Nondeductible IRAs: Worth the Hassle?

When the IRS will pay you hundreds or even thousands of dollars to open an IRA, you've got plenty of incentive to set up an account. But without the prospect of big savings, is there any reason to put money in an IRA?

For most investors considering an IRA, choosing either a Roth IRA or a traditional deductible IRA makes the most sense. With the Roth, you enjoy tax-free distributions for the life of the account; with the traditional IRA, you get an upfront tax deduction for the amount you contribute. Either way, you're ahead.

The third option
But for those who don't qualify for either of those two options -- especially high-income individuals who are covered by a retirement plan at work -- there's a third type of IRA that you don't hear much about. Nondeductible IRAs work a lot like traditional IRAs, except that you don't get a deduction when you contribute.

At first glance, that seems like the worst of both worlds. You miss out on the primary benefit of a traditional IRA -- the deduction -- so in that respect, the nondeductible IRA resembles a Roth IRA. Yet you also don't get the biggest benefit of the Roth: tax-free income. When you take money out, you'll still have to pay tax on your gains -- at higher ordinary income rates.

Given those downsides, is there any reason to settle for third best? Or should you just give up and stick with taxable accounts if you don't qualify for the better IRA alternatives?

The value of tax deferral
Even without deductible contributions, the tax deferral you get with a nondeductible IRA is still worth something. For instance, say you want to buy two 30-year bonds worth $10,000 that pay 5% annually. If you put one of them in a nondeductible IRA and keep the other in a taxable account, you'll end up with $5,000 more from the bond in your IRA -- even after you pay taxes on your IRA withdrawal. The only price you pay is that you can't get at the IRA money without paying a 10% penalty if you're younger than 59 1/2.

With stocks, though, the benefits over time are much less. While stocks in a regular taxable account qualify for lower tax rates on gains, all IRA withdrawals -- even from nondeductible IRAs -- are taxed at your regular rate. With maximum tax rates at 35% versus 15% for capital gains and dividends, that's a huge difference that can wipe out your gains.

For instance, take a look at the table below to compare using a nondeductible IRA back in 1999 to buy some promising stocks versus just investing in a taxable account:

Stock

Current Value of $2,000 Investment 10 Years Ago

Net After Tax: Nondeductible IRA

Net After Tax: Regular Account

Difference

Genzyme (Nasdaq: GENZ  )

$5,747

$4,435

$5,185

$749

Gilead Sciences (Nasdaq: GILD  )

$41,624

$27,756

$35,680

$7,925

Southwestern Energy (NYSE: SWN  )

$68,558

$45,263

$58,574

$13,312

Apple (Nasdaq: AAPL  )

$18,237

$12,554

$15,802

$3,247

Oracle (Nasdaq: ORCL  )

$4,007

$3,305

$3,706

$401

Biogen Idec (Nasdaq: BIIB  )

$12,688

$8,947

$11,085

$2,138

National Oilwell Varco (NYSE: NOV  )

$8,363

$6,136

$7,409

$1,273

Source: Yahoo! Finance as of Jan. 22. Assumes taxpayer in 35% tax bracket and maximum 15% capital gains rate.

The bottom line is that if your stocks go up a lot, you're often much better off just skipping the IRA and keeping shares in a taxable account.

When nondeductible IRAs make sense
There are a couple of situations, however, where nondeductible IRAs are worth the effort:

  • If you're already 59 1/2. If you're old enough to make IRA withdrawals without penalty, then you don't have to worry about losing access to your money if you need it. As long as you choose investments that will maximize the value of tax deferral, you can use a nondeductible IRA to manage your tax burden.
  • As a precursor to conversion. Next year, the tax law will open up a new opportunity for high-income taxpayers. Until now, those with incomes greater than $100,000 couldn't convert an IRA to a Roth IRA. But those income limits are scheduled to go away in 2010. Setting up a nondeductible IRA now with the intention of converting it next year is a back-end way to get around the Roth contribution rules.

For the most part, though, most investors won't find a nondeductible IRA worth the trouble. And certainly, if you have better options available to you elsewhere, such as an employer 401(k), you should make the most of them before considering the nondeductible IRA.

For more on IRA investing, read about:

For more help on picking the right type of retirement account, take a look at our Rule Your Retirement newsletter. You'll find useful strategies with easy explanations on how they work and how you can implement them. Best of all, it's on us with a free 30-day trial.

Fool contributor Dan Caplinger did a nondeductible IRA way back when, but he's sticking with Roth now. He doesn't own shares of the companies mentioned in this article. National Oilwell Varco, Biogen Idec, and Apple are Motley Fool Stock Advisor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is no hassle


Read/Post Comments (4) | Recommend This Article (24)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 07, 2009, at 6:18 AM, ssz123 wrote:

    I have been contributing to my non-deductible IRA for a few years. When I convert it to a Roth IRA in 2010, would I have to pay taxes, considering that I already paid taxes on the $$ I contributed to my IRA, since it was non-deductible?

  • Report this Comment On February 07, 2009, at 6:21 AM, ssz123 wrote:

    This article fails to mention that if you are an active trader, say 1-2 trades a month, a non-deductible IRA is great b/c you wouldn't pay taxes on your gains every year. But true, yes, that if you are a buy-and-hold investor, the non-deductible IRA loses a lot of it's edge.

  • Report this Comment On April 12, 2009, at 8:38 PM, duckbob wrote:

    I've been contributing to a nondeductible IRA for a few years. Since I already paid income tax on my contributions, will I still have to pay tax on the conversion to a Roth IRA?

  • Report this Comment On March 15, 2013, at 2:26 PM, boe81 wrote:

    You also forgot that nondeductible contributions to a Traditional IRA are used as a cost basis (because you already paid income taxes on the contribution, hence the nondeductible status).

    Say you make a nondeductible contribution of $2,000 one year and now the account is worth $20,000 (and you're >59 1/2 years old). You take a $1,000 distribution. Since $2,000/$20,000 = 10%, you're taxed at your marginal tax rate on $900. This is because your 10% cost basis is spread out evenly over your distributions until the entire dollar amount of the cost basis has been withdrawn i.e. the $2,000 nondeductible contribution.

    Hope this helps!

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