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Tax Saving Instruments: Now Save Some Extra Money Legally

Tax Saving Instruments
Investing is a great way to grow your finances over time. However, one disadvantage is that you must generally pay taxes on your investment gains. And, of course, the more taxes you pay, the less of your earnings you get to keep. However, with the right strategy, you can reduce the taxes you pay on your investments. Particular investments are exempt from taxation. Consider including these important tax-saving options as you build your portfolio. If you have any questions about these tax-advantaged investments, never think twice about consulting a financial advisor.

What is the Difference Between Tax-efficient and Tax-free Investing?

The unfortunate reality of earning investment income is that you will never be able to avoid paying taxes altogether. However, how much the government will charge you heavily depends on the investments you choose and how long you keep them.

Investment taxes are known as capital gains. The two types of investments are long-term and short-term. Long-term capital gains indicate that you have held your investment for at least a year. On the contrary, short-term capital gains suggest that you’ve owned them for less than a year.

Your tax treatment will improve if you can reach the long-term threshold. Short-term capital gains taxes rely on standard income tax brackets, whereas long-term capital gains taxes do not.

Major takeaways

  • Taxes should not be the primary motivator for your investment strategy, but it does make sense to take advantage of opportunities to manage, defer, and reduce taxes.
  • Consider how capital gains and losses are recognized in your portfolio to manage federal income taxes.
  • Using tax-deferred accounts can help you keep more of your money invested and working for you—and then you can pay taxes on future withdrawals.
  • Consider strategies such as donating appreciated securities to charity and funding education expenses through a 529 plan to reduce taxes.
  • Learn about the tax implications of your employer’s stock plans.

Tax-Efficient Investments

Holding your investments in the most tax-advantaged type of account can supplement your savings plans by assisting in tax reduction. Spreading your investments across funds with different tax treatments can also give you more flexibility in managing your taxes when you begin drawing from your retirement savings. It’s referred to as “tax diversification.” 

Diversifying by tax treatment is especially important if you’re unsure what tax bracket you’ll end up in later. For example, investing in a taxable brokerage account and then dividing your retirement-savings contributions between a tax-deferred IRA or 401(k) and an after-tax Roth account would provide you with more ways of managing your income in retirement, irrespective of your tax bracket. 

So, suppose your goal is to minimize your overall tax burden. In that case, you could focus on taking qualified tax-free dividends, municipal-bond income,  and long-term capital gains from your taxable accounts and tax-free income from your Roth accounts. 

In this case you can take money for your living expenses from a taxable IRA or 401(K) Of course, this is just one approach. Most  investors choose to depend on their taxable and tax-deferred accounts together with Social Security and pension for income and leave their tax-free Roth savings.

If you strategically use your different accounts based on the tax treatment it will help you plan your charitable giving and estate planning goals. For example, you could donate appreciated securities from your taxable accounts to charity and receive a full fair market value deduction while avoiding capital gains tax. You can also leave such shares to your heirs, who will receive a cost basis step-up after you die .

Roth IRAs are also an excellent bequest vehicle because distributions are tax-free for your beneficiaries. Whatever way you decide to divide your portfolio into account types, keep in mind that you should still consider all of your investments to be part of a single portfolio for asset allocation purposes. To use an oversimplified example, if you kept all of your stocks in your taxable account and an equal amount in bonds in your tax-advantaged account, you would not have two portfolios that were 100% stocks and 100% bonds. You would have a single portfolio split 50/50 between stocks and bonds and various assets happen to be in different accounts.

Now Let Us Discuss Important Tax-Efficient Investments in Detail

1. Bonds Issued by Municipalities

Municipal bonds, or muni bonds for short, are issued by local governments to fund projects such as road improvements or school construction. When you buy a municipal bond, you essentially lend the government money. The benefit to you is that you will receive a guaranteed rate of return from the bond in interest payments. 

Even better, these interest payments are tax-free under federal law. Any state or local taxes on interest earnings may also be exempt from taxation. 

Municipal bonds are sometimes referred to as triple tax-free bonds because, depending on where you live, some are exempt from federal, state, and city taxes. However, not every muni is tax-free, so weigh your options carefully. In other cases, investing in municipal bonds may trigger the Alternative Minimum Tax (AMT), which can significantly impact your taxes. 

When considering investing in a bond, carefully research the returns and taxes to see if the investment is worthwhile. These bonds provide tax breaks for people in higher tax brackets, especially if issued by the city or state where you live. Sometimes, a taxable account may offer better after-tax returns than a tax-free municipal bond.

2. Roth IRAs and Roth 401(k)s

A self-directed IRA or Roth IRA is a retirement account that allows for tax-free investing. You contribute after-tax dollars to your Roth IRA account up to the annual limit. The limit is $6,000, plus a $1,000 catch-up contribution if you are 50 or older.

“After-tax dollars” means that it is impossible to deduct your contributions, unlike a Traditional IRA. The advantage comes when you reach the age of 59 1/2, at which point you can begin withdrawing funds from your Roth IRA tax-free. It includes all of the returns on your investments over the years, which means your assets earned tax-free returns. 

You can continue to contribute after-tax dollars to your Roth IRA indefinitely if you have earned annual income. Furthermore, once you reach the age of 70, there are no requirements for taking minimum distributions. 

That means you can keep your retirement savings growing tax-free until you need them. If you don’t spend all your savings, you can leave it to a spouse or another beneficiary when you die.

A Roth 401(k) is another tax-free method of saving for retirement. Check with your employer to see if these plans are available. If you are self-employed, however, you can enroll in a solo Roth 401(k). You invest after-tax dollars, and qualified withdrawals in retirement are tax-free.

3. Health Savings Accounts (HSAs)

A Health Savings Account enables you to save for future medical costs while lowering your taxable income. Anyone with a high deductible health insurance policy is eligible. You can contribute to your account up to the annual limit ($3,500 for individuals and $7,000 for family coverage in 2019). Some employers may choose to make contributions on your behalf.

HSAs provide a triple tax advantage. Your contributions are deducted from your paycheck before taxes or are tax deductible, lowering your tax bill for the year. The funds in your account grow tax-free, especially if you have an HSA that allows you to invest in mutual funds or other investments. The distribution is tax-free when you withdraw funds from your HSA to pay for qualified medical expenses.

You can use your HSA funds for non-medical expenses, but you’ll have to pay taxes and a 20% penalty if you’re under 65. After age 65, non-healthcare withdrawals are only subject to regular income tax.

4. Exchange-Traded Funds (ETFs)

You should consider exchange-traded funds if you want to invest tax-efficiently (ETFs). ETFs typically have lower costs than mutual funds and provide greater flexibility. The tax advantage is the type of bonds the ETF holds. 

For example, while U.S. government bond ETFs are exempt from local and state taxes, they are subject to federal taxation. On the other hand, municipal bond ETFs may be exempt from federal, state, and local taxes. 

There are numerous ETFs available, and many providers or exchanges supply them. Your age, income level, retirement goals, risk tolerance, and other factors determine your best ETFs. Consult with a tax advisor to determine the best investments for your financial situation and eligibility.

5. 529 College Savings Accounts

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6. Life Insurance

A lesser-known way to accumulate tax-free growth and income is to use cash-valued permanent life insurance policies, such as whole life or universal life. These policies include a death benefit and a cash component that one can borrow against (or draw down) while the insured is still alive.

This money grows at a modest rate yearly through dividends, which are not always taxed. You will not have to pay taxes if you withdraw money that you contributed (the basis). Alternatively, you can borrow tax-free against your policy’s cash value and let the policy dividends cover the interest costs.

7. Donate Highly Valuable Assets

Fulfilling charitable goals can be another excellent way for high-income earners to reduce taxable income and avoid significant taxable gains in the future. Donating low-cost, highly appreciated assets to a qualified charity or a charitable remainder trust (CRT) can help you avoid hefty capital gains taxes while also receiving a tax deduction for the current value of the gift.

8. Increase Other Deductions

If you have a mortgage on your home, you can deduct the interest paid. Deductions are also allowed for state and local property taxes. Although deducting these expenses may not significantly affect your tax bill, every penny counts toward lowering your taxable income. 

You can deduct medical expenses over 7.5% of your adjusted gross income if you file taxes. If you had significant medical expenses to pay for yourself or a member of your household during the year, this could be a valuable deduction.


Tax minimization is a fundamental dogma of investing. Holding tax-efficient investments in taxable accounts and less tax-efficient investments in tax-advantaged funds is an excellent tax-saving strategy. This tax-saving plan gives your accounts the best chance of growing over time.

Any personal budgeting or investment management decision must include tax planning. Tax-deferred and tax-exempt accounts are two of the most common ways to achieve financial independence in retirement.

Remember that you will always have to pay taxes when weighing the two options. Of course, even if it is preferable to keep an investment in a tax-advantaged account, there may be times when you must prioritize something else over taxes.

A corporate bond, for example, may be better suited for your IRA, but you may decide to keep it in your brokerage account for liquidity purposes.

Furthermore, because tax-advantaged accounts have strict contribution limits, you may be required to hold certain investments in taxable accounts. Using tax-saving strategies for high-income earners could help you owe the IRS less money each year.

However, keep in mind that the tax code is constantly changing. So, what works this year may not be as practical – or even possible – in three or five years. Regularly reviewing your tax situation can assist you in avoiding penalties. And, never hesitate to seek help from a financial advisor.

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