Q: I'm in my 40s and work for a company that went private last year. I had been buying stock in the company, and because of the deal, I ended up with a lot of cash. I'm worried about what this will do to my taxes. Is there anything I can do about it? I have been saving for retirement, but with the recession, I wonder if it would be dangerous to invest the cash I have now. Should I just spend it? -- S.S., Chicago
A: There isn't much you can do now to reduce taxes, because the 2007 tax year has ended.
Before the end of the year, you might have been able to sell a mutual fund or other investment that had declined in value.
Then you would have been able to offset at least some of the gain on the stock with the loss on the other investment.
Perhaps you already did sell something at a loss. If so, that would cut the taxes you owe on the stock.
The one tool you have left to reduce your overall taxes would be to open a tax-deductible individual retirement account, or IRA, for the 2007 tax year. You can do this at a mutual fund company, broker or bank and deposit up to $4,000 by April 15 (the day taxes are due.) If you have a spouse, he or she might be able to open an IRA with another $4,000 by April 15. Together, you might be able to deduct $8,000.
You have to have income from a job to do this.
Depending on your gain on the stock, opening an IRA might not do much to help your overall tax bill. But you can see the effect by running the "tax estimator" at http://turbotax.intuit.com/tax-tools/.
Not everyone is entitled to take a tax deduction for an IRA. There are income limits and rules that can stand in the way if you or your spouse have a pension or retirement savings plan--such as a 401(k)--at work.
If you have such a plan at work, your adjusted gross income must be no higher than $62,000 if you are single or $103,000 if married for 2007. In 2008, the limits are $63,000 and $105,000. If you don't have a pension or retirement plan at work, you can plunge into an IRA without concern about your income. But there are rules that apply to couples, so check them and income limits at www.irs.gov, in Publication 590.
Depending on your tax hit, and the effect of opening a tax-deductible IRA, you might want to focus on cutting taxes for the long-term rather than just 2007, said IRA expert Ed Slott.
You could open two Roth IRAs--one for the 2007 tax year, and another for 2008. The maximum contribution for last year can be $4,000, and for this year $5,000. You would still have to pay taxes on the gain you made on the stock, and you would get no tax deduction for your Roth IRA contribution this year. But after that you would never pay taxes on the $9,000 you invest in the Roth IRAs, or the money you earn on your investments, as long as you leave the money invested until you are 59 1/2.
If you have a spouse, he or she could also put another $9,000 into Roth IRAs.
Roth IRAs are a fabulous creation for people who don't want to pay taxes. Let's say you open a Roth IRA this month, and invest the $9,000 in a mutual fund that blends stock and bond investments--perhaps the Vanguard Balanced Index Fund. And let's say you average a 7 percent return a year on the fund--a typical return over many years in a balanced fund.
Your $9,000 would become about $49,000 in 25 years and Uncle Sam would not be entitled to a penny of taxes. You could remove the entire $49,000 when you turn 59 1/2, or you could leave it invested and it could double or triple and Uncle Sam would not take a penny.
And if you started with your $9,000 this year, in 2009 you could add another $5,000. That money, too, would be shielded year after year from taxes, unless, of course, someone changes the tax laws.
If you put $5,000 into a Roth IRA every year for the next 25 years and averaged a 7 percent annual return, you could have almost $400,000 at retirement, and Uncle Sam would let you keep it all.
This is not the case with traditional IRAs. Because you deduct the contribution you make to a traditional IRA during the year you make the deposit, when you remove money after age 59 1/2, you will have to pay taxes on it.
This is why I prefer Roth IRAs. Unlike a tax-deductible IRA, you don't receive any tax reduction the year you make a deposit in a Roth. But everything you earn on the money is yours.
You have one other option to reduce your taxes using IRAs. You could open a traditional tax-deductible IRA for 2007 with $4,000, and help alleviate the sting from your stock windfall. And then going forward--including the 2008 tax year--you could open Roth IRAs, provided your income stays within the allowable limits. For 2008, that's $116,000 for singles or $169,000 for married couples.You could open the deductible IRA for 2007 and the Roth IRA for 2008 immediately.
But keep the money from your stock gains invested--maybe in a money market fund or a certificate of deposit at a bank.
It sounds like you originally invested the money for retirement, so there is no reason to change that plan and spend the money.
You have good reason to be nervous about the economy and stock market. The Standard & Poor's 500 index has fallen sharply and may decline further.
But in a money market fund or CD, you can make about 4 percent a year, which will do more for your retirement than spending the money. And when you feel better about the economy, you can venture from the completely safe investment into a fund that could grow more.
Keep in mind that, while you are in your 40s, you are investing money for many years. And while the next few years could be rocky, eventually you stand to make money if you buy a blend of stocks and bonds. That's why I mentioned a balanced fund.
It's a conservative mixture for times like now. During the last 10 years, the Vanguard Balanced Index Fund has averaged a 6.4 percent annual return.
Typically, during periods of market stress, balanced funds invest about half of your money in stocks and half in bonds.
That prevents you from serious losses. During 2002, for example, the average U.S. stock fund--which invested merely in stocks--lost 22 percent. But the average balanced fund lost only 9.5 percent, according to fund tracker Lipper Inc.
By keeping losses at a minimum, but also staying invested in at least some stocks, investors in balanced funds recovered from the loss in about a year. People who invested only in the S&P 500 index--or all stocks--before the 2000-2002 crash didn't recover until last year.
When investors become scared, they think they should yank all their money out of stocks. That would be fine if they knew when to invest again in stocks. But they usually don't. So a moderate approach is to pull back somewhat from stocks if you are nervous, but to keep a foot in the water.
Using a balanced fund is a way to do that.
Gail MarksJarvis is a Your Money columnist. Contact her at firstname.lastname@example.org.