Tax Free? Does it Really Exist?

Most People Confuse Tax Deferred (will be taxed at some point) with Tax Free (will never be taxed)

When most investors hear “tax free income”, they immediately think about investing in municipal bonds which are free from federal income taxation.  There are many financial calculators for the tax free equivalent yield when investing in municipal bonds.  Clearly one of the main components of the evaluation of tax free investing is your income tax bracket.

Typically an investor whose income is in the 28%-31% marginal tax bracket could assume a 2.25% to 2.5% cost effect for income taxation on their investment yield.  This erosion to the performance of our investments has an even more significant effect as we compound it over longer periods of time.  While the number of years is the most significant determinant on this analysis, another consideration must be the investment environment.  In a period of low interest rates for bond and money markets, and low performance in the equity markets, the 2+% cost is more statistically significant.  As you know, this is the financial world that we are currently investing in.  It appears that the Federal Reserve is content to have a nearly zero interest rate monetary policy in perpetuity.

For these reasons, it is imperative that we, as investors, evaluate and vet any possible tax free investing and income options.  Other than municipal bonds, the only other two tax free options are Roth IRAs and 529 Plans.

What is a Roth IRA?

Roth IRAs work much like regular individual retirement accounts with the exception that there is not a tax deduction for the contribution.  Roth IRA contributions are allowed for most all taxpayers who have earned income, including taxpayers over 70 years of age.  Income limitations are the primary reason investors will not qualify to make annual Roth IRA contributions.  For example, allowed contributions totally phase out at $194,000 of modified adjusted gross income for married filing joint taxpayers ($132,000 for single filing status).

The top benefits of a Roth IRA are:

A.  Distributions

- Distributions aren’t mandatory, unlike regular IRAs which have annual required minimum distributions starting at age 70 ½.  However, you need to be aware of special distribution rules for beneficiaries of Roth IRAs in your estate planning.

B.  Tax Benefits

-Distributions have no tax consequences when received.  Everyone should evaluate on an annual basis if you are allowed to make a Roth IRA contribution.

Other than a Roth IRA, the only other tax free investment vehicle available is the 529 Plan.

What is a 529 Plan?

It is a state sponsored educational savings plan that allows for TAX FREE growth of assets that are set aside for education of a specific beneficiary.  These plans are also commonly known as “qualified tuition plans”.

529 Plans can be used to meet costs of qualified colleges nationwide and are not limited to the plan sponsored by your state of residence.  You can be a resident of Georgia and participate in a 529 Plan sponsored by Virginia and your beneficiary can attend college in New York.  (However, please evaluate the benefits of using the 529 Plan sponsored by your resident state as many times there are state specific advantages.)

The top benefits of the 529 Plan are:

A.  Tax Benefits

- While your contributions are not tax deductible on your federal income tax return, your investment grows tax deferred and distributions for college costs of the beneficiary are distributed TAX FREE, thus the investment gains are never taxed if used for college expenses.

-Many states offer tax breaks in the form of up front tax deductions or credits against your state income tax obligation.

B.  Donor Retains Control of the Funds

- The donor controls the decisions of the account in regard to investment choices and distributions.

- You have the ability to reclaim the funds should you decide the funds aren’t needed for the beneficiary.  (Please be careful as there are special income tax consequences if the funds are withdrawn and returned to the donor.)

- The donor has the ability to change the beneficiary to another qualifying family member, if desired

C.  Donor Reduces Taxable Estate

- The money in the 529 Plan is not included in the donor’s estate.  This is especially important if you have a taxable estate (i.e. total net worth over $5M).

D.  Flexbility

- 529 Plans are portable and can be transferred between plans and rolled over much like an IRA.  If you believe another state sponsored plan provides better options, you can transfer without penalty.

E.  Substantial Funding Permitted

- Anyone is eligible to participate in a 529 Plan and the contributions limits, which vary from state to state, can allow for up to $300,000 in contributions per beneficiary.  There are no income or age restrictions.

If you want to get started, please research whether your state has its own state sponsored plan and then evaluate the benefits of that plan.  Next, compare those benefits to other plans sponsored by other states.  Typically, large investment companies partner with individual states to provide 529 Plan solutions for that state’s residents.  (I believe that almost every state has at least one 529 Plan solution available.)  This would include funding limits, investment options and state tax benefits.

I strongly encourage you to consider using the 529 Plan as a solution to save and fund college education for your children and grandchildren.  The benefits outlined above are just a sample of the planning opportunities these plans provide.

Any opportunity to access tax free investing should be considered and funded to the greatest extent possible.  Evaluate annually your eligibility for Roth IRA contributions, and if you have any need for college funding for any family member, the 529 Plan is a must.

I am very comfortable saying that taxation will remain a significant cost to investors irrespective of the political process, thus we must evaluate any option that removes the cost of that taxation.