Reduce Your Taxes
While selecting tax-efficient investments and making the most of tax-deferred accounts may help reduce your tax bill, it won’t eliminate taxes altogether. There are a few options available that do have the potential to generate income or earnings that you generally won’t have to pay federal income taxes on—including many municipal bonds, Roth IRAs, and college savings accounts.
Reduce taxes with tax-exempt municipal bonds.
With many muni bonds, whether you’re purchasing individual securities directly or through a fund, ETF, or separately managed account, you generally get income that’s exempt from federal taxes. What’s more, in many states, if you hold bonds issued by your state of residence, these bonds offer state tax–exempt income, too. That covers most municipal bonds but doesn’t apply to all: certain municipal bonds, called private activity bonds, when held by investors subject to the alternative minimum tax.
When considering munis, it is important to note that the yield is typically lower than taxable bonds with similar credit ratings and maturity. A lower yield means they will have a higher duration, all else being equal, and a higher duration means the bond may be more volatile as rates change. (For more on duration, read the Learning Center: Duration). It also means that your tax bracket is a key factor to consider when evaluating a muni bond, along with traditional bond characteristics such as yield, maturity, and credit quality. The basic rule of thumb is that investors in higher tax brackets will be more likely to benefit from investing in munis.
Reduce Taxes Through Roth IRA
Instead of deferring taxes, you may want to accelerate them by using a Roth account. A Roth IRA or Roth 401(k) contribution won’t reduce your taxable income the year you make it, but there are no taxes on any future earnings as long as you hold the account for five years and are age 59½ or older, disabled, deceased, or withdraw earnings to pay for qualified first-time homebuyer expenses. That can make a big difference if you think your tax rate will be the same or higher than your current rate when you withdraw your money. There are also no required minimum distributions (RMDs) from a Roth IRA during the lifetime of the original owner.
Roth IRA contributions are only allowed for investors up to a certain income level, but those rules don’t apply to Roth 401(k)s, if your employer offers you one. Higher wage earners can also access a Roth through a conversion from a traditional IRA or 401(k). You pay federal income taxes now on the conversion amount but none on any future earnings—if you meet the requirements.
Reduce taxes by seeking tax advantages for college.
The cost of higher education for a child may be one of your biggest expenses. Like retirement, there are no shortcuts when it comes to saving, but there are some options that can reduce your taxes. For instance, 529 college saving accounts and Coverdell accounts will allow you to save after-tax money but get tax-deferred growth and tax-free withdrawals when used for qualified education expenses. Grandparents can also make significant gifts to a 529 without incurring gift taxes. You may also want to consider EE savings bonds issued by the U.S. Treasury or prepaid tuition plans, which offer other tax advantages when saving for college for certain investors.