Investments are always considered as integral parts to save personal finance, but making the right investments is equally important to grow your savings. However, the downside of investments is that your high yield investment incomes are taxable as per the tax laws of the country where you reside. Therefore, as an investor, your main focus will be on finding such an investment plan that helps you save tax and aids in generating tax-free income. One of the best ways in getting a tax benefit is to invest in a tax-exempt mutual fund.
Tax-exempt mutual funds are simply a collection of investments that generate tax-free incomes in the form of high yield interests. Mutual funds invested in municipal or government bonds are the best tax-free investments as they are the most riskless assets to invest in. The interest accrued from these investments are also not subject to any tax obligations. However, there are some bonds like the Treasury bonds, where the interest incomes are exempt from local or state taxes (if the investors reside in that particular state) but are subjected to federal taxes.
Best Tax- Free Investments
Some of the best tax-free investment funds are listed below.
ELSS, or the Equity-Linked Savings Scheme, is considered among the best tax savings and high yield mutual funds. The maximum exposure of these mutual funds is towards equity and equity-based securities, but a part of it can also be invested in debt instruments as per the preferences of the investors. Equity-linked savings scheme aims at providing the dual benefits of high yield tax savings and capital appreciation to the investors simultaneously. ELSS funds have a mandatory lock-in period of 3 years or more, below which the investors are not eligible for ant tax-exemptions. The investors can continue with the ELSS investments even if the lock-in period ends, quite similarly as any open-ended mutual fund scheme. Here the expense ratio is also less just as in stocks and securities.
However, there are downsides of investing in an ELSS bond fund, and it comes with a disclaimer. An investor should not invest in an ELSS bond fund only because they offer superior returns over a long time period or have a low expense ratio. Investors should only invest in an ELSS bond fund if they have a higher risk appetite like when they invest in stocks or equity. This is because equity is a risky asset and can be very volatile in the short term. Though it has the potential to offer superior returns to the investor over a long time period, that alone is not enough to serve as a criterion to invest in ELSS. Always remember that the ELSS mutual bond funds invest mostly in stocks and securities that are in themselves very risky assets and subject to massive fluctuations.
Also, ELSS returns are neither fixed nor assured and depend on the equity markets’ performance, which in itself is highly unpredictable. To mitigate these risks and uncertainties, investors may diversify their investment portfolio across multiple ELSS schemes based on industry exposure and market capitalization.
2) 529 Education Fund
529 Education fund is another tax saving investment scheme with a low expense ratio that is targeted towards the upliftment of education financing. This plan allows an individual to set money aside for school tuition or higher education. Contributions made towards this plan are calculated after-tax and therefore are tax-exempt. However, sometimes the accumulated tax is deferred. Also, the contributions made for higher education costs may be tax-exempt at the federal level but may be taxed in a few states. Before investing into a 529 Education Fund, you should consider the benefits of your usage of personal finance, because spending money on non-eligible expenses will be subjected to income tax plus a penalty will also be levied on your earnings. Another downside of this plan is that money invested into a 529 Education Fund is not as liquid as other investment options like in a high yield municipal bond. However, the beneficiary of a 529 Education Fund can be changed any time if the intended recipient decides not to go for any higher education.
3) Health Savings Account or Hsa
A health savings Account helps investors to invest in a tax-deferred fund and a tax-free earning on eligible spending. Besides reducing the medical costs and saving for medical expenses, an HSA or the health savings account offers tax exemptions also. Pre-tax contributions are exempted from tax and interest earned is also tax-deferred. Therefore, investors can grow their savings as long as the account does not expire. A health Savings account can be opened for self or for the family members who are dependent on the account holder.
Investing in an HSA account offers many tax benefits, and healthcare spending advantages to the account holders with its attractive tax-exempt healthcare plans. The best thing about opening an HSA account is that, if someone does not use them at all, the fund allocated can be rolled over into a retirement account, and can be later used in the long term for incurring health care expenses at old age.
An Individual Retirement Account or IRA is an effective tax-free instrument preferred by investors for tax-free growth of their long term savings. Both Traditional IRAs and Roth IRAs allow an annual contribution of up to $5,500 and $6,500 respectively to the investors. However, the eligibility and the deductions available to reap the benefits depend highly on the income limits and the retirement plans of a particular company. Traditional IRAs allow investors to fund their pre-tax money into the plan and withdraw it at a lower tax rate at the time of retirement. However, traditional IRAs also have downsides, such as mandatory disbursements of certain amounts of the funds after a certain age. Whereas on the contrary, Roth IRA uses after-tax money and is tax-free at the time of retirement but has some income eligibility requirements. Here, the high-income earners are not eligible to invest directly into their Roth IRA account. For this, they will first have to invest in a traditional IRA account and then convert it to a Roth IRA.
High yield Municipal Bond
Mutual funds invested in a government or a municipal bond are tax-exempt funds, and so the interest generated from investing in these bonds are not subject to income tax. In some cases, an investor is freed from tax obligations in all the three levels, local, state, or federal, if he resides in the state that levies the tax. A Municipal bond fund also has a low expense ratio.
When one invests in a municipal bond, he is giving a loan to the government and is thus entitled to earn a fixed rate of return in the form of interests that are exempt from tax obligations. But a Municipal bond has certain downsides, e.g., the interest rates of returns are greatly affected by inflation and also, they are sometimes subjected to Alternative Minimum Tax (AMT). However, all municipal bonds are not exempt from all taxes. For example, the interest accrued on a particular municipal bond may be exempt from state or local income tax but may be subjected to federal income tax, as in the case with Treasury bonds issued by the US government. As most of the tax-free municipal bond funds are government-issued bonds and are virtually risk-free, they provide much lower interest rates as compared to highly volatile stocks and securities.
Therefore, at first, one should weigh the tax benefits offered by these municipal bond funds, and if it outweighs the reduction in their earning potential, then investing in such bond funds may be lucrative for him. However, whether this trade-off would be beneficial or not depends on other underlying factors of the municipal bond funds as well, like the income tax slab rate or municipal bond rate applicable for a particular and, consequently, his taxable income.
Therefore, before choosing the best mutual bond funds to invest in that give tax exemption to the investors, one should consider the other underlying factors (like municipal bonds rates) that contribute to a safe investment. Factors like liquidity, returns, or safety of a municipal bond fund, etc. would determine how it would be taxed and what tax obligations the investors will have when investing into these municipal bonds. The more the tax obligations the less will be the return in investments, and therefore choosing the right investment is very important.
What Are the Best Tax-Free Investments?
Among the best tax-free investments, there are the Employer-sponsored retirement plan, 401 (k), 403 (b), Health Savings Account (HSA), Tax-free ETFs, or 529 Education Fund to name a few.
What Mutual Funds Are Tax-Free?
Municipal bond funds and government bonds are tax-free investments.
Are Municipal Mutual Funds Tax-Free?
Yes, the interest income from Municipal mutual funds are exempted from all the three levels of taxes, local, state, and federal. However, any capital gains realized when the bond is sold either at a premium or at a discount; the sale proceeds are not exempted from taxes. Both state-level and Federal taxes will apply on the capital gains income.
As the municipal mutual funds investors do not exercise control over the bonds at the time of buying or selling the bonds, there lies a high probability for an unexpected tax bill on the investors if the fund generates a profit from capital gains instead of an interest.
What Are the Best Municipal Bonds to Invest In?
The best bonds municipal bonds to invest in are:
- VTEB – Vanguard Tax-exempt bond ETF
- NXP – Nuveen Select Tax-Free Income Portfolio
- GHYIX – Goldman Sachs High -Yield Muni Instl
- MAYHX- BlackRock High Yield Municipal Instl
- PRBIX- JPMorgan Tax-Free Bond Fund