11 Best Tax-Free Investments to Build Wealth

Few people build wealth on salary alone. Instead, investments compound earnings by putting money to work passively. 

However, it's important to remember that how much you keep is more important than how much you make. Risk and taxes are the two causes of investment losses, but there’s no safer investment than a tax-free investment.  

Allowing your portfolio to grow tax-free removes the stress of moving your money around through 1031 or tax havens. Plus, you have a better chance of beating out inflation without the added burden of taxes. 

So whether you’re self-employed or a salaried individual looking to build wealth for retirement, here are 11 tax-advantageous investments for building wealth. 

1. 401(k)

The best way to tap into tax-free assets is to open up a retirement account. With a traditional employer-sponsored 401(k), employee contributions enjoy tax-free growth while reducing taxable income by transferring earnings out of each paycheck. 

As a result, you can contribute money to your 401(k) without having it taxed while also reducing the amount of taxable income from your regular salary. The only kicker is you’ll eventually pay taxes when you withdraw your funds at retirement.

An individual 401 (k) provides the same tax benefits as an employer-sponsored plan for self-employed people and small-business owners. 

While a 401 (k) is primarily used for investing in mutual funds, it can also be used for index funds, large-cap funds, small-cap funds, foreign funds, bond futures, and real estate funds.

2. IRA: Traditional, Roth, and Self-Directed

IRAs are another popular retirement account used to grow your wealth tax-free. 

There are a few different types of IRAs, including:

  • Traditional IRAs: Individuals contribute pre-taxed money to their accounts and are taxed at the time of withdrawal. 
  • Roth IRAs: Individuals contribute already taxed earnings and can withdraw their funds tax-free at retirement.
  • Self-Directed IRA: These retirement accounts allow people to invest in alternative assets, like crypto, gold, LLCs, or real estate, using a traditional or Roth structured account. 
  • SEP IRA: The Simplified Employee Pension IRA allows employers to contribute to their employee’s traditional IRA accounts. 
  • SIMPLE IRA: The Savings Incentive Match Plan for Employees allows employers to match contributions to an employee’s IRA. 

All IRA accounts are fine options for retirement, with the major difference being whether or not you think you’ll be in a higher tax bracket at retirement. If so, a Roth IRA may be right for you.

Additionally, all IRAs limit your investment options to standard stock market assets, such as stocks, bonds, ETFs, and CDs, with the exception of an SDIRA. 

3. 1031 Exchange

A 1031 exchange is an investing strategy that allows you to "swap" one investment property for another as a way to avoid short-term capital gains. Under normal circumstances, a person must own a home for one year before selling it if they want to avoid getting a hefty tax bill for income earned by selling real estate

The 1031 exchange allows you to avoid paying taxes at the rate of your ordinary income if you use the money earned from the sale to buy another property. 

4. Tax-loss Harvesting

Tax-loss harvesting works by selling an underperforming, money-losing investment to reduce taxable capital gains. For example, dumping an underperforming property can offset your ordinary taxable income to reduce your tax burden for the year. Once the property is off your roster, the money from the sale can be reinvested into a better investment option. 

5. Long-Term Capital Gains

Another way to lower your tax bracket is to hold an asset for more than a year to reduce your capital gains tax. When you hold on to a property or any asset for longer than a year, you'll pay long-term capital gains instead of short-term capital gains. While the short-term capital gains rate ranges from 0% to 37%, long-term capital gains are taxed at 0% to 20%.

6. Form an LLC

Forming an LLC allows you to avoid double taxation. An LLC is considered a pass-through entity by the IRS, which means LLC owners aren't on the hook for paying taxes on the corporate level. For example, many people form real estate LLCs to reduce their tax burden for any sale they make involving their investment properties. 

LLC owners can instead report their profit shares and losses on their personal tax returns, greatly lowering their taxable burden. 

7. HSA

Unlike a Flexible Spending Account (FSA), a Health Savings Account (HSA) doesn't require an employer sponsor. Your HSA will allow you to invest tax-deferred, tax-free earnings for eligible health spending. HSA funds can be rolled over yearly to ensure you don't lose the money you don't spend. The money can keep rolling all the way through to retirement to allow you to cover health services and products in your golden years.

8. Charity/Donations

Charitable donations can be tax-efficient investments. In addition to putting money toward a good cause, a charitable donation can reduce your adjusted gross income for the year. Everybody wins if the money you give to a good cause allows you to move into a lower tax bracket with a lower tax rate.

9. US Series 1 Savings Bond

A Series I bond is issued by the U.S. federal government with dual interest-earning potential that offers inflation protection. Every Series I bond earns both a fixed interest rate and a variable rate that changes with inflation. 

Series I bonds are never taxed at the state or local level. While federal taxes are based on the interest earned while an I bond is held, you can choose the method you want to use to pay your I bond taxes. The first option is only to pay tax on your Series I bond when it's sold back to the government one day. The second option is to pay the tax that is due on interest earned for the year that was added to your principal. 

10. 529 Education Fund

A 529 fund is a college savings plan sponsored by individual states. Money in an account can be used for school tuition, books, and other qualified expenses at most institutions. Contributions to a 529 account are counted as after-tax deductions. 

However, contributions can grow free of federal or state income taxes. Therefore, no income tax is paid when 529 funds are withdrawn for qualified expenses.

11. Municipal Bond

Finally, a municipal bond is issued by either a state or local government to fund investment projects in the community. When purchasing a municipal bond, you're effectively lending money to the bond issuer in exchange for interest payments. 

While short-term municipal bonds may mature in one to three years, long-term municipal bonds may mature 10 to 20 years in the future. Interest on municipal bonds is generally exempt from federal taxes. The bonds are also exempt from state and local taxes if you reside in the state where your bond is issued. 

Final Thoughts on Tax-Free Investment Strategies

We often focus on reducing risk when investing. However, a core principle of investing "for keeps" is to make choices that minimize taxes. The fun begins when you realize that this can be done using investments that involve everything from real estate to health savings accounts.