Tax Free vs. Tax Deferred
These are two concepts that are frequently misunderstood. Both have differing impacts on your current and future tax liabilities.
Typically, this is dividend income coming from investments in municipal securities, primarily bonds. State and local bond investments allow the dividends to be tax free on your federal tax return and will also be tax free if you live in the state that they are issued in. If you purchase a municipal bond mutual fund, you will need to follow the fund’s year end directions to see if some of the dividends are applicable to the state you are living in.
While dividends from Municipal Bonds are generally tax free to you, there is still a capital gain treatment for when you sell them. You will need to calculate the gain or loss on them and pay tax on any capital gain you may have incurred.
Another way to get tax free income but deferred into the future is by opening up a Roth IRA/ Roth 401k and contributing to it with after tax dollars. Providing you keep the account open for at least 5 years, you can withdraw income tax free for your lifetime and for the lifetime of your beneficiary. In the meantime, the income it earns is tax deferred… The disadvantage is that you are not getting a tax deduction for contributions.
This concept of deferring tax on income to some time in the future can be explained by Traditional IRA’s, individual retirement plans and company retirement plans and annuities.
What you are doing here is to postpone income tax both Federal and State until some time in the future when you begin to collect income. Contributions are generally deductible (limitations exist for Traditional IRA’s and will be addressed in a further article).
When you begin to take an income, you will be taxed on the earnings as you receive them. IRA’s and other retirement plans force you to begin taking Required Minimum Distributions when you hit age 70 ½. Annuities, typically don’t specify an age when you must take distributions, unless they are purchased as a qualified retirement plan. However, your heirs will pay the taxes due.