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:


Current Value of $2,000 Investment 10 Years Ago

Net After Tax: Nondeductible IRA

Net After Tax: Regular Account







Gilead Sciences (NASDAQ:GILD)





Southwestern Energy (NYSE:SWN)















Biogen Idec (NASDAQ:BIIB)





National Oilwell Varco (NYSE:NOV)





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.

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