How to Invest in Tax-Free Savings Accounts

It’s not what you earn; it’s what you keep. Even if you get a good return on a savings vehicle, some of that money is going to taxes. That’s not the case with a tax-free savings account or other forms of tax-free investments. Choose from various forms of tax-free savings, including retirement accounts. If you're Canadian, you have options that are not available in the United States.

Tax-Exempt Savings Plan

Canada has a formal tax-free savings account, or TFSA, which is not the case with the U.S. However, there are plenty of opportunities available for U.S. residents to contribute to tax-free accounts. Tax-free money market funds invest in short-term debt obligations, such as municipal bonds, which are federally tax exempt. While these money market funds return a lower yield than taxable money market funds, investors don’t have to pay taxes on the interest. In addition, these funds are very safe investments. However, money market funds are not the same as money market deposit accounts, which are issued by commercial banks. The latter are insured by the Federal Deposit Insurance Corporation for up to $250,000 per account, while the former are not.

Before investing in a tax-exempt money market fund, figure out whether the lower yield is better for you from a tax perspective than investing your money in a taxable money market fund. First, consider your income tax bracket. Tax-exempt money market funds usually make more sense for those in higher brackets. Compare the yield of both funds, and then consider your tax rate. Invest in the type of money market fund that provides the best yield when taxes are taken into consideration.

Tax-Free Municipal Bonds

Another good and safe way to invest tax-free is via tax-free municipal bonds, which you can purchase individually or through a mutual fund. If you reinvest the income, it continues to compound tax-free. State and local governments issue municipal bonds (hence the name) as an interest-bearing debt obligation to pay for infrastructure needs, hospitals and other public projects. Other entities may issue similar bonds for projects benefiting the public, such as a port authority. Municipal bonds are also known as tax-exempt bonds.

The most common type of municipal bond is the general obligation bond, the issuance of which requires voter approval. If you had a bond issue on the ballot in your state recently, you were voting as to whether or not the state government should take on this particular obligation. Revenue bonds, which offer higher yields, are a little riskier. They are so named because these bonds are secured by a particular revenue source, such as tolls. Another type of tax-free bond is known as commercial paper. These short-term bonds are issued by governments for meeting budget shortfalls and other issues requiring quick cash. Since this debt is very short term, usually less than one year, yields on commercial paper are quite low. Again, you can calculate whether a tax-free municipal bond is a better choice for your portfolio than taxable corporate bonds by comparing the yield rates and your income tax bracket.

One caveat: Although municipal bonds are tax-free at the federal level, they are not necessarily tax-free at the state level unless you buy a municipal bond issued by your state. While the state taxes on municipal bonds are not high, they are taxes. If you live in a high-tax state, such as New Jersey or California, make the most of your tax-free investing by purchasing New Jersey or California municipal bonds.

Tax-Deductible Savings Options

You may have a 401(k) or similar retirement plan at work. That is a tax-advantaged plan since the money taken out of your paycheck is pre-tax, and you don’t pay taxes on the amount. The funds in the 401(k) grow tax free until you start making withdrawals once you are at least age 59 ½. At that point, the withdrawals are taxed as ordinary income. You must start taking mandatory withdrawals by the age of 70 ½.

Although you are probably in a lower tax bracket in retirement than during your working years, a 401(k) is not tax-free per se. Neither is a traditional IRA, SEP-IRA or SIMPLE IRA, although you can deduct your contributions to these accounts if you aren’t covered by an employer-sponsored retirement plan at work or you meet the IRS adjusted gross income limits to take the deduction. As long as you earn at least that much, you can contribute $5,500 annually to an IRA and $6,500 if you are age 50 or over. However, like the 401(k), traditional IRA contributions are taxed as ordinary income once you begin making withdrawals

Tax-Free Roth IRA

A Roth IRA is truly tax-free. You make your Roth IRA contributions with post-tax money, so these contributions are not tax deductible. The contribution limits are the same as with a traditional IRA, but once you start taking withdrawals, the income is not taxed as long as the account was open at least five years. Unlike the 401(k) and the traditional IRA, there is no requirement for mandatory withdrawals with a Roth IRA, so you can leave the money to grow tax-free for your heirs. Roth IRA contributions are subject to income limits, so high-income earners may not qualify for a Roth IRA or may only be able to make a partial contribution.

Flexible Spending Accounts

If your company offers a flexible spending account, consider taking advantage of it. There is one issue with an FSA: You must use the money declared at the beginning of the year for eligible expenses or lose it by the end of the year. Qualifying expenses include those for child care or for health care. You can only use FSA monies for medical expenses that are not covered by your insurance. Currently, you can put $2,650 into your FSA account. This amount of your salary is not taxed.

Health Savings Accounts

If your employer doesn’t offer an FSA, and you have a high-deductible health insurance plan, an HSA offers tax advantages. HSAs don’t have the use it or lose it provision of the FSA, and they can earn interest. If the interest is used to pay for eligible medical expenses, it is tax-free. Keep in mind that HSA funds are only used for health-related expenses. Currently, an individual may contribute up to $3,450 to an HSA annually, while the family contribution is $6,900. These contributions are tax deductible.

Canadian Tax-Free Savings Accounts

Canadian residents may take advantage of their country’s TFSA. No taxes are levied on contributions, interest, capital gains or dividends, so all monies are withdrawn tax-free. Anyone age 18 or older in Canada may contribute up to $5,500 annually to the TFSA and can use the withdrawn money for any purpose. Unlike Canada’s registered retirement accounts, contributions made to the TFSA are not tax deductible. Another TFSA advantage is that savers who couldn’t put away $5,500 in one year may carry the amount forward into the following year. For example, if you can only manage to put $3,500 into your TFSA this year, you can contribute up to $7,500 to your account next year.

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