Should hub and I put $8000 into a trad. IRA for 2006?

[Guest ctfudge07]

I will try to make the background brief and leave out unimportant detail, but please feel free to ask. I just don't want to bore everyone by writing a book

I am 41, husband 45. As of now we have no retirement funds whatsoever (please don't throw tomatoes.) We have also just now gotten out of the red; our income is not especially high. We have four young children but cannot claim all of them on tax return every year. I will spare you details on that. (it has to do with the non-custodial father of three of them complying with a technicality that allows him to claim three of the children including the child tax credit - ouch!)

This year (2006) our income is uncustomarily large (for us); the unusual part comes from $22,000 this year only that we wouldn't normally receive; is taxable as income. It is the proceeds from a deceased relative's IRA that was not included in the rest of that estate. So, added to our income from work of $44,000, our income for 2006 is higher than past years and higher than future years (in the nearly foreseeable future, anyway).

To put it into perspective, in 2005, to be approximate, our income was about $33,000 and we had 6 exemptions, and you can imagine that we owed little tax for that year. By contrast:

In 2006, due to increased earnings and the 22K, our AGI is looking like $65,000 with only 3 exemptions that can be made this year. I worked it up and see that we'll owe about $6,000 in taxes. This is no surpise. We were counseled that we could have received those IRA proceeds as a rollover and pay no tax or take it as cash and owe tax; it was well worth it since we had almost that much debt to settle and it's great to be DEBT FREE. But anyway, since we had little tax withheld, we're going to have to come up with the money, and we can do it easily (due to the relative's estate settling soon) but of course like everyone else I would like to pay as little tax as possible.

So my focus now is on reducing our taxes for 2006. The only thing I can see that will reduce our taxable income is to contribute 4K apiece (8K total) to a traditional IRA (we'd have to open them, and that's no problem.) I was surprised to see that we have till April 17th to do this. We will be able to do this with no problem. Here's my question:

As someone only learning fine points about having more money than debts (I know a good amount about investing but am not as sharp on taxes), I have a vague understanding that Roth IRAs are preferred by most, and that if you expect to have accumulated much wealth in the future, traditional IRAs are not the preferred thing to contribute to (I could be wrong.) I am thinking of the here and now and I calculated a savings of $1,200 on our 2006 tax bill if we can throw $8k into IRAs. Question: Does this seem like a reasonable thing to do, to save that amount of tax this year? I know it's totally up to me, but for all I know I'm making a long-term mistake for a short-term gain (that's why I'm asking people who know more about this stuff than I do). Would it possibly be better to just pay the tax and throw the same money into Roth IRAs and settle down for the long haul (we do plan to chart an intelligent course - we're smart people but have been all over the financial map for years now, for reasons I definitely won't go into, but change is on the horizon in part because an inheritance is being settled soon and we are going to work that money like a team of packmules. One of our children is disabled and we really want to work that money, and yes, we know that soon we'll need more comprehensive advice and guidance.) Thanks in advance for anyone's advice on whether I'll regret opening a traditional IRA just to save that amount of money this year in taxes. (and in future years, too - we could contribute 8K each year, as I understand it, more after turning 50). I don't see a lot good being said about traditional IRAs; I get the feeling people are converting them to Roths in droves. But for my situation, are they a good idea? THANK YOU for reading.

[John G]

You paint a complex picture.

I am not sure I understand the details, and those details will drive the answer to your question. The 22k was IRA money - did you take it as a lump or will you be getting it spread out over years? I am also not sure if this is considered taxable income or gift. It is also not clear if you already took the cash in 2006, or if it has not yet gotten to you. It also sounded like you might be receiving additional funds from the estate when it settles. If you have not received the IRA, the tax issue jumps to 2007, not 2006. The accountants who post here might be able to assist on your circumstances.

The second part - roths vs IRAS: Part of the emphasis on Roths stems from the expectation that many folks will amass substantial retirement funds, and likely be in higher tax brackets, even in retirement. It sounds like that may not be true for you. If you are likely to stay in the lower brackets, then go ahead and take the deduction, even if it is only a small percent. The trade off is between tax free distributions much later (ROTH) and possible tax deductions now (IRA).

[Guest ctfudge07]

Thanks for the speedy reply. The $22,000 was a lump I received toward the end of 2006. (2K was a mandatory distribution and 20K was the amount I received from the IRA itself. The total value was about $82K but was divided by me and my three siblings. Two of us took lumps and the others rolled over their share into IRAs.)

Yes, I will receive more funds from the estate but I was told by the attorney that it will not be taxable.

So yes, the IRA proceeds, which were outside of the estate, are definitely taxable income to me. I only mentioned it to explain why our income is unusually high for 2006 only.

I hope to amass substantial retirement funds... I realize we've hardly gotten started but it's the goal to get somewhere. The estate proceeds will not be tiny so I'm assuming I'll be better off later than now. (well, I'm planning and hoping to be better off, based on my own elbow grease and scrupulous planning and investing combined with this inheritance.) I understand the tradeoff between traditional and Roth IRAs; I just thought someone would have a clear "you should definitely do this" (or that) idea I should consider. You can see why I am eyeing up a traditional IRA - just to avoid a chunk of tax in a few months, but I'm not sure if that's smart in the long-term, so that's why I'm looking for opinions.

* I just wanted to clarify that I know we qualify for the deduction because my husband's job for all of 2006 conferred no benefits whatsoever - he was a contractor and made no retirement contributions and none were made on his behalf.

And I apologize if I included too many details because I didn't mean to make it complex. I simply meant to ask if anyone has an opinion on whether it's smart or dumb to open traditional IRAs primarily to avoid a bit of a tax hit this year (and we could elect to shave our taxes in future years the same way, of course.) I realize it's my choice but I'm looking for opinions if anyone has a strong one. THANKS!