Tax-Free

B is correct. Roth IRA contributions are made with after-tax dollars (no current deduction), but qualified withdrawals in retirement are completely tax-free, including decades of accumulated growth. For Marcus, this means he pays tax now at his current 24% rate but pays zero tax later when he would be in the 32% bracket. The tax-free nature of Roth withdrawals is particularly valuable when future tax rates are higher.

A is incorrect because Traditional IRA withdrawals are NOT tax-free; they are fully taxable as ordinary income at distribution. Marcus would indeed receive a $1,800 deduction now, but he would pay taxes on both contributions and earnings when he withdraws funds in retirement, likely at the higher 32% rate. C is incorrect on multiple counts: Traditional IRA growth is tax-deferred (not tax-free), and both account types have the same contribution limits ($7,500 for 2026, or $8,600 if age 50+). D is completely backwards: Roth IRAs provide NO current tax deduction and feature tax-free (not tax-deferred) growth and distributions.

B is correct. Municipal bond interest is exempt from federal income tax, making it truly tax-free at the federal level. For bonds issued in the investor's home state, the interest may also be exempt from state and local taxes ("double tax-free" or "triple tax-free"). Essential public purpose bonds (schools, roads, water systems) are not subject to the Alternative Minimum Tax (AMT).

A (qualified dividends) is incorrect because qualified dividends are tax-advantaged with preferential rates (0%, 15%, or 20% based on income), but they are NOT tax-free. They are still subject to federal income tax, just at lower rates than ordinary income. C (Traditional IRA distributions) is incorrect because all Traditional IRA distributions are fully taxable as ordinary income, regardless of age. Traditional IRAs are tax-deferred, not tax-free. D (long-term capital gains) is incorrect because long-term capital gains receive preferential tax rates (0%, 15%, or 20%) but are NOT tax-free; they are still subject to federal taxation.

C is correct. For a Roth IRA distribution to be fully tax-free (a "qualified distribution"), two requirements must be met: (1) the account must be open for 5 tax years, AND (2) the owner must be age 59½ or meet another exception. Sarah's 5-year clock started January 1, 2025 (the tax year of her first contribution, even though she contributed in March). Five tax years means the clock ends January 1, 2030. Her withdrawal on August 1, 2029 is before the 5-year period ends, so it does NOT qualify as a tax-free distribution.

Roth IRA withdrawals follow ordering rules: contributions always come out first, tax-free and penalty-free (since taxes were already paid on them). Sarah contributed $15,000 total, so the first $15,000 of her withdrawal is tax-free. The remaining $5,000 comes from earnings. Since the 5-year rule has not been met, this $5,000 in earnings is taxable as ordinary income. However, because Sarah is over age 59½, the 10% early withdrawal penalty does NOT apply.

A is incorrect because age 59½ alone is insufficient; the 5-year rule must also be satisfied for earnings to be tax-free. B is incorrect for the same reason: the 5-year requirement has not been met. D is incorrect because contributions are always tax-free, and there's no penalty for someone over age 59½.

C is correct (the EXCEPT answer). Traditional IRA distributions are NEVER tax-free. All Traditional IRA distributions are taxed as ordinary income, regardless of age or whether they are required minimum distributions (RMDs) or voluntary withdrawals. Traditional IRAs are tax-deferred accounts, meaning taxes are postponed until distribution, not eliminated. RMDs simply force you to begin taking taxable distributions; they do not change the tax treatment.

A is accurate: municipal bond interest is generally exempt from federal income tax. Some private activity bonds may be subject to the Alternative Minimum Tax (AMT), but most essential public purpose bonds are federally tax-free. B is accurate: Roth IRA qualified distributions (meeting the 5-year rule and age 59½ or another exception) are completely tax-free, including decades of accumulated earnings. This is the defining benefit of Roth IRAs. D is accurate: 529 plan withdrawals used for qualified education expenses (tuition, fees, books, room and board) are exempt from federal income tax. Non-qualified withdrawals result in the earnings portion being taxed as ordinary income plus a 10% penalty.

A is correct. Only statements 1 and 3 describe truly tax-free investments.

Statement 1 is TRUE: Municipal bonds provide interest that is exempt from federal income tax. When issued in the investor's home state, the interest is typically also exempt from state and local taxes, making it "double tax-free" or "triple tax-free." For a client in the 35% bracket, this tax-free income is highly valuable.

Statement 2 is FALSE: Qualified dividends are NOT tax-free. They receive preferential tax treatment with lower rates (0%, 15%, or 20% depending on income level) compared to ordinary income rates, but they are still subject to federal income tax. For this client in the 35% bracket, qualified dividends would be taxed at 15% or 20%, which is advantageous but not tax-free.

Statement 3 is TRUE: Roth IRA contributions (if the client is income-eligible) provide tax-free growth and tax-free qualified distributions in retirement. While there is no immediate tax deduction, all future withdrawals (after age 59½ and meeting the 5-year rule) will be completely tax-free. This is particularly valuable for someone who expects to remain in a high tax bracket or anticipates higher future tax rates.

Statement 4 is FALSE: Traditional IRA contributions are tax-deferred, not tax-free. While contributions may be tax-deductible (providing immediate tax savings), all distributions in retirement are taxed as ordinary income. The client postpones taxes but does not eliminate them.