Earn Tax-Free Income

By William Baldwin | February 17, 2010 AAA
Earn Tax-Free Income

Take a look at the W-2 you just got. How much of your salary got taken away in taxes? A third? It's going to get worse. Income taxes are going up. Federal rates are going up, state rates are going up, and if you take a look at the deficit you can find 1.6 trillion reasons why tax increases are sooner or later going to hit not just the rich but the middle class as well.

Still, some income in this heavily taxed economy is tax-free. Find yourself some of that income. It beats a raise.

1. Get a cash-back credit card.
The dollars you get back are tax-free income. Smart shoppers have several cash-back cards in their wallet and whip out the one that maxes their benefits. Among the better deals: Blue

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Cash card from American Express (NYSE:AXP), which is good for big spenders, and the Visa offered to Charles Schwab (Nasdaq:SCHW) brokerage customers, which gives back 2%.
2. Be a bureaucrat.
Borrow to the hilt to go to college, taking advantage of the federal student loan program. Work for the government. Make monthly payments for years, then get the balance forgiven. Other workers have to pay for 25 years and the forgiven debt is taxable. But for government workers the loan forgiveness not only occurs much sooner; it is tax-exempt.

3. Be nice to your rich uncle.
Inheritances are not subject to income tax.

4. Do it yourself.
Mow your own lawn, paint your own house, do your own tax return. That beats hiring pros to do these things and then having to work overtime to cover the bills. Reason: Your overtime pay is taxable, but the money you effectively earn by hiring yourself to do chores is not taxable.

5. Pay off credit cards.
Have some spare cash? Invest in your credit card balance. If you were paying 15% interest, this pay-down capital yields 15%, which is (a) way more income than you get on a Treasury bond and (b) unlike the Treasury coupon, tax-exempt. (For more insight, see Expert Tips For Cutting Credit Card Debt.)

6. Give your kid a Roth IRA.
Say Junior makes $3,000 from a summer job, and spends it all on college. You have $3,000 sitting around. Start a Roth IRA for the kid. The limit on what you can put in is his earned income. Tell him to sit on the money for 60 years, until he's 79. At 6%, that $3,000 will turn into $99,000. The $96,000 of profit will be untaxed. If this is money he would have inherited anyway, you have also done him the nice favor of reducing your estate tax by getting $3,000 out of your estate.

7. Have a tag sale.
Sweating for eight hours on a yard sale that hauls in $300 beats sweating at a job for eight hours for $300. Reason: Sale proceeds are tax-free, provided you're selling for less than your purchase cost (or, in the case of unwanted gifts, less than both the giver's cost and the gift's value when you got it).

You can do even better than this. Put up a sign saying that 100% of the sale's proceeds are going to a well-known local charity. That boosts your take, say, to $500. You were going to give this charity $500 anyway. Then the day at the tag sale table has effectively earned you $500, tax-free. Selling tchotchkes (at a loss) on EBay also yields tax-free income; there, however, a boast about charitable aims might not cut any ice.

8. Set up a 529.
Earnings on the popular college savings plans are exempt from income tax, provided you use the proceeds for higher education. These plans are usually a better bet than Coverdell savings plans because (a) there are no income limits on who can participate and (b) in some states you get a state income tax break for putting money in.

9. Buy I-Bonds.
These savings bonds from the U.S. Treasury pay modest interest, but they are inflation-protected. Like all Treasury securities, they pay interest exempt from state income tax. As with most savings bonds, you can defer paying the federal tax until you cash them in. And there's one more goody: If your income is moderate when you cash in and you use proceeds for your kid's college costs, the interest is federally tax-exempt too. The federal exemption begins to phase out at $105,100 of adjusted gross income on a joint return.

10. Be a serial remodeler.

Suppose you spend $200,000 on a house that needs work. You live in it. You put $80,000 of cash into improvements. You also put in your own labor--$120,000 worth, say. Take your time. Sell the spiffed-up house for $400,000. Your $120,000 profit, representing sweat equity, goes untaxed. In fact, you can pocket $250,000 of gain tax-free (couples, $500,000) from home sales every two years. Vacation homes don't qualify. For more on the home sales exclusion, read IRS Publication No. 523.
11. Use UGMA, in small doses.
The Uniform Gift to Minors Act (or, as newly styled, Transfers to Minors Act) lets you set up a bank or investment account for your youngster. The first $950 a year of the child's investment income is tax-exempt. A good choice: a Ginnie Mae fund that throws off a lot of normally taxable income. (Vanguard's is VFIIX; Fidelity's is FGMNX.) The yield on a $20,000 contribution would soak up most of the available exemption. Beware gift taxes that become a problem where one recipient is getting more than $13,000 a year from you (or $26,000 a year from you and your spouse).

12. Rent out your house.
If you live in a desirable city - Orlando, San Diego, New York, Vancouver during the Olympics - you can probably rent it out when you're on your two-week vacation. The rental income is pure gravy. Officially the IRS does not count income from renting if the rental is for no more than 14 days. This arrangement does not prevent you from claiming the full year of property taxes and mortgage interest as itemized deductions. Vacation homes qualify.

13. Own munis.
You can get a 4% yield on a long-term Treasury bond, fully taxable on your federal return. You can also get 4% on a municipal bond, tax-exempt at the federal level. If you mind losing capital, don't buy bonds from states (like California and Illinois) that are getting crushed by welfare caseloads and public employee unions. Check out your state's Forbes Moocher Index before buying.

14. Collect rebates.
Time spent on mail-in rebates is fairly well rewarded, and the resulting cash is tax-free income, assuming the stuff you're buying is for pleasure. (In the eyes of the IRS, the rebate just reduces your cost for the item.) The yield on grocery store coupons is also exempt - but maybe not worth your time.

15. Earn post-recession capital gains.
Do you have any losses on funds or stocks that got killed in the crash? If you haven't already booked them, do so. Sell losers. Use the resulting capital losses to shelter future capital gain income. Aim for that income by investing in growth stocks that don't pay dividends. Examples: Apple (Nasdaq:AAPL), Bed Bath & Beyond (Nasdaq:BBBY), Intuit (Nasdaq:INTU).

16. Give away capital gains.
Buy Apple stock for $2,000. Sit on it for years. When it's worth $3,000, give it to a charity you were otherwise going to give $3,000 in cash. The $1,000 gain goes untaxed. You still claim the full $3,000 as a charitable deduction.

17. Collect return of capital dividends.
Sun Communities (NYSE:SUI), a real estate investment trust that owns mobile home parks, paid a $2.52 dividend last year. Of that, only 66 cents was taxable; the balance of $1.86 was considered a "return of capital" because the real estate investment trust used depreciation to shelter some of the income it got. The return-of-capital payout is cash you can spend now without having to declare it as taxable income; it could increase your taxable gain when you sell the shares, but that might be much later or never. A lot of other REITs have distributions that are at least partly sheltered in this way.

18. Be a landlord.
Buy a condo or, if you feel like it, a whole apartment building. Put down a lot of cash (about half the purchase price). You'll wind up with a nice income stream that is sheltered by depreciation deductions.

Why not borrow to the hilt, like most wheeler-dealers? Because then some complicated rules on "passive losses" will come into play and your depreciation write-offs will mostly go to waste.

Here, in rough measure, is how the numbers might work on a $250,000 purchase, of which you finance $100,000. You collect $18,000 a year in rent. You run up $5,000 in operating costs and $5,000 in interest, clearing $8,000.

If $30,000 of your purchase price was for the land (non-depreciable) and the balance is spread over 27.5 years, your annual depreciation write-off is $8,000. That means your whole cash income is tax-exempt.

Note that the landlord game can be enhanced with the do-it-yourself gambit. To keep your out-of-pocket costs down, be your own rental agent and handyman on the property. In effect, you are earning money for these chores but sheltering that labor income with a depreciation deduction.

Taking depreciation now will increase your taxable gain later when you sell the building. But who says you ever have to sell the building?

19. Set up a Health Savings Account.
These are like IRAs for health costs. You put money in as a pretax deduction from your paycheck. It compounds tax-free. Provided you eventually use the money for healthcare, both the principal and the earnings come out tax-free. Not all employers offer them.

20. Earn airline miles.
In theory, the free trips you earn for yourself by taking business trips should be treated as taxable income (they are a form of commercial bribery). But the IRS knows that going after airline miles would cause a political firestorm. So it gives them a free ride.

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