Are There Any Tax-Free Investments? What Actually Works for High-Income California and Washington Families

By Kevin Luu, Co-Founder and Chief Learning Officer. Reviewed on 2026-09-30.

Yes, there are tax-free investments, but only a few, and “tax-free” usually means free of one tax, not all of them. Interest on most state and local government bonds (municipal bonds) is free of federal income tax, and Treasury bills, notes and bonds are free of state income tax but fully taxable federally. Beyond that, the real tax-free growth comes from accounts, not investments: a Roth IRA or Roth 401(k), a 529 plan used for qualified education costs, and an HSA used for medical bills.

For a California or Washington family earning $750,000 to $3 million, the question is not “which of these exist” but “which of these is actually worth it at our tax rate, in our state”. The answer is different in Palo Alto than in Bellevue, and the most common mistake is holding a large cash or bond position in the wrong wrapper for years.

Which taxes each “tax-free” option actually avoids

The table below shows what each option escapes for a family in our reader’s bracket. “Federal” means federal income tax, “NIIT” is the 3.8% Net Investment Income Tax, and “State” is state income tax.

Sources: IRS Publication 550 (municipal and Treasury interest), the IRS NIIT questions and answers (tax-exempt interest is not net investment income), and the FTB 2025 Schedule CA instructions (California taxes non-California municipal interest and does not conform to federal HSA rules).

Are T-bills taxable? Yes, federally. Not in California

Treasury bills are taxable on your federal return. IRS Publication 550 says interest from Treasury bills, notes and bonds “is subject to federal income tax but is exempt from all state and local income taxes.” So a T-bill is not tax-free, but for a California family it removes the state layer, which at this income is typically 9.3% to 13.3% on the margin (2025 California brackets).

For a Washington family in 2026 the state exemption is worth nothing, because Washington has no tax on wage or interest income this year. That changes from 2028: Washington has enacted a 9.9% income tax on AGI over $1,000,000, starting January 1, 2028 (WA DOR). How interest will be treated is pending DOR guidance, so a $1 million-plus Washington household should revisit this in 2027.

How municipal bonds work for a California or Washington family

Interest on a bond issued by a state or local government “generally is not taxable” federally (IRS Pub 550). Three details matter at this income level:

• Home state matters in California. California taxes interest from other states’ bonds. A national muni fund is therefore federal-tax-free but California-taxable on most of its income. A California muni fund pays dividends that are exempt from California tax if at least 50% of the fund’s assets are in California or U.S. government obligations (FTB Schedule CA instructions). The fund’s year-end tax statement shows the exempt share.
• AMT can reach some bonds. Interest on certain private activity bonds generally is a tax preference item and may be subject to the alternative minimum tax (Pub 550). For 2026, the AMT exemption for joint filers starts phasing out at $1,000,000 of AMT income, at 50 cents per dollar (Rev. Proc. 2025-32, P.L. 119-21), so households near or above that level should ask whether a fund holds them.
• Selling can still create a taxable gain. The interest is exempt. A gain when you sell the bond or fund is not.

Washington families have no state income tax on interest to save in 2026, so they can use national muni funds and pick bonds on credit quality and diversification rather than home state.

Worked example: $600,000 of cash and bonds for a $900,000 household

Assumptions (illustrative): married couple filing jointly, $900,000 of W-2 income from salary and RSUs, each deferring $24,500 to a 401(k) for 2026. Their federal taxable income lands above $768,700, so extra interest is taxed at the 37% federal rate for 2026, plus the 3.8% NIIT (their MAGI is far above the $250,000 joint threshold). In California, their taxable income falls in the 10.3% bracket ($742,958 to $891,542, 2025 schedule; 2026 brackets are not yet published). Their SALT deduction is already at the $10,000 floor for 2026, so extra state tax gives no federal deduction.

They hold $600,000 outside retirement accounts for a home upgrade, a cushion against RSU swings and near-term spending. The yields below are hypothetical, chosen to show the math, not current market quotes.

What this shows:

• In California, a 3.0% in-state muni matches a fully taxable yield of about 6.13% (3.0% divided by 1 minus 51.1%). Against Treasuries, the break-even is about 5.07% (3.0% divided by 1 minus 40.8%).
• Moving the $600,000 from a 4.0% savings account to the 3.0% California muni fund raises after-tax income from $11,736 to $18,000 a year in this example, a difference of $6,264.
• In Washington in 2026, Treasuries and bank accounts are taxed the same, and munis win at these hypothetical yields because they skip federal tax and NIIT.
• The comparison is only fair if the holdings match the job. Money needed in six months usually belongs in short T-bills or a Treasury money market fund, even at a lower after-tax yield, because a longer muni fund can drop in price when rates rise.

Tax-free accounts matter more than tax-free bonds

Muni interest saves tax on income you were going to earn anyway. Roth, 529 and HSA dollars can grow for decades and come out with no tax at all. For this reader, the accounts usually come first.

Backdoor and mega backdoor Roth

Direct Roth IRA contributions phase out between $242,000 and $252,000 of MAGI for joint filers in 2026, so our reader is above the line. The backdoor route (a nondeductible traditional IRA contribution, then a conversion) still allows $7,500 per spouse for 2026 (IRS Notice 2025-67). The larger lever is the mega backdoor Roth inside a 401(k): total annual additions can reach $72,000 for 2026, so after a $24,500 deferral and, say, a $12,000 employer match, a plan that allows after-tax contributions and in-plan conversions has up to $35,500 of room per spouse. Roth accounts have no lifetime required distributions for the owner. Check pre-tax IRA balances before a backdoor conversion; see how nondeductible IRA contributions are handled.

529 plans

Earnings come out free of federal and California tax when used for qualified education costs. California gives no deduction for contributions (the 2025 bill that would have added one died), and it does not follow some newer federal categories of qualified 529 expenses (FTB 2025 Form 540 booklet), so check the California treatment before using a 529 for anything other than college costs. Grandparents or parents who want to front-load can use the five-year election: up to $95,000 per beneficiary per donor for 2026, or $190,000 for a couple splitting gifts, reported on Form 709.

HSAs, with a California catch

For 2026 a family on a qualifying high-deductible plan can contribute $8,750 (Rev. Proc. 2025-19). Federally, contributions are deductible, growth is untaxed, and withdrawals for qualified medical costs are tax-free. California does not conform: the contribution is added back to California income, including the employer’s share, and interest or earnings in the HSA are taxable in California each year. In Washington the HSA works as designed. In California it can still be worth funding for the federal 37% deduction, but invest the balance in something with low taxable distributions. If you are choosing a plan, see how high-deductible plans compare for families.

Options that are sold as tax-free but usually do not fit

• Series I savings bonds for education. I bond interest is state-tax-exempt, but the federal education exclusion is fully phased out at modified AGI of $179,250 for joint filers on the 2025 Form 8815. At our reader’s income, there is no education exclusion.
• “Tax-free ETFs.” ETFs are not tax-free. Broad index ETFs tend to distribute few capital gains, which makes them tax-efficient in a taxable account, but dividends are taxed every year and gains are taxed when you sell. See when a brokerage account creates a tax bill.
• Mutual funds in general. Not tax-free. Only the exempt-interest dividends of a muni fund are, and in California only the in-state or qualifying share.
• Indexed universal life insurance. Cash value grows tax-deferred and can be reached through policy loans, but costs, surrender charges and lapse risk are significant. Decide first whether the family needs permanent life insurance; if it does not, the tax feature is not a reason to buy it.
• Donor-advised funds. A deduction now and tax-free growth for charity, not for the family. Useful in a high-income year, such as a large RSU vest, but it is giving, not saving.

The decision a family actually has to make

1. List every dollar sitting in taxable cash, CDs and bond funds, and what each pile is for (emergency, home, tuition, opportunity).
2. Fill the accounts that grow tax-free first: mega backdoor Roth if your plan allows it, backdoor Roth, HSA if you are on a qualifying plan, then 529s for each child.
3. For what remains in taxable accounts, compare after-tax yields at your real marginal rate, as in the table above. California families usually land on in-state munis for money not needed soon and Treasuries for short-term cash. Washington families usually compare national munis against Treasuries.
4. Recheck the decision when income crosses $1 million (California’s extra 1% applies above $1,000,000 of taxable income; Washington’s new tax starts in 2028).

Common mistakes we see at this income

• Leaving six figures in a bank savings account where, in California at this income, about half of the interest can go to tax.
• California residents buying a national muni fund and assuming the income is fully tax-free.
• Assuming HSA growth is untaxed in California, then missing the yearly California reporting.
• Skipping the mega backdoor Roth because no one checked whether the employer plan offers it.

What to write down for your kids

Children do not see why their parents hold a muni fund instead of a savings account. They only see the balance. A one-page note in your FamilyKnowledge® Library, written once and updated each year, can record the rule you used (“we compare yields after tax, at our real rate”), the numbers from the year you decided, and what would make you change course. As Kevin Luu puts it: “Your kids don’t need to inherit your portfolio. They need to inherit your decision-making process.”

Frequently asked questions

Are government securities tax-free?

Not fully. U.S. Treasury bills, notes and bonds are taxable on your federal return and exempt from state and local income tax. State and local government bonds are the reverse in most cases: generally federal-tax-free, and for California residents, California-tax-free only when issued in California. Washington has no wage or interest income tax in 2026, so the state exemption only matters there from 2028.

Is any investment free of every tax?

A California municipal bond held by a California resident comes close: its interest typically escapes federal income tax, the 3.8% NIIT and California tax, unless it is a private activity bond subject to AMT. Qualified withdrawals from a Roth IRA, or from a 529 used for qualified education costs, are also free of federal and California income tax. Gains from selling a muni bond are still taxable.

Should a high-income family buy munis or Treasuries?

It depends on the after-tax yield at your marginal rate and on when you need the money. In California, divide the muni yield by 1 minus your full rate (federal, NIIT and state) to compare with a bank or corporate yield, and by 1 minus federal plus NIIT to compare with Treasuries. Short-term cash usually stays in Treasuries regardless.

Next step

Pull your last year-end statements and add up what sits in taxable cash and bonds, then run the after-tax comparison above at your own rate. If you would like a second set of eyes on the full picture, including equity compensation and 529 funding, the Tax & Wealth Assessment covers it. Related: investment and risk management and retirement and employee benefits.

This is general education, and the right move depends on the family’s full picture.

Written by

Kevin Luu

Co-Founder and Chief Learning Officer, Bright Advisers

Kevin has advised high-income W-2 tech and biotech families since 2015, and leads the education-first Age Five Family Office from Brea, California.

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