Maximizing Your Savings with Tax-Efficient Investments

Tax-efficient investments and accounts can significantly enhance your long-term returns by minimizing the amount you need to set aside for income taxes. While retirement accounts like a 401(k) are well-known tax-advantaged savings vehicles, they are generally intended for long-term savings, and early withdrawals can incur penalties. If you’re saving for shorter-term goals, here are five options to consider.

1. Treasuries and Federal Bonds

When you lend money to the federal government by purchasing U.S. Treasuries and bonds, your earnings are exempt from local and state income taxes. There are several types of treasuries and savings bonds to choose from, each with different maturity lengths and rules for buying, holding, and selling.

U.S. Treasury bills have maturity lengths ranging from four to 52 weeks, while treasury notes are available with two- to 10-year maturities. Treasury bonds have longer 20- or 30-year maturities, and federal savings bonds, including Series I, were a popular investment option when inflation rates rose in late 2021. All earnings from these investments are only taxable at the federal level, which can be beneficial if you live in a state with high income taxes.

You can buy treasuries and bonds through a bank or brokerage account, or using a TreasuryDirect.gov account.

2. Municipal Bonds

Local and state governments sell municipal bonds, or munis, to help fund everyday expenses and large projects. The interest you earn from munis is exempt from federal income taxes, and if you buy municipal bonds from the state where you live, the interest is often exempt from state income taxes as well. Some states might also exempt interest on munis from other states.

Munis can be a relatively safe investment option, although there have been instances where municipalities declared bankruptcy and didn’t repay bondholders. Other risks include the potential difficulty of selling the bond or getting a good price. The simplest way to compare and invest in munis is through a brokerage account.

3. Money Market Funds

Rather than buying treasuries and bonds directly, you could invest in a money market fund—a type of mutual fund that only invests in safe, short-term securities. There are different kinds of money market funds, and the names reflect the underlying investments. For example, government funds invest in government securities, such as treasury notes, while general-purpose funds might invest in corporate bonds and certificates of deposit (CDs).

Municipal or tax-exempt funds primarily invest in tax-exempt munis, and your portion of the earnings is exempt from federal income taxes. A portion may also be exempt from state income tax depending on the investments and your state’s tax rules. State-specific municipal money market funds can help you avoid state income taxes on most of the earnings.

Money market funds may have minimum investment requirements and often charge a management fee, but they can be easier to get into and out of than managing individual treasury and bond investments on your own. They may also offer higher interest rate returns than high-yield savings accounts, especially when interest rates are rising, making them a low-risk option for your savings. However, they are not risk-free, and Federal Deposit Insurance Corporation (FDIC) insurance doesn’t cover money market funds.

4. Health Savings Accounts

A health savings account (HSA) is a tax-advantaged account you can use to save and invest money for future medical expenses. HSAs offer a triple-tax advantage: tax deductions for contributions, tax-free growth, and tax-free withdrawals for qualified medical expenses. However, you’ll need to meet the eligibility requirements to open an account:

• You need to be enrolled in a high deductible health plan (HDHP).
• You can’t be enrolled in Medicare or have additional health coverage, except for specialty coverage like disability, dental, vision, and long-term care insurance.
• You can’t be claimable by someone else on their tax return.

There are also annual contribution limits. In 2023, the limit is $3,850 for individuals or $7,750 for a family. Each person can contribute an additional $1,000 if they’re 55 or older.

You can withdraw money from your HSA to pay for any qualified medical expenses that you incur after opening the HSA, including copays and deductibles. However, you don’t need to make the withdrawal right away. Instead, you can invest money in an HSA, earn tax-free returns, and make the tax-free withdrawals to reimburse yourself at any point in the future.

5. Roth IRAs

A Roth individual retirement account (IRA) is a tax-advantaged retirement account. Generally, you want to leave money in your retirement accounts for retirement. However, there are times when it might make sense to contribute to a Roth IRA even if you might need the money sooner.

Unlike a traditional IRA, Roth IRA contributions aren’t tax-deductible. However, investment earnings grow tax-free within the account, and you can withdraw the earnings without paying income taxes or penalties once you turn 59½.

Because you contribute after-tax money to a Roth IRA, you’re also allowed to withdraw your contributions without paying income taxes again or an early withdrawal penalty. The withdrawal rules could make a Roth IRA an OK place to keep an emergency fund or other shorter-term savings.

For example, maybe you’re saving for retirement with a 401(k) and building up your emergency fund. Instead of putting your emergency fund in a high-yield savings account, you open a Roth IRA and make a very low-risk investment, such as an IRA CD. You can withdraw your contributions from the Roth IRA if there’s an emergency. But, if there isn’t, you can keep growing the retirement account. Either way, you can leave the interest earnings in the account and let them grow tax-free.

Low- and moderate-income earners might also receive a tax credit for their Roth IRA contributions. However, there are income limits for Roth IRAs, which could keep moderate- to high-income households from contributing to this type of account. Additionally, annual contribution limits apply to Roth IRAs.

Keep the Big Picture in Mind

Tax-advantaged investments and accounts can offer significant benefits, especially for savers and investors in a high tax bracket. But you still need to consider the big picture. After all, higher returns on a taxable investment could be better than a low, tax-free return. There may also be other types of risk—such as limits on when you can sell investments—to consider.

As you’re thinking through ways to maximize tax savings, also look for other ways to improve your personal finances. For example, review your brokerage and retirement accounts to make sure your investments and asset allocation align with your current goals. And if you haven’t checked your credit score recently, get your FICO® Score and credit report and review the factors that are impacting your score the most.

For any mortgage service needs, O1ne Mortgage is here to help. Call us at 213-732-3074 to speak with one of our expert loan officers. We are committed to providing you with the best mortgage solutions tailored to your financial goals.