InvestmentTax Planning

An overview of tax-free investments

Over the past few days I’ve spent time communicating with other financial writers online and skimming published articles on the topic of tax-free investments. In a world where most topics, especially most investment topics, are covered redundantly, it is surprising to learn that this topic has holes in media coverage and that much of the mainstream published media contains “half truths” on the topic. That realization triggered this short and simple blog post.1

First of all, when tackling a topic like this it makes sense to agree on a definition. The term “tax-free investment” as I’m using it here means a security or vehicle where you have a reasonable expectation of a positive net return – in other words you reasonably expect to get more out than you put in – and that amount of gain returned escapes federal income taxation. A scan of popular articles in Forbes, The Motley Fool and Investopedia brings up topics like annuities, retirement plans, charitable donations, etc. that are not truly tax-free investments by this definition. Gains on charitable donations, for example, would not meet the requirements of this definition. Many of the published discussions mingle “tax-deferred”into the mix. However we should distinguish here that tax deferred is not the same as tax-free.2

We can then segregate the legal class of investment vehicles that allow for their gains to be tax-free when used as intended under the tax law. We should distinguish that these investments are not tax free per se but rather that the vehicle used (or “wrapper” for conceptualization) used makes the gain tax-free. This class includes 529 plans, Health Savings Accounts, Uniform Gift to Minors Accounts and cash value life insurance. Under my criteria, these are not the same as truly tax-free investments.

The list of truly tax-free investments under this definition and distinction is actually quite short:

Personal residence – under the most common scenarios described in tax law the gains on sale of a personal residence are tax-free.

Small business stock – Gains on sale of small business stock that meets tax law requirements is tax-free.3

Municipal bonds – Interest paid by government entities is tax-free.4


1This article is meant as a simplification, deliberately omitting reference to tax code and details prescribed under the law.
2Tax advisers use phrases like “a tax deferred is a tax avoided” or “a tax deferred is a tax saved” and from an accrual-based accountant’s perspective “a tax deferred is a tax unpaid”.
3A prominent tax writer is planning an article on this topic presumably for publication in a major news source soon. I expect the increased publicity of this relatively unknown area of tax and investment will help my niche small business practice.
4Some types of municipal bonds where interest is secured by revenue from operating projects rather than from general government taxes generate interest that is subject to Alternate Minimum Tax that is a type of federal income tax.

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