That quarterly statement telling you how your 401(k) has done warms the cockles, doesn’t it? There your investments are, compounding merrily, free from ugly demands by the tax man for his cut of the profits.
Well, you can sock more money away like that, you know. Remember the individual retirement account–that savings vehicle you stopped contributing to after 1986, when the tax law changed and you couldn’t deduct your contributions from your income taxes anymore?
Alas, you still can’t if you’re covered by a pension or other qualified retirement plan where you work, and you are earning $35,000 or more if you’re single, or at least $50,000 if you’re married, filing jointly. Still, you can open a non-deductible IRA whatever your income, and the earnings will still grow tax deferred until you withdraw the money. When you finally do take the money out, you’ll owe taxes only on the part of the distribution that represents earnings.
What many investors don’t realize is how valuable that tax-deferred compounding can be, even without the upfront deduction. Word is starting to spread, however. In 1995, taxpayers funneled an estimated $2.4 billion into non-deductible IRAs, nearly five times what they invested in 1987, according to the IRA Reporter, an industry newsletter.
To see how compelling the case for a non-deductible IRA can be, let’s assume a married couple, both 46 and in the 28 percent federal tax bracket (that’s an adjusted gross income of at least $40,000; $24,000 for singles), put $2,000 apiece each year into their respective IRAs. The investments earn 9 percent annually. Let’s also assume an identical couple invests the same $4,000 annually in a taxable brokerage account returning 9 percent and forks over taxes on their investment earnings every year.
By age 70, according to calculations made by Christine Fahlund, a financial planner at T. Rowe Price, the non-deductible pair has an account worth $369,296, versus $250,102 for the couple that had to pay taxes.
Not bad. But let’s push things a little and assume that at 71 each couple begins taking an equivalent amount out of their accounts each year. For example, after taxes, $10,000 withdrawn from the IRA corresponds to $7,200 withdrawn from the regular brokerage account. The folks remain in the 28 percent bracket and reinvest the balance in their accounts to earn 8 percent. Guess what? The taxable-account duo will run out of money when they are 90, at which time the IRA pair will still have $300,839 left.
Now before you shout “Lead me to the non-deductible IRA!” make sure you’ve considered the drawbacks. Like all IRAs, deductible and non-deductible alike, your contributions are limited to $2,000 a year or less. And you can’t touch the money until you turn 59 1/2 or you’ll trigger a 10 percent penalty on the taxable portion of your withdrawals, not to mention income taxes.
But non-deductible IRAs impose one extra burden: You must be absolutely compulsive about keeping records. When you begin making withdrawals in the distant future, you will have to be able to prove what price you paid for your securities 20 or 30 years before and that you didn’t deduct your contributions at the time.
If you haven’t got the paperwork, then the Internal Revenue Service will tax every penny you withdraw.
That’s why non-deductible IRAs are not for everyone. But if you meet the following three criteria, squirrel away an annual two grand and have your spouse do the same:
– You have maxed out on other tax-advantage savings vehicles. If you are not putting the maximum into your company-sponsored retirement plans like 401(k)s or 403(b)s, do so before you even think of a non-deductible IRA. Since you can write off your contributions to these employer-sponsored plans, your money will go further in them than it would in a non-deductible IRA. Then, if you still have money left, see if your employer permits you to make a non-deductible contribution to its plan.
Roughly 20 percent of 401(k)s do. It’s worth looking into, because the company will handle all the record-keeping for you, and the money comes right out of your paycheck before your good intentions have time to take a detour. If your company plan doesn’t take non-deductible money or imposes restrictions you don’t like (for example, limiting how often you can move your money from one fund to another) or you are not happy with the investment choices you’re offered, then it’s time to consider a non-deductible IRA.
– You are a pack rat. Each year you fund your IRA, you’ll need to fill out IRS Form 8606. Without getting into the ugly details, the IRS forces you to consider the balances in your deductible and non-deductible IRAs as one pot. Edward Slott, a certified public accountant in Rockville Centre, N.Y., says every distribution, whichever account it comes from, is taxed as if it consisted proportionately of your non-deductible contributions (on which you’ve already paid taxes), your deductible contributions (on which you still owe taxes) and the earnings on both accounts (which are also taxable).
Say, for example, that you contribute $2,000 to a deductible IRA one year and a like amount to a non-deductible one the next. Ten years later, the two accounts have grown to $10,000. In that year, 20 percent of all your IRA withdrawals would be non-taxable.
– You are absolutely sure you will not need the money before you turn 59 1/2. If you invade your non-deductible IRA any earlier, you’ll pay a 10 percent penalty on the investment earnings you withdraw, on top of income taxes. In this case, you’d be better off opening a taxable brokerage account instead. Ray Martin, a vice president at Ayco, a financial counseling firm in Albany, N.Y., looked at the effects of the 10 percent penalty and income tax levy on an early withdrawal of your entire IRA balance and compared the result with taking the same amount from a taxable brokerage account. In both cases, he assumed the account earned a 10 percent annual return and the investor was in the 36 percent tax bracket.
His conclusion: If you want the money any time in the next 13 years, you come out ahead with a taxable brokerage account. By contrast, if you leave the money in and let it compound until the magic 59 1/2, your IRA beats the taxable account’s after-tax returns from the second year on.
