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Tax-Exempt Investments: How to Build a Tax-Efficient Portfolio

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Learn how to minimize the impact of taxes on your investments.

an image of a portfolio with a calculator and tax forms in the background. the portfolio contains a mix of municipal bonds, reits, and tax-exempt funds.

One often-overlooked aspect of retirement planning is the effect of taxes. Without proper planning, taxes can take a significant bite out of your portfolio's returns. Fortunately, there are ways to minimize the impact of taxes on your investments, such as investing in tax-exempt funds.

Fixed-income investors hunting for tax efficiency may find these funds highly useful. One popular option for tax-exempt investing is municipal bonds. These bonds are issued by state and local governments to fund public projects such as schools, highways, and hospitals. The interest income from municipal bonds is typically exempt from federal income tax, and in some cases, state and local taxes as well.

Investors can build a diversified portfolio that will never be taxed at either the corporate or individual levels. Read why now is a great time to start investing in tax-exempt funds to maximize your after-tax returns.

On March 28, Reps. Dutch Ruppersberger (D-Md.) and David Kustoff (R-Tenn.) reintroduced the bipartisan Investing in Our Communities Act to help municipalities and other tax-exempt entities finance infrastructure projects. The bill would create a new category of tax-exempt bonds called “qualified infrastructure bonds,” which would be available to state and local governments, public power providers, and certain nonprofits.

You may not be able to dodge Uncle Sam altogether, but some investments have definite tax perks. For example, real estate investment trusts (REITs) are required by law to distribute at least 90% of their taxable income to shareholders in the form of dividends. The dividends from REITs are generally taxed at the investor's ordinary income tax rate, but they may qualify for the qualified business income deduction under the new tax law.

Two new funds from Vanguard and Goldman Sachs Asset Management are expanding investor's options for municipal bond bets. Vanguard's fund will invest solely in AAA-rated municipal bonds, while Goldman's fund will invest in a mix of investment-grade and high-yield municipal bonds.

A tax-exempt organization generally does not pay tax on activities related to its exempt purpose. For example, a nonprofit that provides educational services is generally exempt from federal income tax on the income it earns from those services. However, if the nonprofit engages in unrelated business activities, such as selling merchandise or renting out space, it may be subject to unrelated business income tax (UBIT).

The IRA opens up opportunities driven by tax credits for tax-exempt organizations like local governments, higher ed, and hospitals. For example, a hospital that invests in a solar project could be eligible for a tax credit worth up to 30% of the project's cost. The hospital could then use the tax credit to offset its UBIT liability, reducing its tax bill.

Generally speaking, income you earn from your job or business is fully taxable at the federal level and, where applicable, at the state level. However, there are several tax-exempt investments that can help reduce your tax bill, including municipal bonds, REITs, and tax-exempt funds.

In conclusion, tax-exempt investments can be a valuable tool for minimizing the impact of taxes on your portfolio's returns. By investing in municipal bonds, REITs, and tax-exempt funds, you can build a diversified portfolio that will never be taxed at either the corporate or individual levels. With the Investing in Our Communities Act and other tax incentives available to tax-exempt organizations, there has never been a better time to start investing in tax-exempt funds.

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