Income is taxed at the federal, state, and local levels and earned income is subject to additional levies to fund Social Security and Medicare. Taxes are difficult to avoid but there are several strategies you can use to help ward them off. Here are a few you might want to consider.
Key Takeaways
- Contributing to qualified retirement and employee benefit accounts with pretax dollars can exempt some income from taxation and defer income taxes on other earnings.
- Tax rates on long-term capital gains are low.
- Capital loss deductions can reduce taxes further.
- Interest income from municipal bonds is generally not subject to federal tax.
1. Invest in Municipal Bonds
Governments need money to fund their obligations to their citizens, such as maintaining safe roadways and public schools. They raise this money in part by selling securities: municipal bonds or “munis.”
The advantage here? Assuming you hold the bond until maturity, you don’t have to pay federal taxes on the interest—or state and local taxes either if you live in the locality where the bond was issued. Tax-free interest payments make municipal bonds attractive to investors.
That said, don’t assume that a bond isn’t taxable just because it’s a muni. There are some exceptions to munis’ tax-free status. A “de minimis” tax can apply if you purchased the bond(s) at a discount of more than 0.25%. Interest and gains derived from the discounted amount are taxed, and they’re taxed as regular income, not at kinder, long-term capital gains rates, no matter how long you hold the bonds.
Overall, municipal bonds historically have lower default rates than their corporate bond counterparts. A 2022 data report on municipal bonds from 1970 to 2021 found that the default rate was 0.08% for municipal bonds versus 6.9% for global corporate issuers. The data was based on a five-year period.
Municipals typically pay lower interest rates. Municipal bonds’ tax-equivalent yield makes…
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