in the 15% capital gains bracket, you can get $10,000 to spend while only owing $300 in taxes.
A question I had while reading this lovely article. If a private real estate fund owns property in multiple states, is there any strategy to use 529 contributions in a state with tax benefits to offset any of the income you receive from that fund (either dividends or capital gains)?
Difficult to even write that thought down but hopefully that makes sense.
Thank you!!
I guess you could, sure, but it would be pretty limited. Half the states don’t give you a deduction or credit. They’re all limited to a relatively low amount too so you wouldn’t be able to have much income in those states. And you’d still have to file your taxes there which is the pain people are trying to avoid. Plus the additional complexity would suck.
Thank you Sir.
Like a lot of tax lowering strategies…juice just isn’t worth the squeeze.
Put that energy towards generating more income and accept the increased taxes that come along with it.
2021 will be the first year we will be getting K-1s…so just getting ready for the suck part of passive real estate.
Cheers!
You might be surprised to see how few of those K-1s list a positive taxable income. Most of mine are negative thanks to depreciation, especially in the first few years.
WCI, you are in probably the best position to do exactly this. As I recall you have an investment property in Indiana, which has the best 529 credit in the US. Opening an account takes about 5 minutes and you get a $1000 tax credit for depositing $5000. That is if your investment yields $1,000 of Indiana state tax, since it’s non – refundable (our state tax rate is 3.2%)
No, that syndication finally went round trip last year. Too much complexity for me to play that game for a few hundred bucks anyway. I’ve already got 34 529s to keep track of. I don’t need any more.
Curious if anybody can offer their two cents.
Muni funds as part of your emergency fund?
I’m a youngish attending working for the last three years in a low paid speciality and have almost all my loans paid off due to relative frugality and a loan repayment program.
I’m a fan of muni funds as part of my emergency fund.
I have about 4 months in cash and 4 yrs living costs in my taxable accounts. I keep about 10% of my total investments in muni bonds and the 90% remaining in large cap, mid cap, small cap, and international mutual funds.
Muni funds appeal to me since the net return is higher than taxable bond funds and their volatility is much less than stocks. That’s why I have them as part of my “emergency fund” in case I have to burn through my 4 months cash.
Thoughts?
Sure. I wouldn’t have it all in muni bonds, but some of it could be there. Just realize that the longer the duration, the more likely they are down in value when you need to sell them.
Thanks for your input.
Yeah I’d have some bonds in my 401k but the options aren’t great and the fees add up to almost 1%. I do have the 10% in muni bonds diversified between intermediate and long-term bond funds. Should open up some short-term ones also. Thanks again.
I’m not talking about other bonds in the portfolio. I’m saying some of your emergency fund should be in cash at home, some in the checking account, maybe some in a savings account or money market fund, and maybe some of it in bonds if it is a larger emergency fund.
I would have included paying down debt. Though not an investment in a traditional sense, you get a return equal to the interest that you will not have to pay. If a doc is concerned about paying taxes, he or she could pay down their student loans or home mortgage. If the decision is between bonds at 1.5-2.5% or debt at 2-3%, I would think hitting the debt would be a sound, tax-free investment.
Ahhh…good one.