Prepare to Pay No Taxes

March 01, 2012

Everyone knows that Tax Time is a Fun Time, right? I mean with getting all of the forms, documents, receipts and” what all” together to prepare our tax forms by the April deadline, what could be more fun? Well, paying no taxes at all would be a lot more fun (improbable as it may be)! Paying fewer taxes on the money we earn is achievable but it takes planning. One easy way to look at this is to separate the “tax-advantaged” investments into two groups. The first group is “now money”. The second group is retirement money. I’ll talk about “now money” first.

Every state has cities that issue municipal bonds. Municipalities use this “loan” to pay for such things as airports, roads, bridges, schools, etc. They borrow this money from investors with a promise to pay it back at some point in the future. In the meantime, they pay interest on the borrowed money. This interest is free of federal tax. It may also be state tax free as well, if the person who owns the bond lives in the state of issuance. If you are a North Carolina resident and you owned $10,000 of North Carolina municipal bonds that paid an interest rate of 3% per year, you would get $300 of income per year from these bonds. Unless you are subject to AMT (Alternative Minimum Tax), you would not have to pay taxes on this income either. If you compare this to earning 3% on a savings account, you can see a significant difference in what you get to keep. Here is how the numbers work out. Three percent of $10,000 is $300. If you are in the 25% federal tax bracket, then you would owe $75.00 in federal taxes on the earnings from the savings account. Which would you rather have, $300 or $225? As part of a diversified portfolio, you could build a position in municipal bonds and benefit from the tax free income that they generate. These bonds are backed by the credit worthiness of the specific municipalities that issued them. So you want to make sure that you are buying quality. Municipal bonds benefit those in higher tax brackets, so you typically would not invest in these if you were in the 15% bracket. Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest rate risk. Bond values will decline as interest rates rise.

Perhaps the easiest way to do this is through the use of a couple of retirement ideas. The first one is the Roth IRA. Participation in a Roth is limited to those individuals that have certain levels of income. To find out if you can participate, go to and do a search on Roth contribution limits. If you qualify, you can put up to $5000/year (plus $1000 if you are over age 50) in the account. Contributions to a Roth are after tax contributions (as opposed to a traditional IRA or 401k, which are pre-tax in the majority of situations). The advantage to a Roth is that when you start taking income out at age 59 ½ or beyond, the income is free of taxes. If you think that tax rates are only going to go up (and I do), then the more tax free income that you have access to in retirement, the better. Another fact worth noting is that distributions from a Roth do not currently affect taxation of Social Security benefits. That is a good thing.

Here is the second part of the retirement ideas. Some 401k plans now have a Roth component. Employees that participate in the company 401k plan can contribute $17,000/yr. and an additional $5,500 if they are over 50 years old. If the employer offers to match up to a certain percent of pay, that adds even more to the employee’s savings. If the plan has a Roth option, then the participant can choose that all of their pay period contributions go into the Roth. However, these Roth contributions will be after tax, not pre-tax like the other 401k contributions. Your advisor may be able to clarify how you should approach this. I believe that most plan participants should consider contributing something to the Roth if they can. It will help you out tremendously in your later years after you reach retirement. Distributions received before age 59 ½ are subject to an early distribution penalty of 10% additional tax unless an exception applies. Roth conversions may not be suitable for all investors.


Derek Carawan is a LPL Financial Advisor and LPL Registered Principal with Carawan Financial Partners, Inc. / Securities offered through LPL Financial/ Member FINRA/SIPC and may be reached at,, 919-870-8181 or

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