Three Ways to Earn Totally Tax-Free Income
It’s income tax refund season!
Last week we discussed three smart ways to save or invest your refund. But this week, we’re talking about a slightly more exciting tax topic: how to earn tax-free income.
I’d wager that a lot of people are looking for legal ways to minimize their future tax liability right now. After all, as I mentioned last week, many taxpayers are getting an unpleasant surprise in the form of slightly lower average refunds than last year.
Those low refunds aren’t entirely a bad thing; they’re partially a result of lower withholding under the new income bracket system. But they’re also partially a result of popular deductions, like the state and local tax deduction, being capped.
If you got burned by the IRS or your state tax authority this year, you’d probably benefit from some of the tax-free income investment strategies we’ll discuss today.
And when I say “tax-free income,” I don’t mean “tax-deferred income,” “federally tax-free income,” or “state tax-free income.” I mean totally tax-free income — permanently exempt from federal and state taxes.
Yes, it’s a real thing. Let’s look at three ways to earn it.
Municipal Bonds from Non-State U.S. Territories
Non-state U.S. territories like Puerto Rico, Guam, and the Virgin Islands have a pretty strange and complicated legal status. Their residents are U.S. citizens, but they have no congressional vote, can’t vote in presidential elections, and generally don’t pay federal income taxes.
But there’s an upside to the legal limbo these three territories are in: Interest from their municipal bonds is exempt from federal and state taxes!
Puerto Rico is by far the largest of these three non-state territories in terms of both population and GDP, and it’s worth discussing on its own.
I know what you’re thinking: The island might not seem like a good place to invest. Yes, it went bankrupt in 2017. Yes, it was devastated by Hurricane Maria later that same year.
But Puerto Rico survived both of these catastrophes, and it’s starting to recover. In the process, it’s starting to attract municipal bond investors.
PIMCO actually increased its Puerto Rican municipal bond holdings nearly tenfold after the hurricane. Other large custodians like AllianceBernstein and Massachusetts Financial Services Co. have also grown their Puerto Rican bond portfolios in the last two years.
If the triple-tax-exempt status isn’t enough of an incentive to invest in Puerto Rican bonds, check out the yields. The territory’s bad financial reputation has pushed down bond prices, creating yields as high as 6.7% at the time of writing. Plus, buying them is a good deed — you’re providing infrastructure funding to an island that really, really needs it.
Untaxed State Municipal Bonds
Do you live in Washington, Texas, Florida, Alaska, South Dakota, Wyoming, Nevada, or the District of Columbia?
If so, congratulations — all municipal bond interest is free of federal and state taxes for you!
All municipal bonds are federally tax-exempt no matter where you live or where the bond was issued. And the states listed above have no personal income taxes. The nation’s capital does have an income tax, but it chooses not to tax any municipal bond interest as a matter of policy.
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It contains full details on why dividends are an amazing tool for growing your wealth.
Even if you don’t live in one of the states or districts listed above, there are still ways to earn totally tax-free municipal bond income. Every state except Oklahoma, Utah, Iowa, Wisconsin, and Illinois waives state taxation of interest from its own municipal bonds.
But what if you live in one of the five states that taxes its own municipal bonds and you don’t want to invest in Puerto Rico, Guam, or the Virgin Islands?
Don’t lose hope — there’s one more way that you can earn totally tax-free income...
Treasury Bonds and Proportional Charitable Contributions
U.S. Treasury bond interest is exempt from state taxes no matter where you live. But it's fully taxable by the IRS as income.
Fortunately, the federal income tax code still contains an easy-to-use deduction that can render your Treasury bond interest totally tax-free. I’m talking about charitable contributions — specifically the automatic, recurring variety.
The nice thing about Treasury bonds is that their interest payments are set in stone — you can look them up. Thus, you can calculate how much Treasury interest you’ll collect in a year, multiply it by your income tax rate, divide that number by 12, and set up recurring monthly donations to your favorite charity in that amount.
That might sound like a lot of math, but let’s look at an example to see how simple it really is. Suppose you buy 1,000 one-year Treasury bills for a price of $98 each, with a par value of $100 each. That would mean your interest income for the year is $2 per bond, $2,000 total, since 1,000 x ($100 - $98) = $2,000.
If you’re in the 24% tax bracket, the income tax due on your interest for the year would be $480, since $2,000 x 24% = $480. In monthly terms, it would be $40, since $480 / 12 = $40.
So if you set up an automatic $40-a-month donation to, say, the American Society for the Prevention of Cruelty to Animals (ASPCA), then you’ve created a charitable deduction that completely offsets your interest income for the year. The remaining $1,520 is totally tax-free.
Unlike the other tax-free income strategies we’ve discussed, this method doesn’t let you keep 100% of the income. But it does shelter you from state taxes. And it lets you pay a portion to a deserving charity of your choice, instead of being forced to give it to Uncle Sam.
Getting an income tax refund is a cause for celebration for many Americans. But others see it as a painful reminder of how much of your money the government has sat on for the last year.
These three strategies generate income that’s untouchable by federal and state governments, so you can spend it all on what you choose to spend it on, whenever and wherever you like.
Until next time,
Samuel Taube brings years of experience researching ETFs, cryptocurrencies, muni bonds, value stocks, and more to Wealth Daily. He has been writing for investment newsletters since 2013 and has penned articles accurately predicting financial market reactions to Brexit, the election of Donald Trump, and more. Samuel holds a degree in economics from the University of Maryland, and his investment approach focuses on finding undervalued assets at every point in the business cycle and then reaping big returns when they recover. To learn more about Samuel, click here.
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