New Here? Get the Free Newsletter

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning. Join over 17,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

Is a Nondeductible IRA a Good Idea?

A reader writes in, asking:

“Because of our income level and because my wife and I both have qualified plans at work, we can neither contribute to Roth IRAs, nor make deductible contributions to traditional IRAs. But for years we have been following what I’ve always seen as the accepted wisdom of making maximum contributions to our IRAs anyway, in order to get the value of tax deferral on the growth and earnings within the IRA.

But I’m now questioning whether we’ve been doing the right thing. When we take distributions, the growth on our nondeductible IRA will be taxed as ordinary income (at rates that will likely be 25% or more given the magnitude of our distributions at retirement age), whereas the capital gains and dividends on the assets we purchase would be taxed at only a 15% rate if we kept them in a taxable account instead.”

Is the “Back Door Roth” an Option?

First, I think it would be a good idea to back up a step and ask if the “back door Roth” strategy is a good option here. In brief, under that approach, you make a nondeductible IRA contribution, then do a Roth conversion.

If you don’t have any IRAs that include deductible contributions or earnings, the conversion would be nontaxable — essentially allowing you to make a Roth contribution even though you’re over the income limit. If, however, you do have IRAs that include deductible contributions or earnings, the conversion will be at least partially taxable, thereby making the strategy less appealing.

Nondeductible IRA or Taxable Account

If the back door Roth is not suitable, I think the question of whether to use a nondeductible IRA or a taxable account depends largely on what will be held in the account. If the account will hold tax-efficient stock index funds or ETFs, then I think I would usually opt for a taxable account for the reasons you mentioned (i.e., the advantageous tax rates on long-term capital gains and qualified dividends as compared to ordinary income tax rates).

But if the account will hold something less tax-efficient (REITs or taxable bonds, for instance), then I think a nondeductible IRA can make a lot of sense.

From what I’ve seen though, for most investors, there’s enough space in other tax-advantaged accounts (employer-sponsored retirement plans, rolled over IRAs, etc.) to tax-shelter all of tax-inefficient asset classes — thereby making it possible to arrange the portfolio so that the only thing that would have to go into a taxable account would be something that’s already tax-efficient.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Comments

  1. I do have an existing IRA from prior deductible contributions. I’ve heard I could transfer this into my employer sponsored 401k (where I currently have excellent low-cost options at Fidelity), thereby avoiding any tax liability in that account for future nondeductible IRA contributions converted to a Roth. Is this feasible, and are there any other options to consider?

    Thanks. BTW, this is my first time commenting, and I am a huge fan of your site.

  2. Neal,

    “Step 1” of this article from The Finance Buff does a good job of explaining the topic you’ve brought up. It sounds to me like you’re understanding is on-target though.

    And, I’m happy to hear you’re enjoying the site. 🙂

  3. Thanks Mike. Great link. I also found the following link useful, comparing Roth IRA vs taxable account and a nondeductible IRA vs taxable account:

    http://www.vanguardblog.com/2011.02.16/roth-iras-and-tax-deferral.html

Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a financial or investment advisor, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2017 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy