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.