Urgent Question about IRA and taxes

[Landor n Stella]

First, I'm totally in the world of paying down loans right now, so I have very little knowledge of investments. I was going to wait to jump into that when it was more realistic (much less $$ going to loans). But a crazy tax situation this year has sparked some questions. I'm hoping to get some knowledge/advice/better understanding of how it works by posting it here.

We sold our house last year, and made ~$14,000 on the sale (capital gains). Some of that went to our realtor. We have set aside the rest to pay back the First Time Homebuyer's money we got when we misguidedly bought in 2009. It worked out for us, but we still owe back $8,000 to Uncle Sam from the FTH.

We also have a tax bill on top of that, because of doing some independent consulting over 2011 and not making the right adjustments to my W-4 to account for that. (lesson learned)

So we're looking at a tax bill of $8,000+ (will know more accurately after the accountant is done later this week). I was on Mint.com and saw at tip that stated that maxing out a contribution to an IRA for $5,000 by April 17th means that you can get a full tax credit for the same amount.

Because of the amount that we owe, my line of thought went something like: it would be better to have $5,000 sitting in an IRA, even if we can't withdraw it for a long time than it would to see my bank account drop by over $8,000 and never see it again. If we invested $5,000 in the IRA and thus were able to reduce our tax bill by the same amount, we would have the net same effect on our bank account today, ie, still seeing the account drop by the 8k. But those little worker dollars would be doing something for us over the next 30 years in the IRA. We are 26.

I hope I'm making sense with this explanation. I will be talking to our accountant about it too, but I wanted to get opinions here before calling her.  Will my IRA plan work? How hard is it to withdraw from an IRA, should the need ever arise? We're prepared to pay the taxes, no matter whether the IRA is an option or not, and we have ~$18k available between all accounts, including our E Fund. Advise appreciated in advance!

~Stella

[grantmeaname]

Shouldn't it be a tax deduction, not a tax credit?

Or do I have something totally way wrong here?

[Landor n Stella]

"Open a tax-deductible IRA, and deduct up to $5,000 on your taxes this year.
Take our simple quiz to find out which IRA is right for you." -Mint.com

Yep, you're right. It's a deduction. I just got my terms mixed up.

~Stella-I-Told-You-I-Was-A-N00b

[sol]

Which is not to say there is no tax benefit from contributing to a traditional ira. If it reduces your taxable income by 5k, then you will owe a bit less in taxes. $1250 less in the 25% bracket, which is better than a poke in the eye.

[grantmeaname]

That's okay, it's a simple, honest mistake.

That means that $5,000 you deposit will lower your tax liability by $5,000 times your marginal tax rate (highest bracket). So if you're in a relatively high bracket, like 25%, you could be lowering your tax liability by $1,250. On the other hand, since it's not a tax credit, it's not that gigantic of an opportunity to miss, especially if you'd have to tap into your emergency fund for taxes this year.

[Landor n Stella]

Another basic question- how do I know what bracket I am in? Is there a handy reference somewhere?

~Stella

[AJ]

Another basic question- how do I know what bracket I am in? Is there a handy reference somewhere?

Google "2012 tax brackets"

[Chris]

We sold our house last year, and made ~$14,000 on the sale (capital gains).

Are you certain it's a capital gain? It may be excluded, depending on the circumstances.

[Landor n Stella]

We sold our house last year, and made ~$14,000 on the sale (capital gains).

Are you certain it's a capital gain? It may be excluded, depending on the circumstances.

I will have to ask our accountant. We have not done our taxes on our own since getting married in 08, Landor was self-employed in a partnership until last year and it just seemed too complex.

[Physics]

Yeah, selling your primary residence should not be a taxable event, even if you make a profit on it.

[AJ]

Yeah, selling your primary residence should not be a taxable event, even if you make a profit on it.

I thought you had to live there at least 2 years to avoid capital gains taxes. Since she bough in 2009 and sold "last year", she may or may not be able to exclude the gains, depending on what month she bought and sold.

[the fixer]

I'm no tax expert, but traditional IRA contribution deductions are phased out by income if you or your spouse qualify for an employer's retirement plan (e.g. a 401(k)). Read this: http://www.irs.gov/retirement/article/0,,id=202510,00.html

You mentioned a W4, so the above has a good chance of applying to you.

[Landor n Stella]

Well, I just had to report back. We were expecting to have to pay over $8,000 in taxes this year, mostly because of selling our house before the 3 year limit on the first time homebuyer tax credit from 2009 (AJ- we bought in July of 2009 and sold in November of 2011, so we lived there for over 2 years).
Anyway, our tax accountant did up the paperwork, and even though we walked away with a check from the sale, we only profited $1,556. Thus we only had to pay the $1,556 instead of the full $8,000. I learned that paying it back in full only applies if you profit more than $8,000 on the sale of the house, otherwise you only pay what the profit was. When I said originally that we made $14,000 on the sale, I was only looking at the price we bought it for and the price we sold it for. It make a big difference when taking into account the closing costs and Realtor fees and all of that!
So the fantastic news in all of this was that we have been saving up for the taxes instead of paying down loans. Now that we don't have as big of a tax bill as we thought, we have enough to pay off one student loan IN FULL! The balance on it is $13,400. This is very exciting. :-)
Thanks to everyone for answering my silly questions about investing. I was in a panic over it and I should have just stayed calm.

~Stella

(PS- the fixer- Only I work full time. Landor is a full time student, so he has no 401(k) option. I think that means that we can make contributions to the traditional IRA and are not excluded via the terms you posted).

[Physics]

Fantastic, that seemed to work out well.

[arebelspy]

Now can you take 5k of that amount you were saving, contribute it to a Roth, drop your tax bill by 1250, and then only pay $306 in taxes instead of $1,556?  Then put the rest of what you were saving (the other 8k or so) towards that 13k student loan?

I know it's tempting to get a student loan fully paid off, but instantly getting 25% return on that money put in the Roth due to the tax benefits is amazing, much better than the student loan interest you're paying...

You have about a day to do it, but you absolutely should!

[sol]

Now can you take 5k of that amount you were saving, contribute it to a Roth, drop your tax bill by 1250, and then only pay $306 in taxes instead of $1,556?

She won't get a tax deduction for contributing to a Roth IRA.

[arebelspy]

Now can you take 5k of that amount you were saving, contribute it to a Roth, drop your tax bill by 1250, and then only pay $306 in taxes instead of $1,556?

She won't get a tax deduction for contributing to a Roth IRA.

Sorry, meant contribute to an IRA.  Or 403b.  Or 401k.  Or whatever.  Something tax advantaged that will immediately get that 25% tax reduction (assuming that's her marginal rate, and there's enough income over that marginal rate to reduce, otherwise a bit less).

Thanks for the clarification.

But doesn't that seem to be the better plan?  Instead of paying 1556 in taxes, and paying off student loan of 13k, pay off 8k of student loan, 5k into IRA, and only $306 in taxes?  Total increase to net worth under that plan is 1250 (amount of the deduction)?  Why not take a $1000 net worth increase, since they have the money to do so?

[Landor n Stella]

Now can you take 5k of that amount you were saving, contribute it to a Roth, drop your tax bill by 1250, and then only pay $306 in taxes instead of $1,556?

She won't get a tax deduction for contributing to a Roth IRA.

Sorry, meant contribute to an IRA.  Or 403b.  Or 401k.  Or whatever.  Something tax advantaged that will immediately get that 25% tax reduction (assuming that's her marginal rate, and there's enough income over that marginal rate to reduce, otherwise a bit less).

Thanks for the clarification.

But doesn't that seem to be the better plan?  Instead of paying 1556 in taxes, and paying off student loan of 13k, pay off 8k of student loan, 5k into IRA, and only $306 in taxes?  Total increase to net worth under that plan is 1250 (amount of the deduction)?  Why not take a $1000 net worth increase, since they have the money to do so?

We actually will end up with a return from our taxes, about $1,500 worth. There was more being withheld than we thought, so we went from thinking we would have to pay $8,000+ to getting $1,500 back. Quite a difference! I think we might be able to swing both- paying off the student loan and making a contribution to an IRA. We have quite the stockpile in our liquid accounts right now. Thanks for the advice, Arebelspy.

We are focusing 100% on paying down our student loans right now, as a strategy. That is a requirement for us, regardless of if there might actually be a "better" options in terms of percentages/rates investing than paying off the loans. The loans range from 6.8% down to 1.51% interest. Some are variable rates, and those we want to pay off before they have a chance of changing dramatically on us. Also, being bound to over $50k of debt, even long term debt, is smothering. I started a journal for us in the Journals thread, if you have more advice or thoughts for us. :-)

~Stella