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%|
|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 2013. 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 for the contributions 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 performing some paid services for neighbors 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.