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How Can I Earn Tax-Free Income? Here Are 3 Ways

By Jason Hall - May 20, 2016 at 2:03PM

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Whether you're looking for income today, or for years down the road, here are three great ways to generate income without owing any of it to Uncle Sam.

If you're looking for ways to generate tax-free income, look no further. 

Everyone wants to generate as much income as they can. Whether you're on a fixed income and trying to maximize every dollar, planning for your long-term future, or looking to reduce how much you pay in taxes today, there are ways to generate tax-free income. 

Here are three ways that you can do so, whether you're looking to generate that income today, or planning for years down the road. 

Municipal and government bonds

If you're looking to generate tax-free income from your current investment assets, one of the simplest ways to do so is to invest in municipal and other government bonds. Not only is the interest paid to you tax-exempt from federal income tax, but it may also be exempt from income tax in your state as well. This is particularly true if you invest in municipal bonds issued in the state you reside in. 

Muni bonds won't get you rich, but they're tax-free and relatively safe.

Not sure which bond or bonds to buy? Two ETFs that are worth consideration are the Vanguard Tax-Exempt Bond ETF (VTEB 0.35%) and iShares National Muni Bond ETF (MUB 0.47%), both of which invest in qualified federal tax-exempt bonds, primarily municipal bonds. Investors in either of these relatively low-cost funds should expect an annual yield of 2% to 2.5% in the current yield environment, and for relatively stable long-term capital preservation.

You won't get rich, but if you're looking to reduce your taxable income by shifting some assets to tax-exempt investments, this could be the best way to go. 

Take advantage of your home equity 

Depending on your situation, there are a number of reasons why tapping the equity you've built up in your home could be the perfect source of tax-free income. There are actually three ways to do it. 

  1. Capital gains if you sell your home.
  2. Cash-out refinance/home equity loan (though there are other costs).
  3. Reverse mortgage.

One of the most important assets millions of retirees own is their home. Not only because it provides you with a place to live and to keep your stuff, but because of the equity you have in it. Furthermore, many retirees reach a point when the home they've lived in for many years is simply too much house, whether it's the physical effort to keep clean and maintained, the expense of heating and cooling, or maybe a lack of accessibility as you age. 

There are several ways you can stay in your home while tapping the equity.

If that's your case, maybe it's time to sell and relocate to a smaller home, or even just one that's better-located. If you do sell your primary residence, there's great news on the tax front: Single tax filers can exempt the first $250,000 in capital gains on the sale of a primary residence, while married joint filers can double that exemption to $500,000. 

That's right. The IRS won't charge you income tax on the profit from selling your primary residence. You could even buy muni bonds with the proceeds, and generate tax-free income with your tax-free income!

But even if you don't want to leave your residence, you have two other ways to tap your equity for tax-free money. The first is with either a cash-out refinance or home equity loan, while the second is with a reverse mortgage. Let's look at the difference.

A reverse mortgage is a way to use your home equity to receive either monthly or a lump sum of income, without having to pay interest or monthly payments until either you sell the property, or you and your spouse die, though interest continues to accrue until the reverse mortgage is repaid. This is obviously different from a cash-out mortgage or home equity loan, which would require you to make interest and principal payments, typically every month. 

And while the cash you'd get from any of these options is tax-free (as it is not considered income or capital gains), it does come at the cost of interest payments, which could exceed the tax-free benefits if you have other alternatives. But even with that cost, one of these could be the right tool to generate cash while also keeping you in your home. 

The best way to create tax-free income for your retirement

If you're not yet retired, there are few better ways to create a stream of tax-free income for the future than to invest in a Roth IRA. While contributions to a Roth IRA aren't deductible from your taxable income the year you make them, like 401(k) contributions are, the distributions in retirement are completely tax-free. 

This differs from your traditional IRA or 401(k) distributions, which are treated and taxed like regular income in retirement. Furthermore, Roth IRAs don't have the same required minimum distributions rules that 401(k) and IRAs do after age 70-1/2, meaning you can make those tax-free distributions completely at your discretion, when you need the extra income. 

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Stocks Mentioned

iShares Trust - iShares National Muni Bond ETF Stock Quote
iShares Trust - iShares National Muni Bond ETF
$106.43 (0.47%) $0.49
Vanguard Municipal Bond Funds - Vanguard Tax-Exempt Bond ETF Stock Quote
Vanguard Municipal Bond Funds - Vanguard Tax-Exempt Bond ETF
$49.95 (0.35%) $0.17

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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