Most people open IRAs because of the chance at boosting their tax refund, as most people are able to deduct their traditional IRA contributions from income on their tax returns. Yet if you don't qualify for a deduction for your contributions, is it really worth it open a traditional IRA?
You can learn much more about IRAs and how they work by visiting our IRA Center. For now, let's take a closer look at nondeductible IRAs.
Considering the nondeductible IRA
Most of the time, if you can pick either a deductible IRA or a Roth IRA, you'll be much better off than you are with a nondeductible IRA. Roth IRAs offer tax-free treatment for the income your contributions generate over the course of your career, while traditional IRAs let you deduct your contributions upfront and get an immediate tax benefit. By contrast, nondeductible IRAs will still leave you paying tax on the income from your investments after you retire, without putting anything extra in your pocket at tax time right now. That can look like the worst of both worlds; you miss out on a nice tax advantage when you contribute, and you also never see the tax-free benefits of a Roth.
But some people don't qualify for either Roths or deductible IRAs. Roth IRAs have income limits beyond which you're simply not allowed to contribute at all. Traditional IRAs are always available, but if you earn above certain limits, you won't be allowed to deduct your contributions. If you're stuck in this group that only has a nondeductible IRA option, the question remains whether you should even bother.
What a nondeductible IRA offers -- at a price
It's true that nondeductible IRAs give you the one benefit that most retirement accounts share: tax deferral. As long as the money stays in your account, you don't have to pay income tax on the dividends, interest, or capital gains that your investments generate.
That's especially nice with fixed-income investments like bonds. There, the tax rate that applies in retirement when you take money out of your nondeductible IRA is the same as you'd pay in a taxable account on the interest the bonds generate. As a result, on a $10,000 bond paying 5% with a 30-year maturity, you'd end up with almost $5,000 more in a nondeductible IRA than in a taxable account -- even after accounting for the taxes in retirement. The only price: You'd pay a penalty if you want the IRA money before age 59.5.
With stocks, though, the problem is that taxable accounts offer better rates on dividends and long-term capital gains income than the IRA does. Currently, those in the lowest two tax brackets get tax-free treatment on their dividends and long-term capital gains, while maximum rates of 15% apply to most people and 20% for top-bracket taxpayers. Compare that to ordinary tax rates of up to 39.6% that will apply to distributions of income from nondeductible IRAs in retirement, and you'll often actually end up better off by buying stocks in a regular taxable account.
When nondeductible IRAs can be worth it
Even with these obstacles, nondeductible IRAs can be very useful in two situations. First, if you're already 59.5, you can essentially treat nondeductible IRAs as a savings account that's always available to you when you need it. You can focus on holding the investments that give you the most value from that tax deferral and never have to worry about penalties for early withdrawal.
More importantly, nondeductible IRAs can be useful for what's known as the backdoor Roth strategy. If you convert a nondeductible IRA to a Roth IRA, you only have to include any appreciation from the amount you contributed in the first place as income. What you originally contributed is not taxed, since you didn't get a tax deduction in the first place. Because there are no income limits on conversions, this strategy essentially circumvents the income limits on contributions.
Note, though, that if you have a mix of deductible and nondeductible IRAs -- even if they're not in the same account -- this strategy won't work as well. That's because you have treat the converted amount as a pro-rata mix of your deductible and nondeductible IRAs, and therefore, some of what you convert will be included in your income.
In general, most people will find that nondeductible IRAs aren't worth the hassle. Especially with 401(k) plans and other employer-sponsored retirement options usually available, the nondeductible IRA is almost always the savings vehicle of last resort.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.