Although passive income is a great way to accumulate wealth over time, not all passive income is created equal in terms of tax treatment.  With the risk of higher taxes in the future, it’s important to understand how to generate tax free income, especially if you live in a high income tax state.  In this blog post, we’ll highlight the most common strategies that beginner investors can apply to generate tax-free passive income beyond stashing your money in municipal money market funds and instead using other tax free investments.

1. Municipal Bonds and Bond Funds 

Municipal bonds is debt issued by state, city, and other public agencies as individual financial instruments to fund public initiatives. Typically, they are issued with a fixed interest rate and maturity date. Since they are supported by the full confidence and credit of the issuing municipality, they are typically regarded as relatively safe investments. Mutual funds that invest in a portfolio of municipal bonds are known as municipal bond funds. The fund allows investors to diversify their assets by pooling their money from many investors and using it to buy a range of municipal bonds. The fund will distribute the interest it receives from the bonds to its investors, and the value of the bonds in the portfolio is used to determine the fund’s net asset value. Since the fund offers the benefit of diversification, municipal bond funds are often less risky than individual bonds.

Your home state’s municipal bonds or bond funds are often free from both federal and local/state taxes. Nonetheless, there may be a few circumstances in which municipal bonds are NOT entirely tax-free, such as the following: 

  1. De minimis tax – this tax applies to munis that you acquired at a market discount. This rule states that for bonds purchased at a discount of more than 0.25% for each full year from the time of purchase to maturity, gains resulting from the discount are taxed as ordinary income rather than capital gains. For example, take a bond that matures in 10 years with a face value of 100 – the de minimis breakpoint of this bond is 97.5 (100 – [0.25 x 10 years]). If you bought this bond for less than 97.5, you would be required to pay ordinary income tax on the discount.
  2. Alternative minimum tax – Income from some municipal bonds (e.g., those that fund stadiums, airports or business enterprises) might be subject to AMT. Your interest income would generally be taxed at the applicable AMT rate which could be 26% or more if you’re in the AMT exemption phase-out range.
  3. Increase in taxation of SS benefits – Although muni bonds generally aren’t subject to federal taxes, the IRS does include income from such bonds in your modified adjusted gross income (MAGI) when determining how much of your SS benefit is taxable. If half of your SS benefit plus other income, including tax exempt muni bond interest, amounts to more than $44K for a joint return ($34K per individual), up to 85% of your SS benefits may be taxable.
  4. Increase in Medicare premiums – If you’re covered by Medicare, the federally tax-exempt interest from muni bonds may increase the amount you pay for Medicare Part B or C/D. If you’re married and filing jointly and your MAGI is more than $194K ($97K for single filers), you will be required to pay an additional amount for Medicare Part B and prescription drug coverage.
  5. Capital Gains Tax – If you need to sell the muni bond early before maturity and you receive a price greater than your cost basis, your acquisition price after adjusting for any premiums paid or discounts received, the gain will be subject to capital gains tax.
  6. State income tax – If you purchase a bond from your home state, generally, the interest payments you receive will be exempt from state income taxes. However, interest paid on bonds from outside your home state typically will be subject to state income tax. Interest payments on some in-state munis may also be subject to state income taxes.
  7. Taxable municipal bonds – Some munis are taxable. For example, roughly 10% of recently issued munis were taxable. Taxable muni bonds generally yield more than tax-free bonds to make up for the difference.

Before investing in municipal bonds or municipal bond funds, please read the prospectus and consult your financial advisor or CPA on the potential tax implications because the details matter since every fund is unique! 

As an FYI, the price of municipal bonds and municipal bond funds does not fluctuate based on changes to the Federal Funds rate. This is because municipal bonds are generally issued with a fixed rate of interest, so changes in the Federal Funds rate do not affect the price of the bonds. Similarly, the price of municipal bond funds is determined by the value of the portfolio of bonds they hold, so changes to the Federal Funds rate do not have a direct effect on the price of the funds.

2. Roth IRA

A Roth IRA is a retirement savings account that allows you to make after-tax contributions, but the account grows tax-free, and qualified withdrawals / distributions are also tax-free. This makes Roth IRAs an excellent way to earn tax-free passive income during retirement. To qualify for a Roth IRA, single tax filers must have a modified adjusted gross income (MAGI) of less than $153,000 in 2023. If married and filing jointly, your joint MAGI must be under $228,000 in 2023. The annual Roth IRA contribution limits are $6,500 for people under 50 years old or $7,500 for people 50 and older.

Some strategies investors use to generate regular tax-free income include:

  1. Invest in dividend-paying stocks: Dividend-paying stocks can provide a reliable stream of passive income. Because the earnings in a Roth IRA grow tax-free, the dividends earned on these stocks are also tax-free.
  2. Invest in bond funds: Roth IRA investors can also invest in bond funds to generate passive income. Bond funds pay regular interest payments, which can be reinvested to further increase the investor’s passive income stream.
  3. Invest in real estate investment trusts (REITs): REITs invest in a diversified portfolio of real estate assets and typically pay out a portion of their income in the form of dividends. Because REIT dividends are considered “qualified dividends,” they are taxed at the same rate as long-term capital gains (which is zero for Roth IRA investors who meet the requirements).
  4. Invest in exchange-traded funds (ETFs):ETFs can be a good option for Roth IRA investors looking to generate passive income while maintaining a diversified portfolio. Some ETFs focus on dividend-paying stocks, bonds, or REITs, providing exposure to a range of income-generating assets in a single investment vehicle

The key is to make sure that your investments are held within a Roth IRA. You can withdraw the money that went towards your Roth IRA contributions at any time without penalty, however, any withdrawals beyond your original contributions before the age of 59 ½ may be subject to a 10% early withdrawal penalty. Overall, Roth IRAs are a great method to generate tax-free passive income in retirement. You can create a nest egg that you can withdraw tax-free in retirement by making after-tax contributions and having your investments grow tax-free.

3. Rental Properties 

A fantastic source of passive income is real estate. The majority of affluent real estate investors use depreciation and deductible costs to lower their taxable rental income to zero. By enabling the owner of the property to deduct a percentage of the cost of the asset over the course of its useful life, depreciation can be used to lower taxes on earned rental income. The taxable rental income is decreased by the depreciation deduction, which is applied over time.

For example, if a rental property has a cost of $400,000 and a useful life of 27.5 years, the owner can deduct $14,545 per year for 27.5 years. This deduction is considered a “paper loss” each year which would reduce the taxable rental income by this amount. There are also several advanced techniques that savvy real estate investors apply such as bonus or accelerated depreciation and cost segregation that help further reduce their taxes.

Beyond depreciation, other deductible expenses commonly used to reduce their taxable rental income include the following: 

  • Mortgage interest (if you have a mortgage or any other debt used for the property)
  • Property taxes
  • Insurance premiums
  • Maintenance fees
  • Advertising / Broker fees
  • Legal fees
  • Professional fees
  • Utilities
  • Supplies
  • Travel expenses
  • Cleaning services

Using depreciation and other appropriate deductible expenses helps real estate investors offset their taxable rental income, effectively paying very little or no taxes. Additionally, when real estate investors are looking to sell their property, they leverage a 1031 exchange. A 1031 exchange is a tax-deferred exchange of one property for another. The investor must identify a new property within 45 days of the sale and complete the purchase within 180 days. The 1031 exchange must be structured properly and all proceeds must be reinvested into the new property for the taxes to be deferred.   

4. Health Savings Accounts (HSAs) 

Health Savings Accounts (HSAs) are triple tax-advantaged accounts, which means that the contributions are pre-tax, the appreciation and growth is tax-free and the distributions are tax-free so long as they are used to pay for qualified medical expenses.  Contributions to HSAs are tax-deductible, and withdrawals for qualified medical expenses are tax-free. If you’re eligible for an HSA, it can be an excellent way to earn tax-free passive income that can be used to pay for common IRS qualified medical expenses such as:   

  • Doctor visits (including acupuncture and chiropractor)
  • Prescription drugs and vaccines
  • Dental treatments (e.g., X-rays, cleanings, fillings, sealants, braces, tooth removals)
  • Vision care (e.g., vision exams, contact lenses, eye glasses)
  • Medical equipment (e.g., crutches, personal protective equipment (PPE) like masks and hand sanitizer, hearing aids and batteries)
  • Physical therapy
  • Mental health services
  • Women’s Health (e.g., birth control treatment, feminine hygiene products)
  • Fertility enhancement (e.g., including in-vitro fertilization)
  • Laboratory fees and diagnostic kits (e.g., COVID testing)
  • Inpatient hospital care
  • Emergency medical services
  • Preventive care services
  • Long-term care services

The list of eligible services can be even broader with a letter of medical necessity! The maximum contribution amount per year for HSAs is $3,850 for individuals and $7,750 for families in 2023. For individuals aged 55 or older, there is an additional catch-up contribution of $1,000. To open and enroll in a HSA account, you would need to sign up for a high deductible health plan (HDHP) which is a type of health insurance plan with higher deductibles than traditional plans. For the calendar year 2023, a high deductible health plan is a health plan with an annual deductible that is not less than $1,500 for individuals or $3,000 for family coverage where the annual out of pocket expenses do not exceed $7,500 for individual coverage or $15,000 for family coverage.

5. Cash-value Life Insurance

Cash-value life insurance policies allow you to invest a portion of your premium payments into an investment account.  The different types of cash value life insurance plans are: 

  • Whole life insurance – type of permanent life insurance that provides lifelong coverage for a fixed death benefit and a cash value component
  • Universal life insurance – type of permanent life insurance that provides lifelong coverage with a flexible death benefit and cash value component
  • Variable life insurance – type of permanent life insurance that provides lifelong coverage with a cash value component that is invested in stock and bond investments

Investors can make tax-free income with cash value life insurance through several strategies:  

  1. Tax-free withdrawals: Policies with a cash value account let policyholders to make withdrawals from the account without being taxed. Up to the amount of premiums paid into the insurance, these withdrawals may be made; however, any extra withdrawals may be subject to taxes and penalties.
  2. Policy loans: Policyholders have the option of borrowing money against the life insurance policy’s cash value. As long as they are repaid in accordance with the terms of the policy, these loans are tax-exempt, and any outstanding debts will lower the death benefit provided to beneficiaries. Depending on the insurer, interest rates on loans against the cash value portion of life insurance contracts can range from 4% to 8%. The insurer and the borrower’s creditworthiness will determine the rate.
  3. Tax-free death benefit: The death benefit provided to beneficiaries after the policyholder passes away is often tax-free, so beneficiaries can take the full benefit amount without having to pay taxes on it.
  4. Tax-free growth: Tax-free growth on the cash value account of a life insurance policy is possible. This indicates that the policy’s value may rise over time without subjecting the growth to taxes.

It’s important to note that cash value life insurance policies can be complex financial instruments, and the specific tax implications and investment options may vary depending on the policy and the insurance company. It’s always best to consult with a financial advisor or insurance professional before making any investment decisions.

In conclusion, earning tax-free passive income is an excellent way to build wealth over time and there are several ways to do so.  Regardless of which approach you pursue, it’s essential to do your research to determine which option is best for you.  

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By : Rob Tags: