Tax Yield Investments

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Contributor, Benzinga
February 15, 2023

Taxes can take a hefty bite out of your investment returns, and they can be costlier than you might expect. Not only do you end up with less money, but taxes can take away the growth opportunity you would have had by reinvesting those funds. Tax yield investments can save money with favorable tax treatment, but you need to know which to choose and which to avoid. 

The Best Tax-Free Investments

While you may not avoid taxes altogether, you can choose investments to keep the tax bite down. Consider adding these tax-free investments to the mix when building your investment portfolio. 

Municipal Bonds

With municipal bonds, you loan money to the government to fund projects like building schools or roads. Sometimes referred to as muni bonds, these investments offer a guaranteed rate of return and a low chance of default. The interest you earn is exempt from federal tax. Depending on where you live, you may also qualify for a tax exemption from state and local taxes on the interest you earn.

Tax-Exempt Mutual Funds

Mutual funds are a collection of investments managed by a professional. Most portfolios include securities such as stocks and bonds. Mutual funds that hold municipal bonds or other government securities may be exempt from tax. Investing in tax-exempt mutual funds lets you diversify your holdings across different government securities.

Tax-Exempt Exchange-Traded Funds

An exchange-traded fund (ETF) is an investment product designed to track the performance of a basket of assets or a specified index. ETFs can be similar to mutual funds, but they trade like a stock on an exchange. An ETF that holds municipal bonds or other government securities may be tax-exempt.

Indexed Universal Life (IUL) Insurance

Indexed universal life (IUL) insurance is a type of permanent coverage that builds a cash value and provides a death benefit. The IUL cash value ties its performance to a market index like the S&P 500. When the market performs well, you may see higher returns than if you earned a fixed interest rate. Your principal is guaranteed, which helps protect you from losses in a market downturn. An IUL offers tax-deferred growth. You can take out distributions up to what you have contributed without paying tax. However, distributions that exceed your contributions may be taxable at ordinary income rates.

Roth IRAs and Roth 401(k)s

Roth IRAs and Roth 401(k)s are retirement accounts used for tax-advantaged investing. Unlike traditional retirement accounts, where contributions lower your taxable income when you make them, you contribute after-tax dollars to Roth IRAs and Roth 401(k)s. By contributing after-tax dollars now, future distributions are tax-free. Roth IRAs and Roth 401(k)s can be particularly beneficial if you expect to be in a higher tax bracket when you retire. They can also help if you expect to grow your contributions significantly.

Health Savings Accounts

A health savings account (HSA) lets you save for future medical expenses while reducing your taxable income now. An HSA is like a savings account where it earns interest over time. However, an HSA differs from a savings account as you pay no federal tax on the interest earned.

You can take the money from an HSA tax-free for qualified medical expenses. If you withdraw funds for other purposes, you are subject to federal tax plus a 20% penalty. However, when you reach 65, you can take out distributions from an HSA, similar to a retirement account. You will pay tax on the distributions, but you will avoid the 20% penalty. 

HSAs benefit from a triple tax benefit because contributions are tax-deductible, earnings and interest grow tax-free and distributions are also tax-free – as long as the money is used to pay for eligible medical expenses. 

What is the Tax-Equivalent Yield?

A tax-free investment may seem like a good idea because you can limit or avoid paying tax on your returns. However, there may be times when a taxable investment produces a better return.

A tax-equivalent yield is the return a taxable investment needs to generate to match what you would earn on a tax-free investment. The formula compares the return of the tax-free investment against your marginal tax rate.

For example, assume a tax-free bond yields 8%. If you fall into the 10% tax bracket, your calculation will look like this:

8% / (1 – 10%) = 8.89%

Based on the above example, you would need to earn 8.89% on a taxable bond to make the same return as an 8% tax-free bond. So, while you pay no tax with an 8% tax-free bond, a taxable bond with a higher than 8.89% return may prove to be a better investment. 

What is Your Tax Bracket?

Your tax bracket plays a crucial role in calculating a tax-equivalent yield. There are seven brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. To analyze the tax-equivalent field, consider which bracket you expect to land in based on your income.

Let’s compare the tax-equivalent yield calculation using the above example. When you fall into a 12% tax bracket, the taxable bond produces a higher return:

 8% / (1 – 12%) = 9.09%

 Yet, if you are in a 22% tax bracket, your tax-equivalent calculation is:

 8% / (1 – 22%) = 10.2%

Pros and Cons of Tax Yield Investing

Tax yield investing can help you keep more of your income. As with most investments, tax yield investing has pros and cons.

Pros

  • Limit or avoid tax on investment returns
  • Less risk with certain investments, such as municipal bonds
  • Can produce a reliable source of income

Cons

  • Returns may be less if you fall in a lower tax bracket
  • Retirement and other tax-advantaged accounts may restrict or penalize you for early distributions
  • Contributions may be limited

Frequently Asked Questions

Q

Is tax yield investing safe?

A

Tax yield investing can be safe when you research investments and compare returns before you invest. 

Q

Why is tax lien investing risky?

A

Tax lien investing is risky as there is no guarantee that the owner can pay back their debt. The owner could declare bankruptcy, so money could go to other creditors ahead of you. Or, the tax lien may be on property with little value. 

About Anna Yen

Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate. Her work has been published on sites like Quicken and the crypto exchange Bybit.