Four ways bonds can help reduce your tax bill

Bonds can be an excellent way to save on your tax bill, and there are a wide variety of options to choose from.

Mark Lennihan/AP/File
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Financial advisors recommend bonds to investors for portfolio diversification, as a fixed income investment strategy, and to hedge against inflation. Even better, some major bond classes can help you reduce your tax bill, too.

What's more, they are low-risk investments. Here's how you can reduce your tax bill with bonds.

1. Invest in Municipal Bonds

Municipal bonds have long garnered the attention of high-earners seeking to minimize their tax obligations. Muni bonds are tax-exempt at the federal level and, in some cases, local and state tax exempt as well, especially if the investor resides in the issuing state or municipality.

Though munis faced some scrutiny during the financial crisis, many — if not most — munis deserve a second look now that local government finances are on much more stable footing.

2. Buy U.S. Treasury Bonds

U.S. Treasury bonds pay interest income once every six months. That income is exempt from state, local, and the alternative minimum tax. Some treasury bonds can also reduce your tax bill, even if investing outside of a retirement account.

3. Purchase Zero Coupon Bonds

Zero coupon bonds are exempt from state and local tax. As their name suggests, these government bonds pay no interest, but often offer higher yields. Investors beware, however: Zero coupon bonds come with higher risks than their traditional counterparts, so consider the risk-reward trade-offs before investing in this asset class.

4. Put Bonds Inside Tax-Free and Tax-Deferred Accounts

Investors can defer any taxes owed on interest income by delaying distributions and holding these investments in a tax-deferred retirement account, such as an IRA or 401K. Once the money is withdrawn at retirement age, it'll be taxed based on the individual's tax bracket. Using the same strategy, if they are kept in a tax-free account, such as a Roth IRA or Roth 401K, distributions taken at retirement are tax-free.

This article first appeared at Wise Bread.

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