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By Zach ScheidtPosted January 14, 2020
Tax-Free Retirement Income
Let's face it, no one likes to pay taxes.
Even at today's relatively low tax rates, it still hurts to see how much Uncle Sam takes out of each paycheck — especially if you're behind on your retirement goals.
That's why a huge cornerstone to any good retirement plan should be minimizing the taxes you owe.
To help you create this plan, I'm going to share a special investment that lets you generate income for retirement completely tax-free.
Make Tax-Free Money — By Lending It to the Government
There's one source of retirement income that the IRS hasn't been able to tax, despite its best efforts.
In fact, it's taken the issue before the Supreme Court on two occasions — and lost!
So it's truly tax-free income.
I have to warn you, though — the source of this cash stems from something few people understand.
So before I tell you an easy way to earn money that the IRS can't touch, let me tell you about the investments this strategy is built around — bonds.
A bond is nothing more than a way for companies and governments to borrow money from the public.
Much like a stock share, which represents part ownership of a company, each individual bond represents part ownership of a loan. And like stock shares, they're put up for sale so investors can buy them.
In most cases, a bond is initially valued at $1,000 — known as par value. The entity that creates the bond decides how long it wants to borrow the money for — an exact date known as the bond's maturity. It pledges to pay the bondholder $1,000 on that date, if not before.
The entity also decides how much interest it's willing to pay on that loan. It's a fixed percentage based on the $1,000 par value, known as the yield. It pays that interest every six months over the life of a loan, known as a coupon payment.
So if you buy a bond, the entity that issued it is legally obligated to pay you back. And until it does, it is required to send you coupon payments every six months.
This is non-negotiable. The only way to avoid the payments is to default on the loan — essentially going bankrupt.
But even if that happens, the entity must figure out some way to pay the money it owes. In the worst-case scenario, assets are typically sold and the proceeds are given to the company's creditors. Bondholders are creditors… so they're entitled to anything they can get.
As I said, bonds can be issued by companies or governments. But I don't just mean the federal government. States, counties and cities can also borrow money from the public by issuing bonds.
They're called municipal bonds… often called "munis" for short.
Collect Tax-Free Income From Helping a City Grow
Municipal bonds are simply bonds issued by local governments to fund construction projects.
The government pays the bondholder back from collected taxes or even the proceeds from whatever the money helped build.
One of the defining features of a municipal bond is that you don't have to pay federal taxes on the coupon payments you receive.
In fact, the IRS has a space for the money you get from munis on its 1099-INT (Interest Income) form, box 8: tax-exempt interest.
Gains from municipal bonds can also be immune from state income tax, too — it usually depends on your state's laws.
Now, municipal bonds — like all bonds — can be expensive. Remember, they have a par value of $1,000… and most bond brokers require you to buy a minimum number of bonds.
But there is a much more inexpensive way to earn tax-free income from municipal bonds — bond funds.
Big financial institutions can afford to buy large numbers of municipal bonds from all over the country. They can then create stock shares that represent that pool of bonds. They're known as bond funds.
You can buy shares in these bond funds on the stock market just like any other stock. You just need an account with a stock broker.
When the municipalities make their coupon payments or the bonds mature, the cash goes to the financial institution.
The institution can use the money to buy more municipal bonds. It also takes out fees for itself. Then it can send whatever's left over to the fund's shareholders.
Like a dividend, the money is paid on a per-share basis. So the more shares of the bond fund you own, the more money you will receive.
And since the source of the money isn't taxable, you generally don't have to pay federal taxes on the money you receive. (You may have to pay state taxes on income from the fund, however. Check with your broker or a tax adviser to be sure.)
Because of this, a bond's fund true yield is effectively higher than regular stock dividends.
If you buy a regular stock that pays a 5% yield, you'll pay taxes on that income. If you get 5% from a municipal bond fund, you won't pay taxes on it — so your investment dollars go farther.
So these bonds could be a great way to generate tax-free income to fund your retirement!
Here's to growing and protecting your wealth!
Editor, The Daily Edge
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