The Difference Between Tax-Free and Taxable Investments

This article, last updated in December 2023, is original content written by Manchester, CT Financial Advisor Thomas Scanlon, CFP®, CPA.

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Investors need to know the difference between tax-free and taxable investments.

Tax-Free Investments

One way to have tax-free investments is to own state or municipal bonds. The interest paid on these bonds is not taxable income on your federal income tax return. State or municipal bonds may have state income tax ramifications. A state or municipal bond issued by the state that you are a resident of is also tax-free on the state income tax level. For example, if you are a Connecticut Resident and you purchase a bond issued by the State of Connecticut there is no federal or state income tax to be paid on the interest.  This is what is also known as double tax-free; no federal or state tax needs to be paid. However, if a Connecticut resident purchased a bond issued by New York this would be tax-free income on their federal return but taxable on their Connecticut return.

Another way to have tax-free income is to fund a Roth IRA. In 2023 taxpayers can contribute up to $6,500 into a Roth IRA if they have at least this much in earned income. Taxpayers age 50 and older can contribute another $1,000 in a so-called ‘catch-up contribution’ for a total contribution of $7,500.  Contributions to the Roth IRA are not income tax deductible. However if the account is open at least 5 years and the taxpayer is over age 59 1/2 when distributions are made then all of the distributions are tax-free. High income taxpayers are not allowed to fund a Roth IRA.

Another advantage to the Roth IRA is that it is not subject to the Required Minimum Distribution rules (“RMD”) during the owners and surviving spouses lifetime. This could potentially allow for decades of tax-free growth.

Taxable Investments

Taxable investments are from earnings that not tax-free as mentioned above. Additionally it is not for investments that are tax-deferred. Tax-deferred investments include 401(k) plans and IRA’s. These investments are taxable only when distributions are made. Taxable investments can produce taxable interest, dividends, capital gains distributions and capital gains. These would be taxed in the year received.

Which is Better?

Are tax-free investments better than taxable investments? It really depends on your goals and objectives and your tax bracket. For investors that are eligible to fund a Roth IRA they may consider taking advantage of this vehicle. Whether an investor should have tax-free state or municipal bonds you will to run a calculation. The tax-free rate of return would need to be compared to what they could earn in a taxable account minus their tax bracket. Generally higher income taxpayers benefit more from tax-free investments that do lower income taxpayers.

The information contained in this report does not purport to be a complete description of the securities, markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the forgoing material is accurate or complete. Any opinions are those of Thomas F. Scanlon, CPA, CFP® and not those necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Tax preparation and accounting services are provided by Borgida & Company, P.C., not as a service of Raymond James. You should discuss your tax or legal matters with the appropriate professional. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Past Performance is not indicative of future results. All investing involves risk.

While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax, state or local taxes. Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment.

RMD’s are generally subject to federal income tax and may be subject to state taxes. Consult your tax advisor to assess your situation.