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Non-deductible IRA contributions are a common option for savers to get more money into retirement accounts. While saving into an IRA is certainly never a bad idea, we find that for most high income households or households with a high savings rate, basic brokerage account contributions are more tax efficient, and better option for long-term retirement savings than non-deductible IRA contributions.
For many, contributions to a traditional IRA can be tax deductible. However, if you are covered by an employer’s retirement plan (a 401(k) or 403(b) for example) you are not allowed to make contributions to IRAs that are tax deductible if your income is above a certain level.
Further, households in this category are also usually unable to make Roth IRA contributions as well since their income is above the maximum set by the IRS to be eligible for Roth IRA contributions.
However anyone, regardless of income, is able to make a contribution to a traditional IRA, but receive no tax deduction for the contribution. This is commonly referred to as a Non-Deductible IRA contribution.
With a nondeductible IRA contribution, you don’t receive a tax deduction at the time of contributing. However, the money in the account will grow tax deferred. This is commonly cited as a benefit of doing a non-deductible IRA contribution.
While this may be valuable for a select few, we find that many of our clients see no long-term tax benefit to saving in a non-deductible IRA. In fact it may end up costing them much more in taxes in the long run!
This is because any gains you see from the investments in a non-deductible IRA will be taxed at ordinary income tax rates when you withdrawal the money in retirement. Compare this to a standard brokerage account where gains are taxed at long term capital gains rates.
Ordinary income tax rates are potentially much higher than the long term capital gains tax rates. Your exact tax rates will depend on your other sources of income. But for example, here are the tax rates that the gains on a non-deductible IRA would be subject to in 2023:
And for comparison, here are the tax rates for long term capital gains, which a brokerage account would be subject to:
Notice that at any income level, the tax rate on capital gains are lower. But there are a number of “sweet spots” that make long term capital gains a much better option to reduce taxes. First, below about $90,000 in taxable income long term capital gains are taxed at 0%. This is a huge opportunity for a lot of retirees!
And then, for high income households the 15% tax rate of long term capital gains are significantly lower than income tax rates. For example, a household with $200,000 in taxable income would have gains from a non-deductible IRA taxed at 24%, while gains in a brokerage account would be taxed at just 15%.
Besides the potentially lower tax burden, taxable brokerage accounts also have many more advantages:
They allow you to tax loss harvest. This can provide a tax deduction of up to $3,000 for you when the stock market declines. While this requires a little more management over time, the tax deduction can be very valuable for high income households. And, this provides a tax deduction that is not available at all if you contributed to an IRA!
Also, brokerage accounts are much more flexible. You can access the money at any time, and better control your taxes from withdrawals. This is valuable for anyone, but especially valuable for early retirees, or retirees that plan on having years with high expenses. For example, buying a retirement home, cars in retirement, or big vacations.
Lastly, brokerage accounts have little to no administrative burden when it comes to filing your taxes. Doing non-deductible IRA contributions can be a tax and recording keeping burden. Each year you will have to file a tax form 8606 to keep track of the after-tax basis for the IRS. Withdrawals add more complexity as well.
There is one big advantage to doing non-deductible IRA contributions, however. And that is the protection from creditors that IRAs provide. If you are ever involved in a bankruptcy or lawsuit, money that you have saved in IRAs is generally protected, though be sure to check with the laws of your state to verify.
The tax deferral of non-deductible IRAs can be an advantage for some. However, we find that this is quite rare. If you are very sensitive to capital gains associated with dividends and interest from investments in a taxable brokerage account though, this could be a consideration.
If you are in a position where you are considering doing non-deductible IRA contributions, please reach out and have us help you create a tax efficient savings plan to ensure you are not setting yourself up for a big tax surprise in retirement.