4 Investments You Can Make Completely Tax Free
Never let tax tails wag investment dogs. Financial advisors generally counsel their clients not to invest for the sole purpose of reducing their tax liabilities. It can end badly.
"When people make investments primarily for tax reasons, they usually end up making a lot less than they otherwise would," said Ric Edelman, a registered investment advisor and president of Edelman Financial Services LLC.
Robert Keebler, a partner with tax advisory firm Keebler & Associates, agreed.
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"You can save taxes, but if you're going to lose money doing it, it doesn't make sense."
With the increase in top marginal income-tax rates last year and the introduction of new investment income taxes to finance Obamacare, Keebler and Edelman recommend that their clients consider investments and strategies that offer better after-tax returns in a higher tax environment.
(Read more:Red flags for private equity investors)
"The squeeze is on," said David Grecsek, director of investment strategy and research at Aspiriant LLC.
"Investment returns are expected to be smaller this year, and the tax bite will be bigger."
Here are five ways to help reduce that tax bite and improve after-tax investment returns.
IRAs and 401(k) plans. For most investors, the simplest way to reduce taxable income is to take full advantage of tax-deferred investment accounts.
Individuals can contribute (and deduct for tax purposes) up to $17,500 to an employer-sponsored 401(k) plan and, depending on your participation in a company-sponsored plan, up to $5,500 to a personal IRA.
Contributions to Roth IRAs are not tax deductible, but the investment growth inside the account is.
If your company has a formula for matching employee 401(k) contributions, take advantage of it. It's as close to a free lunch as you can get in the investment world.
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Muni bonds. Between the financial crisis, Meredith Whitney's doomsday analysis and the problems of issuers such as Puerto Rico and the city of Detroit, the tax-exempt muni bond market has had a tumultuous last few years. However, the headline risks have created a buying opportunity, according to investment experts. With the 3.8 percent Obamacare investment income tax kicking in at $200,000 for individuals, the tax-free income of muni bonds looks all the more attractive.
"The selloff last year has created more value in the market," said Peter Hayes, head of the municipal bonds group at BlackRock. He noted that a 4 percent return on intermediate muni bonds is equivalent to a more than 7 percent return on taxable bonds.
"Investors were concerned with duration [interest-rate risk] last year. I think they'll get back to focusing on the tax benefits of muni bonds this year."
Fear from the bankruptcies of Detroit and several other issuers have hit prices in the last year, but the financial outlook for most issuers is improving along with the economy.
The average 6.5 percent return in the high-yield sector is equivalent to a 10.5 percent yield in taxable bonds.
"Investors are getting paid well to take credit risk," Grecsek said. "We think the high-yield municipal bond space is one of the most attractive opportunities in the market today."
(Read more: It's time to cash in those dividends)
ETFs. The lower cost alternative to mutual funds is also far more tax efficient.
With most ETFs still tracking indexes, portfolio turnover is limited, as are capital gain distributions to investors (now taxed at a higher 20 percent rate for investors with more than $400,000 in annual income).
Taxes on gains in ETFs are due when investors sell the funds, giving them a significant tax-deferral advantage over mutual funds.
"Investors don't have to incur the huge tax liabilities that mutual funds can cause," Edelman said.
With the explosion of new offerings in recent years, ETFs now give exposure to a huge variety of markets and investments. Long a favorite of financial advisers who like the low-management fees, their better tax profile versus mutual funds could make them even more popular.
MLPs. Master limited partnerships offer the tax benefits of limited partnerships and the liquidity of exchange traded securities.
The boom in domestic energy production, coupled with tax incentives offered to investors, has resulted in the rapid growth of exchange traded master limited partnerships.
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They offer a high yield and major tax benefits, as distributions to investors are treated as a return of capital rather than taxable income.
"No other asset class has the combination of above-market yields, growth in distributions and tax-deferral benefits," Grecsek said. "They're a slam dunk for long-term client portfolios."
They're not without risk, however.
Grecsek prefers companies in the midstream segment of the market that provide infrastructure for the movement and handling of energy.
They aren't as sensitive to moves in energy prices and generally have stable and reliable cash flow growth.
Additionally, MLPs aren't cheap.
They have significantly outperformed stocks in the trailing five-year period, and while they behaved more like equities last year, they could be vulnerable to further rises in interest rates.
Grecsek, however, said he expects MLPs to have a similar trajectory to real estate investment trusts, which saw yields fall from 8 percent to 10 percent in the 1990s to roughly 3.5 percent today.
He suggested diversifying among the midstream entities of the more than 200 MLP structures now available.
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There are tax-compliance headaches as investors have to file K-1 schedules as limited partners in an MLP investment. Funds of MLPs solve that issue, but they also lose the tax-deferral benefits of investing directly in individual companies.
"We see a lot of investors willing to take on the K-1s to get the tax benefits," said John Frownfelter, managing director of investment solutions for SEI Advisor Network.
Later distributions will be taxed as capital gains, but Grecsek said MLPs enable a "yield-and-shield strategy" that offers very attractive after-tax returns.
(Read more:Afraid of stocks? Check this out)
The Top 9 Tax-Free Investments Everybody Should Consider
It's not like the heyday of real estate investing programs in the early 1980s, when tax rates were much higher. However, private real estate investing can still bring big tax advantages, such as deductible expenses, interest costs and depreciation of the buildings (not the land), that can offset other income.
(Read more:What's hot in the real estate market?)
"In the 1980s, people didn't care if the investment didn't make money, because they could write off several times their original investment for tax purposes," Edelman said.
The Tax Reform Act of 1986 got rid of most of those investment programs, and dramatically lower tax rates have reduced the demand for such products.
Nevertheless, for investors in high tax brackets and who may be subject to the Obamacare taxes, investments in rental real estate can provide major tax savings.
Again, the risks are significant and managing properties can be an ordeal.
"Clients have to be actively involved and deal with tenants, said Richard Scarpelli, head of financial planning at UBS Financial Services.
"The depreciation deduction can be great, but managing the investment can be painful."
—By Andrew Osterland, Special to CNBC.com