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Earning money while you sleep is possible, but did you know that you can also avoid taxes while growing your passive income streams?
There are several ways to protect your income from taxes, but many types of passive income require that you pay business income taxes or tax on all of your earnings.
So, instead of building income streams just to pay more in taxes, you can create passive income that doesn’t require you to pay anything. And these strategies shouldn’t require a ton of extra time on your part, making them the ideal way to invest!
Buy Tax-Free Municipal Bonds
U.S. Treasuries and corporate bonds have become popular in 2023 due to rising rates and up to 5% guaranteed returns on short-term bonds. But those are taxed at your income tax rate if investing less than a year, which can take a big chunk of your profits.
Instead, consider investing in tax-free municipal bonds. These bonds are debt instruments that fund state and local infrastructure projects and carry a relatively low risk of default. The income from these bonds and bond funds is not taxed at the federal level, though you may pay state or local income tax on them.
There are several popular municipal bonds funds available from investing firms like Vanguard, Fidelity and iShares, with very low expense ratios and solid returns. For example; the Vanguard Tax-Exempt Bond Index Fund (VTEB) is currently paying out more than 3% in tax-free dividends yearly, and has an expense ratio of 0.05%.
Open a Roth IRA and Invest
The Roth IRA is an after-tax retirement account that lets you fund up to $6,500 per year (or $7,500 if over age 50), and it grows tax-free. Even better, the Roth IRA lets you withdraw your investments tax-free at retirement (age 59 1/2), letting you enjoy that passive income without a huge tax bill.
If you want to grow your passive income, you can open a Roth IRA at a brokerage of your choice and deposit funds each year. Inside the account, you can invest in a variety of investments, including dividend-paying stocks or index funds, which help grow your passive income without any additional income tax.
And since the Roth IRA is a tax-free account, you can also withdraw any of your principal investment at any time without penalty or taxes assessed. But you must leave the earnings in until age 59 1/2 to enjoy tax-free income.
Sell Your Home
If you’ve owned a home for any length of time, chances are you have some home equity available. Selling your home can provide a huge cash return, and you can avoid paying taxes on any of the gains. There is a personal residence tax exemption that lets you exclude up to $250,000 in capital gains on the sale of your personal home. If you’re married filing a joint return, the exclusion is $500,000.
To qualify for the exclusion, you need to have lived in the home for at least two out of the past five years. This means if you owned a home that you lived in for two years, and have rented it out for the last three years, you can still sell it and get the tax exclusion. Or if you have a rental home that you moved back into, as long as you stay there for two total years (out of the previous five), you can qualify.
Earn Long-Term Capital Gains
When you make an investment and then sell it for a profit, the earnings on that investment are called “capital gains.” If you hold that investment for a year (or longer), the earnings fall under the tax category of “long-term capital gains.”
The beauty of long-term capital gains is that they are taxed at a lower rate than your regular income tax. And if you have an annual income of $40,400 or less (or $80,800 for married filing jointly), your tax rate could be 0% on these investments. This is because long-term investments aren’t taxed for lower-income individuals.
If you have an investment that has gained value over the years, you can sell it without paying any taxes as long as you meet the income qualifications.
Collect Social Security Benefits
If you’re getting ready to collect Social Security benefits, you might be able to do so without paying any income taxes on them. If your annual income is below $25,000 or you earn less than $32,000 as a joint filer, then your Social Security income is not taxable.
If you earn more than those amounts, a portion of your benefits may still be considered tax-free. For example; a single filer earning more than $25,000 but less than $34,000 still avoids paying taxes on 50% of their Social Security income.
Get Disability Insurance
Disability insurance pays out a portion of your regular income if you are injured and become permanently or totally disabled and unable to work. If you paid the entire cost of the disability insurance plan (and none of it was covered by your employer), then the income is considered tax-free. If your employer covered a portion of the insurance premiums, then that same portion of the income from your disability insurance payout is considered taxable, but the rest is tax-free.
For example, if you paid 50% of the premiums, and your employer covered the other 50%, then half of your disability income is considered tax-free.
Invest In an HSA
Health savings accounts (HSAs) are tax-deductible investment accounts that allow you to pay for healthcare expenses without paying taxes. You must have a high-deductible health insurance policy in place to open an HSA account, but once you do, you can contribute up to $3,850 as a single filer, or up to $7,750 for family coverage.
The money you put in is tax deductible in the year you contribute, the investments grow tax-free, and if you withdraw funds for healthcare-related expenses, then growth is also tax-free. It’s a triple tax benefit inside an investment account!
After you reach age 65, you can actually start withdrawing funds from your HSA just like an IRA and use the funds for anything, but you will need to pay ordinary income taxes on the withdrawals.
Investing is still one of the best ways to grow your passive income. And investing inside a tax-protected account can help you avoid paying extra taxes and let your investment compound faster. But there are some other great ways to enjoy passive income without the huge tax bill, especially if you have a low annual income.
Remember, avoiding taxes is a great way to keep more of your hard-earned money, but sometimes the restrictions on these investments and opportunities make them not worth the hassle. You have to do your own due diligence to make sure they make sense for your financial goals.
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