The most popular form of tax-free investing is in the bond market. Bonds issued by corporations are taxable, but bonds offered by state and local governments are tax-free. One way cities and states raise money to operate is by selling bonds to investors. In return, they get the capital needed to complete infrastructure projects and pay off debts. The gains you realize from municipal bonds -- known as "munis" -- are not taxed; therefore, they offer a unique incentive that other investments cannot provide. Be aware, however, that tax-free bonds typically offer lower returns.
In certain situations, a muni may be priced to compete with taxable bonds, thus offering a great benefit. In June 2009, many 10-year municipal bonds offered the same yield as Treasury bonds. Because Treasuries are taxable, this made munis a logical choice. In 2009, California muni bonds yielded between 6 and 7 percent interest. This return is on par with other investments that pay close to 10 percent when the zero tax is factored in. Furthermore, unlike corporations, a state government is unlikely to default on its promise to repay bondholders. Companies go bankrupt often, but it is highly unlikely that the U.S. government will allow a state to declare bankruptcy. Historically, only three in every 1,000 municipal bonds default.
Bills, notes and bonds offered by the U.S. Treasury are exempt from state and local income taxes. Treasuries are taxed at the federal level, however. Even so, the overall returns are better than with other investments, which are subject to both federal and state taxation. Treasuries offer short-term as well as long-term investment opportunities. Treasury bills may be held only a few weeks while Treasury bonds are typically held from 10 to 30 years, depending on the bond purchased.
Some tax-free investments are innovative. Affluent individuals looking for investment strategies that will not pay off in their lifetime but instead will provide heirs with tax-free income might consider life insurance as an investment. Rather than paying interest, life insurance policies earn interest. Certain policies pay the entire policy value plus interest to the policyholder's beneficiaries upon his death. The entire investment plus the premiums paid is returned, with interest, and the money received by the heirs is not subject to income tax. Insurance companies make a profit by investing the premiums by the policyholder in higher yield strategies that allow them to earn more interest than they will eventually pay out.