When you have a large sum of money, such as from a profit-sharing plan, and you want to invest it with an eye toward minimizing taxes, where should you put your money?

Usually when employees are ready to retire or are switching companies, they roll over their capital from a profit sharing plan into an IRA account or to another employer’s 401(k) plan. The rollover to either of these retirement accounts is tax free and the money grows tax deferred. However, taxes will eventually need to be paid, but only when you're ready to take distributions. The distributions from an IRA and 401(k) are considered income and are taxed accordingly. (For more, see: Common Questions About Retirement Plans.)

Municipal Bonds

It's understandable that investors will want to limit their tax burden to a minimum. This is especially the case if you are in a higher tax bracket. If this is the case and you are looking to invest a large sum of money tax free, financial advisors suggest looking closely at municipal bonds, or munis, for short.

Municipal bonds are a type of debt security issued by government entities to help finance expenditures on projects such as the building of local infrastructure — roads, bridges, schools, etc. The government issues bonds that contractually promise to pay an interest rate on your investment over a certain period of time. Once the bond reaches its maturity the principal investment is returned to you. Municipal bonds are mostly tax exempt at the federal, state and local levels. They generally have higher credit quality and lower price volatility than comparable taxable bonds, as well.

If you live in a high-tax state, such as California or New York, you may benefit from the tax treatment of muni bonds. Some research has even found that investors in all bracket (rather than the highest bracket of 39.6%) can see a significant benefit from investing in municipal bonds.

Municipal bonds can be purchased through any full-service broker and some municipalities allow you to buy bonds directly from them.

There are also municipal bond ETFs, such as the iShares National Muni Bond ETF (MUB), which has net assets of well over $7 billion. There's also the SPDR Nuveen Barclays Short Term Municipal Bond ETF (SHM) and the SPDR Nuveen Barclays Municipal Bond ETF (TFI), as well as the VanEck Vectors AMT-Free Intermediate Municipal Index ETF (ITM) and the PowerShares National AMT-Free Municipal Bond Portfolio ETF (PZA).

And there are several muni bond mutual funds from well-known fund companies, such as these.

John Kvale, a financial advisor with J. K. Financial in Dallas, agrees that municipal bonds as an excellent opportunity for investors who are looking into growing their money tax free. “Municipal bonds will allow you an income without taxes. There are various types of municipal bonds, some associated with better taxes according to what state you live in. Be sure to check your taxing authority for optimal tax savings.” (For more, see: The Basics of Municipal Bonds.)

Equally, Michael Conway, a financial advisor with Conway Wealth Group in Parsippany, N.J., points out the benefits and detriments of investing in muni bonds. “Municipal bonds are often considered tax-free investment options because the interest on the bond is exempt from federal income tax. In addition, investors who reside in the issuing state or locality can avoid state and local taxes on the interest.”

However, as Conway points out, because of the tax-free advantage the interest on the bonds is not as high as with other comparable investments that are taxable. “Muni yields are generally lower than for similar taxable securities because of the potential tax advantage,” Conway added.

Some Muni Bond Tax Pitfalls

One important matter to keep in mind is that although muni bonds are generally tax-free at the federal level, some local or state tax still needs to be paid on the sale of the bonds. “Although muni investors avoid the interest rate income tax, they must pay tax on money gained from the sale of the bonds (capital gains tax),” Conway noted.

There's also the possibility that the IRS will consider any interest you earn as part of your modified adjusted gross income for determining how much of your Social Security benefits, if any, are taxable. That could lead to an unexpected tax hit, so investors should factor in this possibility.

There's also the potential for triggering the alternative minimum tax when investing in private activity bonds, which are issued to fund fund construction of hospitals, stadiums, public housing projects and the like. While interest in these bonds free from ordinary income taxes, that income is factored in as part part of the AMT calculation. If you are subject to the AMT then your 'tax-free interest' could wind up being taxed at a rate of 28% on the margin. Such bonds tend to carry a slightly higher yield than normal municipal bonds but an AMT tax hit would negate that advantage, so watch out. If investing in a fund, check the prospectus to see if it invests in private activity bonds.

The Bottom Line

Placing a large sum of money, such as the capital from a profit sharing account, into an IRA can be a good idea, as it constitutes a tax-free transfer and the money grows tax-deferred. Municipal bonds are a good solution for investors who seek tax-free or tax-advantaged income. If you have a larger sum of money, consider investing in municipal bonds. Investing in munis can also help your local government execute projects where you live and can benefit from. (For more, see: Avoid Tricky Tax Issues on Municipal Bonds.)

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