Not only do you have to pay taxes on your income, but also on the interest and other profits that you receive from investments. You may be tempted to spend all your money – why invest if the IRS is just going to take a chunk of it? – but remember, you will always have more by saving instead of spending, even if you have to pay taxes on it. Plus, there are many tax-lowering strategies you can engage in.
A bond is a loan to a company or the government, with you, the bondholder, as the lender. Organizations issue bonds when they want to raise funds. Typically, you receive the principal at the maturity of the bond and the interest periodically (usually twice a year) while you are holding the bond. In most cases, you have to pay taxes on the interest you receive. However, this is not true for all bonds.
Municipal bonds are issued by cities, counties, states, and other non-federal government agencies to fund public projects. In general, the interest received on municipal bonds is exempt from federal income tax, as well as state tax if you live in the state you purchased the bond from. If you purchase a municipal bond with a yield (total return) of 5%, you receive the full 5%. In contrast, if you purchase a corporate bond with a yield of 7% and have a marginal tax rate of 30%, you are essentially getting only 4.9% due to the taxes you have to pay.
In the U.S., the biggest issuer of bonds is the federal government. Most federal bonds are issued by the Department of the Treasury. Typically, you do not have to pay state taxes on interest received from federal bonds. However, you do have to pay federal taxes. (One exception: you do not have to pay federal taxes on U.S. Series EE or I savings bonds if the funds are used to pay for college tuition or fees.) A nice feature of federal bonds is that you do not need a fortune to purchase them: most types can be bought for as little as $25-$100.
Treasury bonds can be purchased online at www.treasurydirect.gov. You may be able to purchase municipal bonds directly from the government or agency offering them. Bonds can also be purchased from investment firms, bond brokers, and many credit unions and banks.
Keep in mind that tax-free bonds don’t always provide the best deal. If the yield on the corporate bond mentioned above was 8% instead of 7%, it would provide an after-tax yield of 5.6%, a better deal than a municipal bond at 5%. Generally, the higher your income, the more advantageous tax-free bonds are. You may want to consult with a financial advisor about what would be best for you.
There are no tax-exempt stocks, but you can lower your tax burden by making sure you do not sell your stocks too quickly. Profits made from stocks held less than a year are considered short-term gains and are taxed at the regular rate that your income is taxed at. Profits made from stocks held more than a year are considered-long term gains and are taxed at the capital gains tax rate (on the federal level). For people in the 10% and 15% tax bracket, the capital gains tax rate is 0%. For people in the 25% tax bracket and above, the capital gains tax rate is 15%, a difference of at least 10 percentage points.
If you are currently renting, have you thought about buying a home? A house is not just a place to live but also an investment. Over the long term, the values of most houses increase. You can deduct several expenses associated with homeownership on your tax return, such as mortgage interest and property taxes. Furthermore, when you sell the house, you are exempt from paying taxes on up to $250,000 ($500,000 for married couples filing jointly) of the profits from the sale, as long as the home had been your primary residence for at least two of the five years prior to the sale. So if you buy a house today for $200,000, live there, and sell it five years from now for $300,000, your $100,000 in profit would be completely tax-free! Of course, purchasing a $200,000 house is a much bigger commitment than purchasing a $50 bond and is something that should only be done if you can afford the mortgage payments and other responsibilities of homeownership.
Most tax-advantaged vehicles have restrictions on how much you can contribute/purchase annually, and you may not qualify if your income is above a certain amount. Visit the IRS’s website at www.irs.gov for more information or consult with a qualified tax advisor.