The Non-Deductible IRA Contribution: A Bad Idea?

While many folks would tell you that it can be a good idea to make non-deductible contributions to your traditional IRA, I believe it’s in the “Bad Idea” category.  This is primarily due to the way the tax law works for IRA and non-IRA money.

IRA Taxation

As you may be aware, distributions from your IRA are generally subject to taxation.  Of course, your non-deductible contributions are not taxed, but any growth in your account and any deductible contributions will be taxed at the ordinary income tax rate.

And since non-deductible contributions (typically) make up a small amount of your total IRA balance when it comes time to withdraw the money, there is little benefit to be had, pro rata from the non-taxed portion of each withdrawal.  This is because of the way your withdrawals are treated:  all of your IRA funds are considered in total and only the percentage of your entire IRA balance that represents the non-deductible contribution will be applied to each withdrawal.

Here’s an example:  You have an IRA, which you’ve made deductible and non-deductible contributions over the years.  Your non-deductible contributions total $5,000.  The deductible contributions amounted to $5,000.  The investments for each contribution has increased by 50%, so the entire IRA is worth $15,000.  Since the non-deductible contributions equal 33 1/3% of the balance, if you take a distribution from your IRA of $1,000, only $333.33 (33 1/3%) will be non-taxable, the remaining $666.67 will be taxed at ordinary income tax rates.  As you’re aware, the ordinary income tax rates range from 10% to 35% (in 2010), so this taxation can amount to quite a hit.

Non-IRA Taxation

By contrast, in a non-IRA account, you are taxed on the gains using the capital gains tax rates.  So from our example above, if you had made your $5,000 investment in a taxable account instead of a non-deductible IRA contribution, if gains on the $5,000 amounted to 50% or $2,500, when you use the $7,500 from this account you’ll only owe capital gains tax on the $2,500 in gain.  And capital gains tax rates presently range between 0% and 15%… although they’re set to go up to 20% after 2012.

When you put the two concepts together and compare them, it’s hard to imagine why you might choose to subject your investments to a higher tax rate when you don’t need to.  And that’s why I think this is a bad idea.  The only thing you’re giving up is tax deferral on growth of your non-deductible contribution, but you can achieve this (more or less) by investing in growth-oriented assets that don’t produce dividends or other current income.

Two More Things

Two additional benefits to the taxable investment over the non-deductible IRA:

1. Your taxable account will never require you to take Required Minimum Distributions, but your IRA will, at your age 70½.  So technically you could leave that investment alone to grow for your entire life, never having to sell it and pay the capital gains tax on it… which brings us to the second additional benefit:
2. At your death, your heirs can receive a stepped-up basis on the entire account.  So not only can you avoid having to pay taxes for your entire life, your heirs may not have to pay tax on the capital gains in your taxable account either!  With an IRA, all of those gains would still be taxable as ordinary income to your heirs.

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