Tax-Free Investments: Federal, state, and local governments pay bond interest that is partly or fully tax free. Munis is a catch-all term for municipal bonds sold by state and local governments. The interest munis pay is generally exempt from federal tax and is usually exempt from state and local taxes for residents of the locality where the bond is issued. If you sell munis for a profit, however, you may owe capital gains tax. And, in some cases, the interest may be subject to the alternative minimum tax (AMT). Municipal bonds, like other investments, have specific advantages but also carry certain risks.
If interest rate on newer bonds is higher than the rate on the bonds you own, you might have to sell for less than par value if you sell before maturity. Tax-free bonds that pay the highest interest tend to be issued by governments with low credit ratings. That means the issuers have an increased potential to default. That could mean your losing interest payments or return of principal or both. Financial advisers suggest sticking to highly rated bonds unless you’re ready to take this risk. Some mutual funds, including some money market funds, invest only in tax-exempt bonds.
That may be an alternative to buying individual munis. Remember, though, that because each fund owns a number of bonds, there’s not a fixed interest rate or a maturity date. Nor does a fund promise to return your principal.
Investment earnings on US Treasury securities are free of state and local taxes. But the interest is subject to federal income tax. Treasury bills are available with terms of up to 26 weeks. Treasury notes have terms from two to 10 years, and Treasury bonds have terms of more than 10 years — though the government isn’t currently issuing new long-term bonds. The tax on note and bond is due annually, but interest on bills is taxed at maturity, or, if you sell before maturity, in the year the bills are sold.
Before buying tax-free bonds, you need to know whether the yield, or what you earn as a percentage of the bond’s cost, is better than the after-tax yield on a corporate bond or on another taxable investment. To make that calculation, you have to take federal, state, and local tax rates into account, especially in high-tax states such as California and New York.
Tax-free bonds may not offer much advantage if you’re in the 10%, 15% or 25% federal tax brackets. But the higher your marginal tax rate is, the more likely you are to receive a greater net yield on a tax-free investment than on one that’s taxed. A taxpayer in the 28% bracket, for example, needs a taxable return of about 6. 94% to match a tax-free yield of 5%. But if you’re in the 35% bracket, you’ll need to find a taxable return of 7. 69% to equal that 5% tax-free yield. These numbers don’t reflect state and local taxes. The taxable return must be even higher if you take those factors into account.
Tax Free Investments These are important and will become increasingly so as your investments earn interest and benefit from capital growth. Each year you will currently pay 20-50% tax on interest earned unless your investment is tax-free. In addition, where you have sold investments which have seen capital growth i. e. shares, funds, investment trusts, second homes you will have to pay capital gains tax where your gains exceed 10,600 during 2012/13 tax year, unless they are in a tax-free investment or are exempt.
Capital gains tax is 18% on gains exceeding the 0,600 tax free allowance for those whose annual income and capital gains do not exceed 53,075 in a tax year ( 42,475 higher rate tax threshold + 10,600 allowance). For those whose income/gains exceed this, 28% capital gains tax applies. The importance of Tax Free Investments Here we take a look at the effect tax has on your savings and investments. Neither the basic rate nor higher rates taxes are payable on interest bearing investments, similarly these investments are free of capital gains tax. The assumptive data in the yellow boxes may be changed in the download file.
The red boxes highlight savings you could make after 40 years: Here are 11 investments which are free of capital gains tax:
- Individual Savings Account (ISA) which replaced PEPs (Personal Equity Plans)
- Pension Plans
- National Savings & Investments (NS&I)
- Premium Bonds
- Life Assurance Investment Plans
- UK Government Gilts
- Qualifying corporate bonds
- Gold held in Sovereigns or Britannias
- Your principal private residence (house)
- Trusts
- Cars (privately owned).
They allowed a maximum of 9,000 to be invested, the interest earned was tax free although withdrawals were not permitted for 5 years. These have now become Cash ISAs and may be converted into a Shares ISA. You should be aware that when you withdraw money out from your Cash ISA or a Stocks & Shares ISA you will never be able to regain the tax free status on the amount you have just withdrawn. Therefore, drawing down on your ISA’s should be considered carefully. Money held in a cash ISA may be transferred into a Share ISA but not vice versa. Set Up Costs
Cash ISA’s are free to set up, whereas Share ISA’s often have a set up cost, though this is often waived if you purchase through one of the large independent investment financial advisers. Tax – Share ISA’s This is only payable on dividends made at the basic rate of tax currently 10%. There is no tax payable on the capital growth.
Pension tax relief For each pound you contribute to your scheme, the pension provider claims tax back from the government at the basic rate of 20 per cent. This means that every 80 you pay into your pension it converts to 100 in your pension pot.
If you are a higher rate tax payer e. g. 40%, the tax relief converts a 60 payment into 100 in your pension pot. The relief works slightly differently, the first 20% relief is handled as above, but the second 20% needs to be claimed back by yourself via your annual tax return or writing to your tax office. If you don’t pay tax, the most you can pay in with tax relief is 2,880 a year. But you’ll still get basic rate (20 per cent) tax relief. In other words the government will ‘top up’ your contribution to make it ? 3,600 on 20% tax relief. Limits on tax relief:
People under 75 can pay as much as they earn into their pension each year up to a maximum of ? 50,000 and still get tax relief up to their highest marginal rate. Contributions made above this level will be subjected to a special tax at 40%. Income tax relief is capped for anyone seeking to claim more than 50,000, the cap is 25% of income. Tax Free: Any increase in value of the scheme’s assets is classified as capital gains and is tax-free. When you come to take benefits you may be able to draw out up to a quarter of the value of your stakeholder or personal pension fund as a tax-free lump sum.
One cannot really call these an investment however, the prizes are tax free. These are government bonds. The main attraction to these is that they entitle the holder to enter monthly cash prize draws. There is now one 1 million prize draw each month and a number of smaller prizes ranging from 25 to 100,000. Each month’s prize draw is equal to one month’s interest of the total sum invested in Premium Bonds nationwide. So as interest rates rise and fall so will the prize draw. The number of prizes are also subject to change.
The minimum purchase is ? 100 and the maximum holding for any individual is 30,000. There is no set length of term for your holding. All prizes are free of income tax and capital gains tax. The June 2011 estimated prize draw was: Odds on to win in the above example was 24,000 to 1. Note: No interest is paid on any holdings and inflation will reduce the real value of your holdings.
Tax free investments should be sought out and maximised as your Number 1 priority wherever possible. These are legitimate ways you can avoid paying 20-50% tax on your investment income and 18% on capital growth. Pensions should also be considered, these offer unique tax benefits, where in effect ,000 invested into a pension plan by a lower tax payer costs the individual just 800 and the same 1,000 would cost just 600 for a higher tax payer.
However, there is a limit of ? 20,000 per annum or your normal contributions whichever is the greater, which can benefit from higher tax benefit. Apart from the regular investment options under Section 80C of the income tax act, this year investors have an added advantage of investing in infrastructure bonds and enjoy an additional deduction in tax under section 80CCF of the Income Tax Act.
Investment options under Section 80C can be broadly categorised as market linked, fixed income and insurance. The fixed income category includes investment options such as the Public Provident Fund (PPF), Employee Provident Fund (EPF), tax-saving bank fixed deposits, National Savings Certificate (NSC) and senior citizens savings schemes. While it is the most popular tax saving category, market-linked instruments including tax-saving equity mutual funds (ELSS) and unitlinked insurance plans (ULIPs) are gradually catching up.
One of the oldest investment options, PPF scores on all grounds as it is one of the very few investment options that fall under EEE (exemptexempt-exempt) tax regime. This implies that not only the investor can enjoy deduction on the amount invested in this scheme but the interest received on maturity is also exempt from tax. PPF offers an interest rate of 8% compounded annually, with the maximum investment restricted to Rs 70,000 a year and mandatory investment tenure of 15 years. An investment of Rs 70,000 every year in PPF for 15 years will amount to a taxfree maturity sum of Rs 20. lakh at the end of the 15 year tenure.
Under the current norms, 12% of the employee’s salary is contributed towards EPF, which is exempt from income tax. Any contribution over and above the 12% limit by the employee towards EPF is consider as voluntary provident fund (VPF) and the same is also exempt from tax, subject to the overall 80C limit of Rs 1 lakh per annum. Like PPF, EPF, also falls under the EEE tax regime wherein the interest received (on retirement from service) is tax-free in the hands of the investor.
The interest payable on EPF is determined each year by the Employee Provident Fund Organisation (EPFO). After having maintained a steady interest rate of 8. 5% per annum for quite some time, the EPFO has enhanced the rate of interest to 9. 5% for the financial year 2010-11. While it is still not sure whether such an attractive interest rate will continue in the following years, those who have been contributing to EPF for quite some time now and have accumulated a large corpus are bound to benefit immensely with this year’s higher interest as interest is compounded annually.
Similar to PPF, NSC also earns an interest rate of 8% per annum and investment up to Rs 1 lakh is exempt from tax under section 80C. However, unlike PPF, interest received on NSC, at the time of maturity, is taxable in the hands of the investor which makes it comparatively less attractive. On the positive note, however, NSC has a relatively shorter lock-in period of just about 6 years and the interest here is compounded halfyearly. Thus, every Rs 100 invested into NSC will grow to Rs 160. 10 on maturity.
Investment up to Rs 1 lakh in these special tax saving bank fixed deposits also entails an investor tax deduction under Section 80C. These fixed deposits mandate a lock-in period of five years and interest is compounded quarterly, just like any other ordinary bank fixed deposit. The drawback is taxability of interest income upon maturity. As most banks are currently offering attractive interest rates, tax-saving bank fixed deposits are currently offering interest rates as high as 8. 5% to its investors.
Indian citizens who have attained 60 years of age or those who have attained at least 55 years of age and have opted for voluntary retirement scheme are eligible to invest in senior citizens saving scheme, which offers a fairly attractive interest rate of 9% a year, payable on quarterly basis. While investment in this scheme is eligible for tax deduction under Section 80C, interest earned shall be taxable in the hands of the investor.
These tax saving mutual fund schemes do carry an embedded market risk and calls for investor prudence before making an investment decision. However, their returns are equally rewarding and tax free in the hands of the investor. As ELSS has a mandatory lock-in period of three years, they are positioned as long-term equity assets and thus returns are taxfree in the hands of the investor. And though these schemes mandate a threeyear lock-in period, investors are likely to be better off if they continue to stay invested for a longer term as equities generate best returns over a longer time frame Tax Saving Options in Public Sectors Banks Fixed deposits are among the most popular tax saving options in most of the public sector banks.
