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 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.
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Mark says
TBF,
Thanks for the advice. I think in the long run, converting my wifes “long lost” pre-tax trad IRA (and paying the tax on 17k) along with our after-tax non-deductable IRAs (no tax) this year will be to our benefit.
GIRISH S GUPTA says
I HAVE A CLIENT WHO CLAIMS HE IS CONTRIBUTING TO NON DEDUCTIBLE IRA SINCE 1970. I DO NOT KNOW THE HISTORY OF IRAS. CAME TO US IN 1974 AND STARTED PRACTISE IN 1979. HE CLAIMS THAT FOR LAST 30 YEARS HE IS CONTRIBUTING TO NON DEDUCTIBLE FOR 40 YEARS.
Jerry says
I have a dilemma. I have several pre-tax deductible Traditional IRAs. I also chose to open an exclusive after-tax non-deductible IRA. I have never comingled the accounts, thus my non-deductible account is clean and pure. In 2010 I was informed I could convert the non-deductible IRA into a Roth IRA.
The basis of the after-tax non-deductible IRA, in my view, would be purely the sum total of my annual contributions. At the time I made the decision to convert my non-deductible IRA to a Roth the after-tax IRA valuation was at a deficit to my basis; it was a loss position. It’s my understanding with a non-deductible IRA you should only be taxed on the appreciation in value. Logically any liquidation, full or partial, should then be tax free, because I had already paid taxes on all the contributions to the account.
I took the 2010 RMD based on the 2009 account value prior to conversion, and then transferred the net pre-tax funds to the new Roth IRA.
Now, the basis of my dilemma is the IRS Form 8606, as I read the instructions, require that ALL IRAs held be entered onto the Form thus comingling deductible and non-deductible funds, which I have never done, and would result in a prorated taxable event on my after-tax conversion.
Any advice?
Harry Sit says
Jerry – Your previous understanding was incorrect. When you comingle the pre-tax and after-tax funds or not, the IRS sees all your IRAs as one combined pot.
When exactly did you convert the traditional to Roth? In 2010 or 2011? If in 2010, you should’ve discovered this last year when you did your Form 8606. If you converted in 2011 — it sounds like the case because you are looking at Form 8606 now — and you’d like to avoid the prorated taxable event, you still have time to undo the conversion.
It’s called a recharacterization. Call the IRA provider and tell them you’d like to recharacterize your conversion. They will tell you what form to fill out. If you recharacterize before April 15, it will be as if you never converted in the first place. If you converted in 2010, it’s already too late; there’s nothing you can do about it.
Mike says
I came up with a similar conclusion that a non-deductible IRA can make sense. My spreadsheet determines whether to convert a nondeductible IRA to a Roth IRA. It has an input to delay when the money will be needed and also the number of years to pay out the Roth IRA. For example: convert now, wait 10 years to start distributions, and then spread the distributions out 20 years. After the 30 years, the value in the account is zero. Higher after-tax contributions, converting sooner, delaying when the money is needed, and lengthening the distribution years makes the nondeductible IRA and its conversion to a Roth worthwhile.
Maybe an improvement to your great spreadsheet is to extend the distribution years. I think it will make the non-deductible IRA make even more sense.
JohnB says
Is your spreadsheet still available? The link doesn’t work for me.