Are There Any Tax-Free Investments?
Are There Any Tax-Free Investments?
Are There Any Tax-Free Investments?
Though death and taxes may be certain, investors should always seek legal ways to minimize their tax liability.
Lower taxes mean higher net investment returns and higher disposable income. The more money investors are able to keep, the more they can allocate their money according to their priorities.
If tax efficiency is a priority for investors, then focusing on tax-free and tax-efficient investments that allow money to grow while avoiding or minimizing tax liability is a must.
Here are 10 of these tax-free and tax-reducing investments that are great selections in any investor's financial planning:
Municipal bonds.
Tax-exempt mutual funds and ETFs.
Roth 401(k) plans.
Roth IRAs.
Health savings accounts.
529 education savings plans.
Indexed universal life insurance.
Donor-advised funds.
Qualified opportunity funds.
Community development financial institutions.
Though death and taxes may be certain, investors should always seek legal ways to minimize their tax liability.
Lower taxes mean higher net investment returns and higher disposable income. The more money investors are able to keep, the more they can allocate their money according to their priorities.
If tax efficiency is a priority for investors, then focusing on tax-free and tax-efficient investments that allow money to grow while avoiding or minimizing tax liability is a must.
Here are 10 of these tax-free and tax-reducing investments that are great selections in any investor's financial planning:
Municipal bonds.
Tax-exempt mutual funds and ETFs.
Roth 401(k) plans.
Roth IRAs.
Health savings accounts.
529 education savings plans.
Indexed universal life insurance.
Donor-advised funds.
Qualified opportunity funds.
Community development financial institutions.
Municipal Bonds
Municipal Bonds
Treasury bonds are debt instruments the federal government uses to raise money. Municipal bonds are used by state and local governments and other government entities for the same purpose.
Like Treasury bonds, investors receive interest payments in the form of coupons, and their capital will be returned at maturity.
Unlike Treasury bonds, however, interest earnings from municipal bonds are tax-free at the federal level. They can also be tax-free at the state and local government level, depending on the bond, where it is issued and where it was bought. In most cases, you won't pay state taxes on interest income if you bought the municipal bonds of your state of residence.
Note, though, that this tax benefit does not extend to capital gains. If you sell your municipal bonds for profit, you will pay both federal and state taxes.
Treasury bonds are debt instruments the federal government uses to raise money. Municipal bonds are used by state and local governments and other government entities for the same purpose.
Like Treasury bonds, investors receive interest payments in the form of coupons, and their capital will be returned at maturity.
Unlike Treasury bonds, however, interest earnings from municipal bonds are tax-free at the federal level. They can also be tax-free at the state and local government level, depending on the bond, where it is issued and where it was bought. In most cases, you won't pay state taxes on interest income if you bought the municipal bonds of your state of residence.
Note, though, that this tax benefit does not extend to capital gains. If you sell your municipal bonds for profit, you will pay both federal and state taxes.
Tax-Exempt Mutual Funds and ETFs
Tax-Exempt Mutual Funds and ETFs
Instead of buying individual municipal bonds and other tax-free investments, you could buy a basket of them in the form of mutual funds or exchange-traded funds, or ETFs.
These funds provide the benefit of diversification. Any investment expert will tell you that the best way to reduce your risk is to put your eggs in multiple baskets. In this way, the loss of one basket does not spell financial doom.
Mutual funds and ETFs help you do this. A share in one of them may give you exposure to hundreds or even thousands of securities (stocks, bonds, real estate investment trusts, etc.). Achieving the same level of diversification with individual purchases of securities will be expensive and out of reach for most retail investors.
When mutual funds and ETFs invest in municipal bonds and other federal tax-free investments, they become federal tax-free investments that you can use to lower your investment tax bill.
Most mutual funds are actively managed, meaning they seek to beat a market index, which results in higher management fees that are passed on to fund owners. On the other hand, most ETFs are passively managed, which means they seek to mirror the performance of a market index and consequently makes them more cost-effective. Also, mutual fund trades only execute after trading hours, while ETFs can be traded on stock exchanges during trading hours.
Instead of buying individual municipal bonds and other tax-free investments, you could buy a basket of them in the form of mutual funds or exchange-traded funds, or ETFs.
These funds provide the benefit of diversification. Any investment expert will tell you that the best way to reduce your risk is to put your eggs in multiple baskets. In this way, the loss of one basket does not spell financial doom.
Mutual funds and ETFs help you do this. A share in one of them may give you exposure to hundreds or even thousands of securities (stocks, bonds, real estate investment trusts, etc.). Achieving the same level of diversification with individual purchases of securities will be expensive and out of reach for most retail investors.
When mutual funds and ETFs invest in municipal bonds and other federal tax-free investments, they become federal tax-free investments that you can use to lower your investment tax bill.
Most mutual funds are actively managed, meaning they seek to beat a market index, which results in higher management fees that are passed on to fund owners. On the other hand, most ETFs are passively managed, which means they seek to mirror the performance of a market index and consequently makes them more cost-effective. Also, mutual fund trades only execute after trading hours, while ETFs can be traded on stock exchanges during trading hours.
Roth 401(k) Plans
Roth 401(k) Plans
You may already be familiar with the 401(k), the popular employer-sponsored retirement plan. Well, there is a variant of it called the Roth 401(k).
Unlike the traditional 401(k), you can invest after-tax dollars into a Roth 401(k), which means any qualified withdrawals from the account when it's time to retire will then be tax-free.
If you prefer to pay taxes now and then avoid them when you are retired, a Roth 401(k) is a good option to explore. This is especially useful if, for some reason, you expect your tax rate in retirement to be higher than what it is now.
Many employers provide both a 401(k) and a Roth 401(k), and some will even allow you to switch between the two or divide up your contributions between them.
Unlike Roth IRAs, there are no income limits on Roth 401(k)s. You can contribute to the account no matter how much you earn. For tax year 2025, the contribution limit is $23,500 for those less than 50 years old and $31,000 for those 50 years old or older.
You may already be familiar with the 401(k), the popular employer-sponsored retirement plan. Well, there is a variant of it called the Roth 401(k).
Unlike the traditional 401(k), you can invest after-tax dollars into a Roth 401(k), which means any qualified withdrawals from the account when it's time to retire will then be tax-free.
If you prefer to pay taxes now and then avoid them when you are retired, a Roth 401(k) is a good option to explore. This is especially useful if, for some reason, you expect your tax rate in retirement to be higher than what it is now.
Many employers provide both a 401(k) and a Roth 401(k), and some will even allow you to switch between the two or divide up your contributions between them.
Unlike Roth IRAs, there are no income limits on Roth 401(k)s. You can contribute to the account no matter how much you earn. For tax year 2025, the contribution limit is $23,500 for those less than 50 years old and $31,000 for those 50 years old or older.
Roth IRAs
Roth IRAs
A Roth IRA is an individual retirement account that allows you to invest after-tax dollars so you can make tax-free withdrawals in retirement.
Unlike a Roth 401(k), you don't need an employer sponsorship to participate in a Roth IRA. This is an advantage since it allows you to explore more investment opportunities, but it's a disadvantage since there is nothing like employer match-up contributions.
Once you are 59? years old – and your account is at least five years old – you can make tax-free and penalty-free withdrawals from a Roth IRA. Also, you don't have to take required minimum distributions, also known as RMDs; your money can grow for as long as you want.
Contribution limits for Roth IRAs for the tax year 2025 are $7,000 for those younger than 50 and $8,000 for those 50 or older. However, if your modified adjusted gross income is $150,000 or higher ($236,000 or higher for joint filers), you won't be able to make a full contribution to a Roth IRA. Income eligibility for Roth IRA contributions tops out at $165,000 for singles and heads of household and $246,000 for married couples filing jointly.
A Roth IRA is an individual retirement account that allows you to invest after-tax dollars so you can make tax-free withdrawals in retirement.
Unlike a Roth 401(k), you don't need an employer sponsorship to participate in a Roth IRA. This is an advantage since it allows you to explore more investment opportunities, but it's a disadvantage since there is nothing like employer match-up contributions.
Once you are 59? years old – and your account is at least five years old – you can make tax-free and penalty-free withdrawals from a Roth IRA. Also, you don't have to take required minimum distributions, also known as RMDs; your money can grow for as long as you want.
Contribution limits for Roth IRAs for the tax year 2025 are $7,000 for those younger than 50 and $8,000 for those 50 or older. However, if your modified adjusted gross income is $150,000 or higher ($236,000 or higher for joint filers), you won't be able to make a full contribution to a Roth IRA. Income eligibility for Roth IRA contributions tops out at $165,000 for singles and heads of household and $246,000 for married couples filing jointly.
Health Savings Accounts
Health Savings Accounts
HSAs are tax-advantaged accounts where individuals and families with high-deductible health insurance plans (HDHP) can save for medical expenses not covered by those plans.
These accounts provide tax benefits in three ways. First, you can contribute pre-tax income to the account, thus reducing your taxable income. Second, money in the account will grow tax-free. Third, qualified withdrawals (for prescription drugs, medical care, copays, vision care, dental care and psychiatric treatment) from the account are also tax-free.
Since only those with HDHPs can open these accounts, let's consider what that means.
For 2025, an HDHP is "a health plan with an annual deductible that is not less than $1,650 for self-only coverage or $3,300 for family coverage, and for which the annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) do not exceed $8,300 for self-only coverage or $16,600 for family coverage," according to the IRS.
Contributions to HSAs are capped at $4,300 for individuals and $8,550 for families. Those 55 or older can also make catch-up contributions of $1,000.
Both employed and self-employed individuals can open an HSA, provided they meet all the requirements.
HSAs are tax-advantaged accounts where individuals and families with high-deductible health insurance plans (HDHP) can save for medical expenses not covered by those plans.
These accounts provide tax benefits in three ways. First, you can contribute pre-tax income to the account, thus reducing your taxable income. Second, money in the account will grow tax-free. Third, qualified withdrawals (for prescription drugs, medical care, copays, vision care, dental care and psychiatric treatment) from the account are also tax-free.
Since only those with HDHPs can open these accounts, let's consider what that means.
For 2025, an HDHP is "a health plan with an annual deductible that is not less than $1,650 for self-only coverage or $3,300 for family coverage, and for which the annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) do not exceed $8,300 for self-only coverage or $16,600 for family coverage," according to the IRS.
Contributions to HSAs are capped at $4,300 for individuals and $8,550 for families. Those 55 or older can also make catch-up contributions of $1,000.
Both employed and self-employed individuals can open an HSA, provided they meet all the requirements.
529 Education Savings Plans
529 Education Savings Plans
Not many people in the U.S. can afford to pay out of pocket for a college education, thus the prevalence of student loans.
But there is an alternative to student loans that you should consider if you hope to get a college education down the line. You can also use it to save toward the college education of your children. They are called 529 education savings plans.
Most states in the U.S. offer these plans, and you don't even need to be a resident before you can register for a plan in the state.
Contributions to a 529 education savings plan are not tax deductible for federal taxes, but many states offer tax incentives to encourage investment in these plans.
However, your contributions will grow tax-free, and all qualified withdrawals (from tuition to textbooks and more for K-12 and college) are also tax-free. Qualified withdrawals also include paying for apprenticeship programs, student loan repayment (up to $10,000), and rollover into a Roth IRA (up to $35,000 but only for accounts at least 15 years old).
Not many people in the U.S. can afford to pay out of pocket for a college education, thus the prevalence of student loans.
But there is an alternative to student loans that you should consider if you hope to get a college education down the line. You can also use it to save toward the college education of your children. They are called 529 education savings plans.
Most states in the U.S. offer these plans, and you don't even need to be a resident before you can register for a plan in the state.
Contributions to a 529 education savings plan are not tax deductible for federal taxes, but many states offer tax incentives to encourage investment in these plans.
However, your contributions will grow tax-free, and all qualified withdrawals (from tuition to textbooks and more for K-12 and college) are also tax-free. Qualified withdrawals also include paying for apprenticeship programs, student loan repayment (up to $10,000), and rollover into a Roth IRA (up to $35,000 but only for accounts at least 15 years old).
Indexed Universal Life Insurance
Indexed Universal Life Insurance
Unlike other types of life insurance that pay a fixed interest rate, indexed universal life insurance (IUL) ties your earnings to the performance of a stock index while guaranteeing the protection of your principal.
Said simply, you can earn a higher return on the upside while protecting your capital on the downside. However, this downside protection is at the cost of actual returns being lower than the index returns. For example, if the index returns 7%, your account might only grow by 5%.
IULs also have tax benefits. The cash value grows tax-free and withdrawals are also tax-free. Even death benefits to beneficiaries are tax-free.
Unlike traditional retirement accounts, there are no contribution limits and you don't need to wait until a certain age before you can make qualified withdrawals. You can also take out penalty-free and tax-free loans from certain IUL plans.
Unlike other types of life insurance that pay a fixed interest rate, indexed universal life insurance (IUL) ties your earnings to the performance of a stock index while guaranteeing the protection of your principal.
Said simply, you can earn a higher return on the upside while protecting your capital on the downside. However, this downside protection is at the cost of actual returns being lower than the index returns. For example, if the index returns 7%, your account might only grow by 5%.
IULs also have tax benefits. The cash value grows tax-free and withdrawals are also tax-free. Even death benefits to beneficiaries are tax-free.
Unlike traditional retirement accounts, there are no contribution limits and you don't need to wait until a certain age before you can make qualified withdrawals. You can also take out penalty-free and tax-free loans from certain IUL plans.
Donor-Advised Funds
Donor-Advised Funds
Donor-advised funds are accounts created to manage the charitable donations of individuals, families and different types of organizations. More than $52 billion was granted to charities from DAFs in 2022, according to the National Philanthropic Trust.
Any contribution you make to a DAF is tax deductible, thus reducing your tax liability. You don't have to donate the contribution immediately. Contributions can grow tax-free until you have decided on what charitable project to support.
In addition to cash, you can also contribute securities and other assets (including cryptos and private stocks) to a DAF. These securities would also be excluded from the capital gains tax.
Donor-advised funds are accounts created to manage the charitable donations of individuals, families and different types of organizations. More than $52 billion was granted to charities from DAFs in 2022, according to the National Philanthropic Trust.
Any contribution you make to a DAF is tax deductible, thus reducing your tax liability. You don't have to donate the contribution immediately. Contributions can grow tax-free until you have decided on what charitable project to support.
In addition to cash, you can also contribute securities and other assets (including cryptos and private stocks) to a DAF. These securities would also be excluded from the capital gains tax.
Qualified Opportunity Funds
Qualified Opportunity Funds
Qualified opportunity funds are vehicles that stimulate investment in economically distressed and low-income communities, also known as opportunity zones.
Investors are encouraged to invest in real estate and businesses in these zones through certain incentives, including tax benefits. To qualify as an opportunity zone, a community must be classified by the state as such and the Secretary of the Treasury must approve the classification.
Capital gains used to fund qualified opportunity funds are deferred until the fund is sold or until Dec. 31, 2026, whichever is earlier.
Also, the longer you hold on to a qualified opportunity fund, the lower the capital gains you will eventually pay. If held for more than five years, 10% of the deferred gain won't be taxed when the asset is sold. After seven years, 15% of the gain will be excluded.
Also, when you hold the fund for more than 10 years, no federal income taxes will be paid on the fund's appreciation when it is finally sold.
Qualified opportunity funds are vehicles that stimulate investment in economically distressed and low-income communities, also known as opportunity zones.
Investors are encouraged to invest in real estate and businesses in these zones through certain incentives, including tax benefits. To qualify as an opportunity zone, a community must be classified by the state as such and the Secretary of the Treasury must approve the classification.
Capital gains used to fund qualified opportunity funds are deferred until the fund is sold or until Dec. 31, 2026, whichever is earlier.
Also, the longer you hold on to a qualified opportunity fund, the lower the capital gains you will eventually pay. If held for more than five years, 10% of the deferred gain won't be taxed when the asset is sold. After seven years, 15% of the gain will be excluded.
Also, when you hold the fund for more than 10 years, no federal income taxes will be paid on the fund's appreciation when it is finally sold.