Expert: Gina Boykin - 12/17/2007

Question
Sometime around July of 2008 I will receive a large inheritance. I am planning on investing a portion of it with a view towards retirement. I'm 52 and am thinking about retiring somewhere between 60 and 65. I will want to shelter as much of as is possible from having to pay taxes. I know that the inheritance is tax free. Neither my wife nor I have an IRA yet. I figure that opening a Roth IRA( we qualify for a Roth on the income allowed for a Roth)is a good place to start. The money available for investment will well exceed the maximum per year allowed for a Roth. For what difference it makes we do have some self-employment income, maybe about $35,000 gross next year. In addition to the Roth that each of us will open what other plans/options can you suggest that I look at as I get up to speed in planning? Thank you for your time and advice.

Answer
The Roth IRA is a good idea, and you will be able to place $4K in this year and $5K in January for 2008.

For the remaining amount, the options that come to mind include:
-college funds for any children or grandchildren (if you want to be generous)
-tax advantaged mutual funds
-municipal bonds
-treasury notes/bonds

Treasury notes and bonds are issued by the government and are exempt from state/local tax, but they are subject to federal tax.  Notes come in denominations of 2, 5, and 10 years.  Bonds are 30 years.  You can visit www.treasurydirect.gov for more information.

Municipal bonds are bonds that have been issued by local governments, schools, hospitals, and other public projects.  They are attractive because the interest is exempt from federal income taxes, and in many cases, it is exempt from state/local taxes.  

Because bonds provide steady income, they are also attractive to someone that is interested in preserving capital.  Bonds range from low to high risk, of course, so you will need to review that before you select one.  Remember that the value of bonds may rise and fall, but if you keep a bond until maturity, you receive the full face value.

There are also tax-advantaged mutual funds for stocks and money-markets.  These are specifically designed for people in a high tax bracket.  In these mutual funds, the dividends are exempt from federal tax.  These vary by broker, but all of the major ones have a section on their website devoted to mitigating taxes.

However, your self-employment income is not high enough to put you in one of the top tax brackets.  In general, tax-advantaged investments will provide a lower return in exchange for lower tax payments, but it may not be worth it. To figure this out, you'll need to compare the tax-free yield with the taxable investment (after considering that you'll be paying taxes on it). There are comparison charts on the web that do this for you, but here's an example.

If you get a 5percent yield on a tax-free account, and you are in the 25percent tax bracket, this is the same as getting 6.67percent on a taxable investment.  However, if you are in the 35percent tax bracket, it's the same as getting 7.69percent.  As you can see, it makes a big difference if you're in a high tax bracket.