Is Non-deductible IRA foolish?

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quanuec
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Is Non-deductible IRA foolish?

Post by quanuec »

Say year after year you are doing a non-deductible IRA and not setting up a backdoor IRA. You are not doing a backdoor IRA because your tax bracket is high and you feel stupid converting i.e. you took the tax break years back at a lower tax bracket, and if you now convert, you will pay 10-20% more.

Under such circumstances, should you still pursue a non-deductible IRA? If yes, what should you in host in them (bonds or your highest income producing assets).

Comments please :)
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Re: Is Non-deductible IRA foolish?

Post by livesoft »

Yes, it is foolish. I have one from years ago and wish I didn't.
A taxable account invested tax-efficiently is the way to go when you cannot contribute to a Roth with the money.

The taxable account may even make your traditional 401(k) and deductible IRA tax-free when you withdraw in retirement, so it has a very nice side effect.
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quanuec
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Re: Is Non-deductible IRA foolish?

Post by quanuec »

Could you explain more? Isnt the tax deffered nature of these accounts attractive to hold income producing assets? At withdrawal, you still dont have tax liability on your contributions....
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Re: Is Non-deductible IRA foolish?

Post by livesoft »

One should have plenty of deductible accounts for holding income producing assets.

There is also no tax liability on contributions to a taxable account. That is, return of capital is tax-free. Plus one can easily tax-loss harvest. Try doing that in a non-deductible IRA.
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quanuec
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Re: Is Non-deductible IRA foolish?

Post by quanuec »

livesoft wrote:Yes, it is foolish. I have one from years ago and wish I didn't.
A taxable account invested tax-efficiently is the way to go when you cannot contribute to a Roth with the money.

The taxable account may even make your traditional 401(k) and deductible IRA tax-free when you withdraw in retirement, so it has a very nice side effect.

There is something that I dont know then and I have been in the pursuit of for the last few weeks on this forum. Pray explain in detail the following -

(a) "A taxable account invested tax-efficiently " - How do we invest tax efficiently? :) Holding TSM and TISM is tax efficient considering they have dividend distributions?

(b) The taxable account may even make your traditional 401(k) and deductible IRA tax-free when you withdraw in retirement, so it has a very nice side effect -- HOWWWW?
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quanuec
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Re: Is Non-deductible IRA foolish?

Post by quanuec »

livesoft wrote:One should have plenty of deductible accounts for holding income producing assets.

There is also no tax liability on contributions to a taxable account. That is, return of capital is tax-free. Plus one can easily tax-loss harvest. Try doing that in a non-deductible IRA.
Plus one can easily tax-loss harvest. Try doing that in a non-deductible
**** Try avoiding paying taxes on coupons or dividends in a taxable:)
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Re: Is Non-deductible IRA foolish?

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Re: Is Non-deductible IRA foolish?

Post by Drain »

From the perspective of asset protection--in certain states, anyway--I think I'd prefer a non-deductible IRA to a taxable account. And I find that, in practice, there really aren't that many opportunities for TLH once you get past the first few years of share ownership.

That said, if I ever find myself in a situation where I can't contribute to a Roth, I'll do a backdoor.
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Re: Is Non-deductible IRA foolish?

Post by umfundi »

quanuec wrote:Say year after year you are doing a non-deductible IRA and not setting up a backdoor IRA. You are not doing a backdoor IRA because your tax bracket is high and you feel stupid converting i.e. you took the tax break years back at a lower tax bracket, and if you now convert, you will pay 10-20% more.

Under such circumstances, should you still pursue a non-deductible IRA? If yes, what should you in host in them (bonds or your highest income producing assets).

Comments please :)
Here's my short explanation.

The "correct" answer depends on the conditions when you contribute, and the conditions when you withdraw. So, at least half of it is speculation or prediction on future conditions.

If you contribute after-tax dollars to a (non-Roth) account, the earnings are tax deferred but taxable as ordinary income when withdrawn. There are restrictions on withdrawing earnings before age 59 1/2.

If you put those same after-tax dollars in a taxable account, distributed earnings are taxable when they occur, but capital gains are taxable only on withdrawal, at rates that can be much lower than those for ordinary income. Plus, there are no restrictions on early withdrawal.

Given the current scenario, an after-tax investment in a tax-efficient taxable account seems to be a better bet than after-tax investments in a tax-deferred plan. This has not always been the case.

The current advantage rests on the much lower potential taxation of capital gains vs. ordinary income.

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quanuec
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Re: Is Non-deductible IRA foolish?

Post by quanuec »

what about the taxes on dividends which need to be paid regularly in taxable and are neatly avoided in tax deferred?
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Re: Is Non-deductible IRA foolish?

Post by umfundi »

quanuec wrote:what about the taxes on dividends which need to be paid regularly in taxable and are neatly avoided in tax deferred?
That's where "tax efficient" comes in. Don't make taxable investments that throw off significant distributions, unless you are looking for the income.

There is no 100% right or wrong answer. If you are indeed worrying at this level, you are way ahead of most people.

For my own part, I lean towards making those non-deductible contributions. Who knows what income tax rates will be in the future? Putting the contributions in your plan mentally fences them off as retirement savings. That is not as true for taxable savings accounts.

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Re: Is Non-deductible IRA foolish?

Post by madbrain »

quanuec wrote:what about the taxes on dividends which need to be paid regularly in taxable and are neatly avoided in tax deferred?
You can invest your taxable account efficiently. For example, in muni bonds. In this case, there is no ongoing tax due.
You can also buy some tax-managed funds. Yes, they will be active funds. But even Vanguard has some tax-managed versions of certain indexes.

Or you can be more active and do TLH to offset these. But that requires much more work on your part. Some years, you may not have enough losses in the taxable account to offset the taxable dividends.
It's one of these years for me. Almost all my losses are in my 401k (from EM, VWO). I have a couple thousand dollars of capital losses on my California munis, but I didn't realize them yet due to wash sale issues as I contribute regularly to the fund in my taxable account every 2 weeks. I also don't know fund what I would TLH them to. I should have thought of it before. I may yet figure it out, this is only my 2nd year with significant holdings in a taxable account.
If you are not keen on doing all this tax management work yourself, the non-deductible IRA may still be preferable, even without backdoor Roth. It will be simpler, except for the filing of form 8606 every year.
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Re: Is Non-deductible IRA foolish?

Post by quanuec »

umfundi wrote:
quanuec wrote:what about the taxes on dividends which need to be paid regularly in taxable and are neatly avoided in tax deferred?
That's where "tax efficient" comes in. Don't make taxable investments that throw off significant distributions, unless you are looking for the income.

There is no 100% right or wrong answer. If you are indeed worrying at this level, you are way ahead of most people.

For my own part, I lean towards making those non-deductible contributions. Who knows what income tax rates will be in the future? Putting the contributions in your plan mentally fences them off as retirement savings. That is not as true for taxable savings accounts.

Keith
Keith, I buy your point. Here is something I have been asking a lot "Don't make taxable investments that throw off significant distributions" - Can you provide me your list of examples which do not throw off significant distributions in taxable?
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quanuec
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Re: Is Non-deductible IRA foolish?

Post by quanuec »

madbrain wrote:
quanuec wrote:what about the taxes on dividends which need to be paid regularly in taxable and are neatly avoided in tax deferred?
It will be simpler, except for the filing of form 8606 every year.
keeping a record of 8606 is the bigger issue in my opinion :)
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Re: Is Non-deductible IRA foolish?

Post by livesoft »

Qualified dividend income is taxed at a rate as low as 0%. What's your annual income and your marginal income tax rate?
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Re: Is Non-deductible IRA foolish?

Post by madbrain »

quanuec wrote:
madbrain wrote:
quanuec wrote:what about the taxes on dividends which need to be paid regularly in taxable and are neatly avoided in tax deferred?
It will be simpler, except for the filing of form 8606 every year.
keeping a record of 8606 is the bigger issue in my opinion :)
It's a once a year thing. You should always have your previous year tax return to look at the previous 8606. Then add your annual contributions, which ideally are at the annual maximum, a still relatively low $5000/year.
Whereas doing TLH is work that requires monitoring markets, looking at specific shares that may have losses, selling them when there are enough, finding adequate replacement securities, being careful about wash sales, etc. That is much more work and has far more pitfalls.

Another thing to think about : if you have significant non-deductible funds in your IRA, when your RMDs get calculated, the taxable portion will be smaller.
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Re: Is Non-deductible IRA foolish?

Post by umfundi »

quanuec wrote:
umfundi wrote:
quanuec wrote:what about the taxes on dividends which need to be paid regularly in taxable and are neatly avoided in tax deferred?
That's where "tax efficient" comes in. Don't make taxable investments that throw off significant distributions, unless you are looking for the income.

There is no 100% right or wrong answer. If you are indeed worrying at this level, you are way ahead of most people.

For my own part, I lean towards making those non-deductible contributions. Who knows what income tax rates will be in the future? Putting the contributions in your plan mentally fences them off as retirement savings. That is not as true for taxable savings accounts.

Keith
Keith, I buy your point. Here is something I have been asking a lot "Don't make taxable investments that throw off significant distributions" - Can you provide me your list of examples which do not throw off significant distributions in taxable?
quanuec,

The Wiki explains it better than I ever can:

http://www.bogleheads.org/wiki/Principl ... _Placement

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Re: Is Non-deductible IRA foolish?

Post by madbrain »

livesoft wrote:Qualified dividend income is taxed at a rate as low as 0%. What's your annual income and your marginal income tax rate?
That's all good, but not everyone can bring their taxable income down to levels low enough to qualify for that rate. Otherwise you will pay 15% federal tax rate on QDI.
Many states don't have preferential tax treatment for dividends, also. In California for example, you could pay up to 13.3% state income taxes on QDI in addition to the 15% federal.

Edit: federal tax on QDI can be up to 20% if you are in the highest tax bracket.
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Re: Is Non-deductible IRA foolish?

Post by livesoft »

And if one get that qualified dividend income in a non-deductible IRA, what will the eventual tax on it be?
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Re: Is Non-deductible IRA foolish?

Post by umfundi »

livesoft wrote:And if one get that qualified dividend income in a non-deductible IRA, what will the eventual tax on it be?
No one knows the future.

But, it will likely be taxed as ordinary income.

In fact, you can put federal tax-free municipal bonds in your IRA, and their income will be taxed!

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Re: Is Non-deductible IRA foolish?

Post by madbrain »

livesoft wrote:And if one get that qualified dividend income in a non-deductible IRA, what will the eventual tax on it be?
Until you withdraw or have RMDs, it is zero. After that, who knows ?

For many people, the federal tax bracket is likely to be lower in retirement as well. But of course what happens to taxes in the future is unpredictable. Qualified dividend rates might disappear too, as they were rumored to this year, but it didn't happen. At least with the non-deductible IRA you aren't being taxed in the meantime. The non-deductible IRAs are the devil you know.

You could move to a no/low-tax state in retirement to avoid the state income tax, while such a move may not be possible while you are working. That alone may be worth as much or more than the current special QDI rate.
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Re: Is Non-deductible IRA foolish?

Post by umfundi »

livesoft wrote:And if one get that qualified dividend income in a non-deductible IRA, what will the eventual tax on it be?
Except for penalties for early withdrawal:

Deductible IRA: Withdrawals are taxed as ordinary income.

Roth IRA: Withdrawals are not taxable.

Non-deductible non-Roth contributions: Contributions are not taxable when withdrawn, earnings are taxable as ordinary income when withdrawn.

It is hard to imagine that there will be future distinctions on the types of gains in tax-advantaged accounts.

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Re: Is Non-deductible IRA foolish?

Post by quanuec »

madbrain wrote:
livesoft wrote:And if one get that qualified dividend income in a non-deductible IRA, what will the eventual tax on it be?
Until you withdraw or have RMDs, it is zero. After that, who knows ?

For many people, the federal tax bracket is likely to be lower in retirement as well. But of course what happens to taxes in the future is unpredictable. Qualified dividend rates might disappear too, as they were rumored to this year, but it didn't happen. At least with the non-deductible IRA you aren't being taxed in the meantime. The non-deductible IRAs are the devil you know.

You could move to a no/low-tax state in retirement to avoid the state income tax, while such a move may not be possible while you are working. That alone may be worth as much or more than the current special QDI rate.

I think it makes sense to pursue a non deductible IRA ! Thanks everyone. I am starting a new thread - "Will only an idiot invest in tax free munis in his/her tax deferred accounts?"
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Re: Is Non-deductible IRA foolish?

Post by Default User BR »

The other solution is to move the taxable IRA amounts to an non-IRA account, such as a 401(k) or the like. This requires access to a plan that will accept IRA rollovers and has decent fund selection. How much in taxable IRA amounts are we talking?


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Re: Is Non-deductible IRA foolish?

Post by quanuec »

around 25k combined (me & spouse) ...tax rate ~ 43%...
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Re: Is Non-deductible IRA foolish?

Post by Default User BR »

quanuec wrote:around 25k combined (me & spouse) ...tax rate ~ 43%...
Do you have 401(k) plans? If so, find out if they accept rollovers from IRAs.


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Re: Is Non-deductible IRA foolish?

Post by ps56k »

Something that always got me on the forum was how to handle an IRA with the usual $5k yearly contribution,
when you have say $10k more that you want to invest in long term retirement ?

I never had a 401k - and have always contributed to our IRA,
and currently have been putting money into our wife's non-deductible IRA,
since she also contribs to a teacher pension fund in Illinois, which is another whole can of worms.

So - after we put $5k into each of the non-deductible and deductible IRA accounts,
then what do we do with the remaining $10k more ?
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Re: Is Non-deductible IRA foolish?

Post by livesoft »

I-bonds.
HSA.
Invest tax-efficiently in a taxable account.
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Re: Is Non-deductible IRA foolish?

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livesoft wrote:I-bonds, HSA. Invest tax-efficiently in a taxable account.
We do contrib to a "medical flex spending" acct, which is sorta like an HSA - uses pre-tax dollars.
Also - just discovered that the school district has a 403b plan -
and just setup an acct with Fidelity for Puritan fund (no Vanguard offered)
Wife didn't know what "403b" was and kept deleting the emails for enrollment !!! ARRGHHHHH
This will help greatly to reduce our taxable income, as our Schwab stock divs are now about $50k.

Lastly - and I think I've been doing this wrong - "Invest tax-efficiently in a taxable account" -
Our current holdings are at Fidelity - (had an office in our downtown Chicago building),
and was looking for "growth" - to be worth more in the long term future... and some div generation.

Fidelity IRA funds - equally funded/invested -
growth, divs/blend, SEasia, emerging mkts, conv securities, tot bonds, and now the 403b Puritan fund.
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Re: Is Non-deductible IRA foolish?

Post by livesoft »

I don't think most folks would complain about $50K in stock dividends in a taxable account. That suggests a taxable portfolio of almost $2million. However, one would want to try to have them all qualified dividends.
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Re: Is Non-deductible IRA foolish?

Post by ps56k »

Some of that $50k was from REITs and some Apple stock selling... so, it was divs and cap gains.
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Re: Is Non-deductible IRA foolish?

Post by White Coat Investor »

It seems bizarre to me that anyone would consider a non-deductible IRA over a Roth IRA due to a high tax bracket. Let's see.....no tax deduction with any future gains fully taxable or no tax deduction with any future gains tax-free.....which one should I choose......

The only reason I can think of that someone would do a non-deductible over a backdoor Roth were if he had a big IRA or SEP IRA he couldn't convert or roll into some 401K, but thought he might be able to at some point in the next decade or so. There might also be some asset protection benefits. Otherwise, I agree with livesoft that a taxable account would be preferable.

The big issue is you aren't getting the preferable capital gains treatment. I ran the numbers once and it took decades for the additional deferral to make up for that difference in tax rates on the earnings.
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Re: Is Non-deductible IRA foolish?

Post by joe135 »

to the last point, I have a similar dilemma. I cannot do back door because of other IRAs. IF I am going to eventually convert to ROTH on retirement with lower income tax rate, and IF this is less than 10 years away, does it make sense to contibute? I have no more tax deferrred space available and would put bonds in there. I think it can make sense in this scenario, no?
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Re: Is Non-deductible IRA foolish?

Post by livesoft »

Tax-exempt munis can go in taxable, so no need for non-deductible tradtional IRA that cannot be immediately converted to a Roth.
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Re: Is Non-deductible IRA foolish?

Post by Mitchell777 »

60% of my investments are in non retirement accounts. I have maxed out on every tax advantaged retirement option over many years and also used IBonds and Munis in the taxable accounts. I suppose I could have all my fixed income outside of retirement accounts in munis but I want more diversification than that. At my age and comfort level I now have less than 50% in stock funds. So, each yr I look at my non retirment accounts and if I have money in fixed income non retirement funds that are not tax advantaged such as munis and IBonds are, I decide to move some of that to a non deductible IRA. Hope to convert to Roth at retirement if that option still available. If not I'll accept what I have
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Re: Is Non-deductible IRA foolish?

Post by afan »

There are asset protection and certainty equivalent concerns.

IRA's receive protection from creditors, at least in some states. This is not generally available in non-retirement taxable accounts.

Every year that you do not pay tax on your nondeductible IRA you are ahead of the game. If you put money into a Roth, and take it out in 2013, then you can be pretty sure that the money will not be taxable. Given the rate at which tax laws change, it would be foolish to assume that this feature of the Roth will persist for decades. The value of avoiding taxes goes down as the certainty of that tax avoidance decreases. That certainty decreases with time.

I would argue that the longer your time horizon, the less value it is appropriate to attribute to the non taxable nature of Roth withdrawals. Since your time horizon may not be just the time until you retire, or your life expectancy, but the life expectancy of your heirs, it is common to have time horizons of many decades. If you are 60, your youngest child is 25, do you really think you know what the tax laws will be 75 years from now?
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Re: Is Non-deductible IRA foolish?

Post by madbrain »

EmergDoc wrote:It seems bizarre to me that anyone would consider a non-deductible IRA over a Roth IRA due to a high tax bracket.
Surely you know that there are income limits for Roth contributions. That is most certainly the case for the OP.
He doesn't have the option of contributing directly to a Roth IRA. He doesn't have the option to make traditional deductible IRA contributions either.

Backdoor Roth is always an option for the OP, but he indicated that he has made deductible IRA contributions in the past.
A backdoor Roth would have costly conversion costs in terms of taxes to convert the existing IRA balances.
The big issue is you aren't getting the preferable capital gains treatment. I ran the numbers once and it took decades for the additional deferral to make up for that difference in tax rates on the earnings.
Only if you ignore the state income tax issue. Many states don't have preferential capital gains rates. It's always possible to move and avoid state income taxes in retirement when withdrawing from the IRA. OP stated a 43% tax rate, so clearly there are some state income taxes at play here.

I agree the OP should try to rollover all the current IRA balances to a 401k first, though. But failing that, a non-deductible IRA is the best option.
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Re: Is Non-deductible IRA foolish?

Post by archbish99 »

In general:
HSA > Deductible Traditional > Roth > Taxable > Non-deductible Traditional

...though the difference between deductible and Roth will vary depending on your tax bracket.

Basically, for tax-inefficient investments (taxable bonds, REITS), tax-deferral is an okay thing, but not great per se. It doesn't really buy you much to pay tax at the end versus as you go -- your net amount of tax paid over a lifetime is comparable. You might as well save a hair less and use that money to pay the taxes due on your existing savings. For tax-efficient investments (equity index funds), tax-deferral is an actively bad thing -- it transforms qualified dividends and capital gains, which can be taxed at a more advantageous rate, into ordinary income when you withdraw them.

The counter-balance is that the deduction you get when contributing to a tax-deferred account up front (usually) sufficiently compensates you for the additional taxes you pay on the back end. The higher your tax bracket, the higher the Deductible Traditional IRA moves on that ladder.
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