The Pros And Cons Of Tax-Free Investments

There actually are a few tax-free investments available to investors in the United States today. The catch is that they are mostly related to municipal bonds, abbreviated as muni bonds. As with anything, there are pros and cons to the several investments based on municipal bonds.

Muni bonds are local government-issued bonds floated to pay for government projects like constructing schools and improving roads. In reality this investment is a loan to the local government. A significant benefit to a muni bond investment is that it offers a guaranteed return rate via dependable interest payments. The strongest selling point to these munis is that the interest payments are completely federal tax exempt. This tax exemption often applies to local and state taxes on interest too.

While the risk of default is very low, there are some downsides to investing in municipal bonds. The rates of return may not be high enough to significantly outperform inflation. Some muni bonds interest is eligible to be taxed under the Alternative Minimum Tax.

There are also mutual funds that can allow investors to earn tax-free returns as part of a strategy to minimize tax liability in retirement. Mutual funds are baskets of investment securities such as stocks, bonds, or both. This type of fund is either professionally managed or tracks an index. The great appeal to this investment is that it is truly hands off.

Some mutual funds have a tax-exempt status, allowing them to deliver truly tax-free returns. The vast majority of funds with this designation invest in municipal bonds as well as additional government securities. Besides providing tax-exempt earnings these mutual funds offer effective and easy diversification in various kinds of government securities, according to Smart Asset.

There are some downsides to these tax-exempt mutual funds. Potential investors should carefully investigate how much the return actually is. This real return will be impacted by the management fees, making it important to be aware of the expense ratio.

A third option for earning truly tax-free income is with a tax-exempt exchange traded fund. ETFs are much like mutual funds with the difference that they are listed on exchanges similarly to stocks. When these ETFs focus on municipal bonds they deliver that coveted tax-exempt benefit.

ETFs often follow a passive management strategy, meaning that the holdings in the funds are not regularly turned over as with funds that are actively managed. This gives these funds a significant advantage. The ETFs typically track an actual index instead of having a fund manager who is selecting securities. It results in often significantly lower costs in fund management.

There are limited downsides to these ETF funds. Like with the bucket strategy, potential investors are able to select from short-term, mid-term, and long-term bond ETFs that enjoy this tax-exempt status. An investor's goals and investing time frame will affect which ones are most appropriate. Two big factors to consider with the tax-exempt ETFs are the tax-free ETF inflation-adjusted returns and the investment fees. Besides tax-free investments there is also a trust that can help you avoid paying taxes.