IRAs are incredibly valuable tools for retirement savings. With a traditional IRA, you may be able to deduct thousands from your income, leaving more money in your pocket. The Roth IRA can be even more valuable; even though you don't get a deduction when you contribute, you'll never pay taxes again.
The only problem with IRAs is that some taxpayers aren't able to get the full benefit of using them. You can find all the details in our IRA Center, but here's a quick summary. Single Fools making more than $114,000 aren't allowed to contribute to a Roth IRA at all. If you're covered by a retirement plan at work, then you won't get any deduction for a traditional IRA contribution if you make more than $62,000. For couples, those limits are $166,000 and $103,000. If your income exceeds those limits, your only choice is a nondeductible IRA.
Better than nothing?
Even though you miss out on a deduction, nondeductible IRAs offer a few nice features. Your money grows on a tax-deferred basis while it's inside the account. This means you won't have to pay tax on dividends or interest you earn, and you won't have to worry about capital gains if you decide to change up your IRA portfolio. Also, when you do start taking distributions after retirement, you won't have to pay taxes on what you contributed. For instance, if your $4,000 nondeductible IRA grows to $40,000 when you retire, and you withdraw $10,000, you'll only have to pay tax on $9,000 -- the other $1,000 is part of your initial contribution.
However, there are some definite downsides to nondeductible IRAs. Most importantly, you lose the benefit of lower tax rates on qualified dividends and long-term capital gains that regular taxable accounts enjoy. When you pull money out of your IRA, it all gets taxed as ordinary income, at rates up to 35% -- even if you had it invested in stocks and stock funds the whole time. In contrast, if you took the same money and found some good buy-and-hold stocks to hang onto until retirement, you'd only pay 15% on your dividends and stock appreciation. That 20% difference is a big hit, especially for higher-income folks who have to resort to nondeductible IRAs in the first place.
Your happy accountant
Another negative with nondeductible IRAs is the big accounting hassle they create. In order to avoid paying tax twice, you have to keep track of your nondeductible contributions in relation to the total value of your IRA. When it comes time to take distributions, doing the math to figure out how much of your withdrawal is taxable can be a big pain. It gets even more complicated if you've got several different IRAs, some of which were funded with deductible contributions. Your accountants might like it -- especially if you pay them at an hourly rate -- but you probably won't.
On the whole, as long as the tax laws offer low rates on dividends and capital gains, stock investors are probably better off just putting more money in their taxable accounts. Even though IRAs generally can play a huge role in successful retirement planning, making nondeductible IRA contributions probably isn't worth the trouble for most people.
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The Fool's IRA Center is a great resource for all sorts of information about IRAs, including how to open an account, comparing your various options, and finding the IRA that's best suited to your retirement needs. If you want even more hands-on advice about your retirement, check out the Fool's Rule Your Retirement newsletter. Each month, you'll read about news you can use to make your golden years more comfortable. Check it out with a free 30-day trial.
Fool contributor Dan Caplinger has about $300 of nondeductible contributions floating around somewhere in his IRA. The Fool's disclosure policy is always worth it.
