What are Tax Free Investments

There are a number of different types of bonds that you can invest in that will give you taxfree returns and interest. The first type is government securities, such as Treasury bills, notes, and bonds. These equities are fully taxable for federal tax purposes, but are tax-free from state and local taxes. If you live in an area of the United States that has high state and local tax rates, these would be a good way to help save on those taxes. Now if you live in a state like Wyoming that has no state income tax, there is no reason from a tax point of view to invest in U.S. government securities.

Municipal bonds that are offered by state and local municipalities are free from federal taxes. Plus, if you live in the area from which the bond is issued, they will be free from state and local taxes as well. Therefore, if you live in Albany, New York and purchase a New York State general obligation bond, you would receive tax-free income from the bond. However, if you purchased the same bond, but lived in Michigan, you, generally wouldn’t receive the state income tax-free, although it would still be tax-free on the federal level.

Beware that you don’t undermine your tax-free investment income by purchasing the equity within a qualified plan. By holding tax-free muni bonds and muni bond funds within an IRA, 401(k), or other tax-qualified plan, you negate the benefit derived from the bond or bond fund. This is because when you begin to take distribu- tions from your qualified plan, you will be taxed on the amount coming out, regardless of what the money was invested in. For this reason, it’s best to hold taxable income-producing equities, such as income-geared mutual funds or stocks with historically high dividends, inside a qualified account. To own a tax-free investment inside a qualified account is to needlessly tax yourself on tax-free income. Who would want to do that?

Another potential mistake is when people in the lowest tax bracket purchase municipal bonds and bond funds. Because their tax bracket is already as low as it can go, the advantage of owning muni bonds is lost on them. Muni bonds and bond funds are the most advantageous for investors who are in the higher tax brackets. If you are considering investing in either individual muni bonds, or in muni bond funds, figure out what your tax bracket is, and then decide if the tax-free interest is worth it. It may not be.