Some investments provide tax advantages by either eliminating or postponing income tax on the investment income or growth. In what kinds of investments can you place your money to shield yourself from taxes? Here are some you might want to consider:
- Tax-free municipal bonds. Interest earned from these government certificates of debt is usually free from federal income tax. Earnings from the sale of municipal bonds are subject to capital gains taxes.
- Annuity contracts. An annuity is a series of guaranteed lifetime payments usually paid by an insurance company. Earnings from investor contributions to the annuity are immune from income taxes until the annuity is paid. Distributions from annuities prior to age 59½ may be subject to an additional 10 percent penalty tax. Annuity withdrawals will be taxed in the same year they are withdrawn.
- Rental real estate. Property price appreciation is not subject to income tax each year. If the property is held longer than one year, any profit will be taxed at the long-term capital gains rate, which is usually lower than the taxpayer's ordinary income tax rate. Rental real estate can also offset income with losses and has the potential to earn tax credits in special situations.
- Cash value life insurance (loans). A portion of the premium payments is invested by the insurance company and builds the policy's cash value tax-deferred. This cash value can later be converted into a taxable withdrawal or borrowed, without tax consequence.
- Tax credit investments. Certain investments, such as low-income housing and energy resources, may qualify for tax credits.
- Another way to shelter your income is to invest in certain types of businesses that allow you to use their losses to offset your income. These include limited liability companies, partnerships, and certain trusts. These are sources of passive income, because the investor does not materially participate in their operations. A limited partnership, for example, allows you to invest with limited liability and take the resulting profits or losses as part of your tax liability. However, deductions from passive activity losses are limited to the amount of net income passive activities generate.