2-Minute Money Manager: How Can I Get Tax-Free Income?

Welcome to the “2-Minute Money Manager,” a short video feature answering money questions submitted by readers and viewers.

Today’s question is about income; specifically, how to get income without having to pay those pesky income taxes that so often come with it.

Watch the following video and you’ll pick up some valuable info. Or, if you prefer, scroll down to read the full transcript and find out what I said.

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For more information, check out “9 Types of Retirement Income That Are Tax-Free” and “How All 50 States Tax Your Retirement Income.” You can also go to the search at the top of this page, put in the word “taxes” and find plenty of information on just about everything relating to this topic.

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Got a question of your own to ask? Scroll down past the transcript.

Don’t want to watch? Here’s what I said in the video

Hello, and welcome to your “2-Minute Money Manager.” I’m your host, Stacy Johnson, and this answer is brought to you by Money Talks News, serving up the best in personal finance news and advice since 1991.

Today’s question comes from Herb:

“I’m fully retired at age 83, and I have a traditional IRA, Roth IRA and municipal bonds that generate income. Federal and state tax on the bond income kills me at tax time. Is there any investment I can make with this income to avoid the tax crunch?”

Understanding municipal bonds

Like most retirees, Herb invests for income and safety, which typically means investing in bonds.

For the uninitiated, a bond is simply an IOU. You lend money to a company or government agency, and it promises to pay it back at a specific date in the future, along with some interest along the way.

Bonds come in several types, all appropriately labeled. Corporate bonds are issued by corporations. Government bonds, also known as Treasury bonds, are issued by Uncle Sam. Municipal bonds are issued by municipalities: state or local governments.

Bonds can be purchased individually, as well as collectively in mutual funds and ETFs.

While these different types of bonds work basically the same way, the interest they pay can get vastly different treatment at income-tax time. At a glance:

• Interest on corporate bonds is generally taxable at both the federal and state level.
• Interest on U.S. government bonds is taxable at the federal level, but is generally free of state income taxes.
• Interest on municipal bonds is taxable at the state level, but is generally federally tax-free.
• Interest on municipal bonds issued in the state where you live can be completely exempt: no federal, state or local taxes.

Since municipal bonds offer income that’s potentially free of federal, state and local income taxes, you might logically wonder why anyone would invest in anything else. The answer is that because they’re tax-free, they often pay less interest.

To illustrate, here are some recent examples from Vanguard. Intermediate-term, high-quality municipal bond mutual funds are paying about 2%. Intermediate government bond mutual funds are paying about 2.5%. And intermediate-term, high-quality corporate bond mutual funds are paying about 3%.

In short, while municipal bonds offer tax-free interest, there’s often less of it, so it balances out. In fact, depending on your tax bracket, taxable bonds can pay more in after-tax income than the tax-exempt kind. Municipal bonds generally pay off for only for those in the highest federal tax bracket, currently 35%.

Municipals: Tax-free — mostly

Now, let’s go back and look at Herb’s question again. He says he has “municipal bonds that generate income. Federal and state tax on the bond income kills me at tax time.”

Since municipal bonds are free of federal taxes, and could be free of state income tax as well, how could they be killing Herb at tax time?

It could be that Herb is mistaken and doesn’t realize his income from municipal bonds is federally tax-free. But there are situations when even tax-free income can hurt you at tax time. For example, when computing your income to determine whether you’ll owe taxes on Social Security benefits, income from municipal bonds is included in the computation.

To learn more, see “5 Ways to Avoid Paying Taxes on Your Social Security Benefits.”

What should Herb do?

In addition to municipal bonds, Herb is also taking advantage of another source of tax-free income: distributions from a Roth IRA. Since these accounts were funded with after-tax dollars, you don’t pay taxes when you take money out.

Another thing he could do is donate his required minimum distribution (RMD) from a regular IRA to charity. You can donate up to $100,000 of required minimum distributions to charity every year and avoid taxes. This is called a qualified charitable distribution, or QCD.

Of course, since you’re donating that money to charity, that’s money you won’t be able to use for yourself.

There are ways to shelter income from taxes, but most involve jumping through hoops of some sort. For example, deductions on rental real estate can offset rental income and the taxes associated with it. But investing in real estate is time-consuming and risky. It’s not something I’d be doing at Herb’s age.

As a result of the latest federal tax reform, you can shelter up to 20% of self-employment earnings. But to capture that write-off, you have to be self-employed. That, like real estate investing, isn’t something I hope to be doing when I’m in my 80s.

Some passive investments, like real estate investment trusts (REITs) and annuities, can offer some income that’s free of tax. But that’s because the regular payments from these investments can include the return of some of your investment, called return of capital. It’s not really tax-free income.

Bottom line? What Herb should probably do is what a lot of us do around tax time: Grit our teeth and pay our taxes. For most of us in common situations, there are simply not many ways to legally avoid taxes on our income. Frustrating? You bet, especially when you read about how 60 of America’s biggest companies paid no federal income tax in 2018.

But if you don’t like it, the next time you write a check for income taxes, take an extra minute or two and write your representatives.

Hope that helps, Herb. See you all right here next time!

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About me

I founded Money Talks News in 1991. I’m a CPA, and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate.