A Non-Deductible IRA Is Worth It For Me
In Alternatives to a High Cost 401k Or 403b Plan , I mentioned non-deductible IRA as one of the options. If you are not eligible to contribute to a Roth IRA, you can still contribute to a Traditional IRA. Even though the contributions are not tax deductible, the money in the IRA still grows tax deferred. For some people this option beats investing in a taxable account. If you are eligible for a Roth IRA, of course contributing to a Roth IRA is better than contributing to a non-deductible IRA but not all people are eligible for a Roth IRA. Instead of listing the pros and cons of a non-deductible IRA qualitatively, I created this spreadsheet which lets you calculate the bottom line and compare it against investing in a regular taxable account:
After you enter your assumptions, the spreadsheet will calculate how much you will have in a non-deductible IRA and how much you will have in a taxable account, after all taxes are paid. Of course the calculated result will depend on your assumptions. So play with some what- ifs. For example under this set of assumptions,
| Marginal Tax Rate at withdrawal | 28% |
| Capital Gains Tax Rate at withdrawal | 20% |
| Tax Rate on Distributions | 28% |
| Investment Return | 8% |
| Distributions in Taxable Account | 2% |
| Number of Years Until Withdrawal | 30 |
a non-deductible IRA beats a taxable account after all taxes even for a tax efficient fund which only distributes dividends. In the above scenario I assumed the laws will stay as we know now. In other words, capital gains will be taxed at 20% and dividends will be taxed as ordinary income, because under the current laws the special 15% rate for long term capital gains and qualified dividends will go away in 2011. If the fund isn't so tax efficient and its distributions are 2.5% instead of 2.0%, a non-deductible IRA's advantage goes up.
A common argument against the non-deductible IRA is that it converts capital gains into ordinary income. While true, as the actual calculation demonstrates, if the investor has a long timeframe, the benefits from tax deferral can overcome the higher tax rate on withdrawal.
Another thing that comes up whenever a non-deductible IRA is mentioned is tax form 8606. If you make a non-deductible IRA contribution, you have to file this form. It's a very simple form. Mine has only 3 numbers on it. In the ages of computers, tax software does the calculation and produces the form. Filing Form 8606 is really a non-issue.
The non-deductible IRA is already better than a taxable account for me (use the spreadsheet with your own assumptions and see if it's better for you). The possibility of converting it to Roth makes it even better. Under the current laws, a traditional IRA can be converted to a Roth IRA in 2010 and every year thereafter without any income limitation. The spreadsheet calculation does NOT include the effect of such conversion. If there are no changes to the laws and a traditional IRA is allowed to be converted to Roth with no income limit, a non-deductible IRA's advantage over a taxable account will be much larger.
I have IRAs with both pre-tax and after-tax money. My current plans for taking advantage of the Roth conversion are:
- In 2008, establish a Self-Employed 401(k) Plan (aka "solo 401k"). All I need is a little bit of self employment income, which I already have. Otherwise washing the neighbor's car for $5 should count. Fidelity offers a no-fee solo 401k .
- In 2009, roll over from my Traditional IRAs to my solo 401k everything except non-deductible contributions. This is crucial because otherwise the pre-tax money in the Traditional IRA will also be taxed during the Roth conversion. The solo 401k provides a safe haven for the pre-tax money.
- In 2010 and every year thereafter, make a new non-deductible contribution to Traditional IRA. Convert the entire Traditional IRA to Roth.
Even if the Roth conversion option goes away, a non-deductible IRA is still not bad by itself. It's well worth the effort for me.
Elsewhere on the Internet:
- Fairmark: Conversion Rule Changes
- Bogleheads Wiki: Non-deductible Traditional IRA
Popularity: 32% [?]
Software picked, likely related posts:
- TFB's Stumbles: Week Ending March 28, 2008
- Alternatives to a High Cost 401k Or 403b Plan
- Solo 401k For Part-Time Self-Employment
Comments
10 Comments on A Non-Deductible IRA Is Worth It For Me
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Marc Hedlund on September 2, 2008 |
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Anonymous on September 2, 2008 |
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Marc Hedlund on September 2, 2008 |
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James on September 7, 2008 |
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Bharat on February 14, 2009 |
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Bharat on February 14, 2009 |
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Hey, TFB,
I have an IRA-related question on which you might have an opinion. My wife and I are expecting our first child soon, and I already am planning a 529 account for education savings. However, I was thinking about the standard pitch personal finance advisers give about investing in IRAs early ("it's better to invest $10,000 when you're 20 and never invest again than to start investing $1,000 a year when you're 35" or whatever the numbers are), and it occurred to me that starting an IRA for our child — specifically, a Roth IRA — would make sense as early as the child's first year of life. Do you know if that's allowed, and if so, what do you think of the idea?
If Roth contributions were taxed at current tax rates, and could grow for a full 65 years before being withdrawn without further taxation, the benefit of that seems substantial. I also always think of retirement accounts as essentially a once-a-year opportunity to invest, which expires at the end of the year and cannot be re-obtained after that (in other words, once the 2008 tax year is over, you never again have access to 2008's maximum contribution — you can go on to 2009's contribution but 2008 is gone forever). From that view, not investing in retirement for the first 20 years of a child's life is essentially letting 20 opportunities lapse.
Any thoughts on this?
Excluding the Roth conversion option, while the numbers may work out *slightly* in favor of the non-deductible IRA over a taxable account, the edge will be very slight.
In exchange for that slight edge, you add complication to your life and tie up money in an IRA account.
When you die, your heirs get to try to figure out how much of your contributions were deductible versus non-deductible. They won't be able to figure it out, and will pay more tax on your estate than they need to.
Further, it's quite likely that tax rates will increase in the future (gotta pay for the national debt somehow). So in my opinion, any analysis which assumes static tax rates is automatically suspect.
I've considered the non-deductible route, and in my opinion even ignoring the latter two reasons, keeping things simple with a taxable account was by far the better choice.
Marc – In order to contribute to any IRA, Roth included, the person must have earned income up to the contribution amount. That means your child has to earn something. If you employ your child in your own business, you must be able to reasonably claim that the child worked in the business to earn his or her wages. Both the employer and the employee portion of the Social Security and Medicare taxes must also be paid. It's probably not feasible for a one-year-old but not inconceivable for a 6-year-old. As soon as your child has some earnings, I think it's a great idea to contribute 100% of that income until you hit the annual contribution limit. Like you said, you only get that opportunity once a year. You can't make up for it.
Anon – The purpose of this post is to present a tool for comparing a non-deductible IRA with a taxable account. You can make your own assumptions and decide whether it's worth it. The "complication to your life" to me involves a once-a-year contribution and a simple tax form. Chances are that I will use up all my IRA money before my heirs see anything. I think it's worth it for me. It's also reasonable if you conclude it isn't. That's why you need a tool to compare the bottom line.
Marc – This article from Fairmark has more info on Roth IRA for a child.
TFB: Thanks much for the response and the pointer. Both are great. I didn't know that IRA contributions had to be based on earned income — I was thinking that gifts from us to our child might be enough.
It sounds to me like the best structure might be to set up a "matching program" for IRA contributions once our child is legitimately earning income. For instance, say, we will match your income in the form of IRA contributions up to the maximum amount you can contribute in a year. That way, the contributions are strictly limited to what our child is earning, but effectively allow them to contribute their income to an IRA and to have those contributions matched in "allowance" payments.
Thanks again.
TFB, I am interested in your comment about washing neighbor's car for $5. Suppose that someone made $20 (for the year) washing car, does that mean that they can contribute 15% of that $20 to a solo 401K? Is that worth the trouble since they have to file a self-employed income on the income tax?
James – Establishing a solo 401k is primarily for providing a safe haven for the pre-tax money in the traditional IRA. They don't have to contribute $3 to the solo 401k because that's not the point. Just rolling over money from existing traditional IRA is good enough. Having earned $20 in self-employment income qualifies them for setting up a solo 401k. Otherwise they can't do it. Suppose they have 90% pre-tax money and 10% after-tax money in their traditional IRA. If they don't move their pre-tax money to a solo 401k or a workplace 401k, when they convert to Roth, they will pay income tax on 90% of the converted amount. If they protect the pre-tax money in a 401k, they will basically convert only the after-tax money in the IRA with very little tax due.
If we are talking about only $20 of self-employment income, there is only one extra tax form (Schedule C-EZ). There won't be any self-employment income tax because the income is under $400. The form is very simple because it's got EZ in its name. The tax software will do it in a minute.
TFB,
A fellow boglehead!
Great article. I have been contributing to "non-deductible" IRA with the expectations to move them into Roth IRA. But based on your argument about potential increase in dividend/cap gain taxes it seems that even without the Roth IRA option, "non-deductible" IRA make sense for me.
I have one question about rollover IRA.
If i move my money from 401K to Vanguard, will they create a separate account for rollover IRA or move the 401K amount into my existing "non-deductible" IRA? If there is no separate account for rollover amount then i guess, the only option is to open account with another fund company like Fidelity to keep all 401K rollover separate from "non-deductible".
Bharat – When you rollover your 401k, you can ask for a new account or roll into your existing account. It's OK to mix non-deductible money with rollover money, but some prefer to keep them separate. Whether you mix them or keep them in separate IRAs, the implication for Roth conversion is the same. That's why I'm planning to move my pre-tax money to a solo 401k before I do Roth conversion. If you also want to do Roth conversion for your non-deductible money, perhaps you should consider postponing your 401k rollover or roll them into a 401k instead of an IRA.
TFB,
Thanks for clarification on option to keep rollover IRA in a separate account.
I am planning to keep the current 401K & if the new 401K offers better options than rollover into it. So that way, i will only have after tax contribution into the "non-deductible" IRA.
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