Beat the Taxman With Tax-Free Income

Jump start your wealth-building efforts by increasing your tax-free income.

Grab the nearest math whiz who you know, and ask her this question: "If 25 percent of my annual income goes to the IRS, at what point during the year do I actually start working for myself?" The truth is, it's tough to get ahead financially when the taxman gets a big, double-digit percentage of each dime you earn. You can minimize the impact that Uncle Sam has on your finances by going after the following dimes that the IRS can't touch.

Eeny MUNI miny moe

Municipal bonds, also known as munis, are debt securities issued by state, county, or local government entities. The federal government gives municipal bond issuers and investors a break by exempting the bond interest from federal taxes. In some cases, the interest may be exempt from state and local taxes, as well.

To evaluate the impact of that tax-free status, you can calculate the taxable equivalent yield (TEY) of any prospective muni bond. The formula is simple-just take the muni bond's coupon rate, and divide it by 1 minus your tax percentage. Here's an example: If you're in the 25 percent tax bracket, the earnings on a 4 percent muni bond are equivalent to the after-tax earnings on a 5.33 percent taxable investment. If you're in the 35 percent tax bracket, that 4 percent muni bond has a TEY of 6.15 percent.

All work and no tax

If you own your own business, or you have an inside line to your employer's benefits manager, you have several opportunities to enhance your tax-free income. First, get employer-sponsored health coverage. Assuming the 25 percent tax bracket again, a health policy costing your employer $300 per month is worth $400 a month to you-because that's what you'd have to earn pretax to absorb that expense on your own.

You can also use your employer-sponsored Flexible Spending Account to pay for other non-taxable benefits. Depending on your plan, these benefits might include group life insurance, accident benefits, or dependent care.

Try also convincing your gracious employer to send you to school and foot the bill. You can accept up to $5,250 in employer-paid tuition per year, and it's all tax-free.

Flip that house

If your home has increased in value since you bought it, sell it, and enjoy tax-free capital gains. Since 1997, the IRS has allowed homeowners exclusion on capital gains earned from the sale of a primary residence. There are a couple of caveats, however. The exclusion only applies to the first $250,000 of gain (or $500,000 for married couples filing jointly), and you can only take it once every two years.

Getting back to our question: if you work 50 weeks per year, 12.5 of those weeks benefit the IRS. But increase your tax-free income, and maybe you won't have to wait until spring to start earning money that's just for you.