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I was not aware that if you have a work-sponsored retirement plan, then traditional IRA contributions are pre-tax only if your salary is low enough (according to this).

Given that, is there any difference at all between having a traditional IRA and a normal, taxable (non-retirement) investment account?

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5 Answers 5

You ask about "traditional IRA VS taxable (non-retirement) investment account."

You already know about tax deductible IRAs, which are similar, mostly, to your 401(k).

A Traditional IRA can have a non-deducted component. In a sense, it then functions similar to the fully pre-tax IRA as it grows tax free, but then withdrawals are made and taxes paid on the pro-rated not-yet-taxed money.

It also offers the simple conversion to a Roth IRA. For those who have no current IRA with pre-tax money, a conversion will be tax free, for those with an existing pretax IRA, conversions are prorated for tax due, if the account had say $10,000, and $5,000 was post-tax, any conversion will have half taxed at your marginal rate.

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> ... which are similar, mostly, to your 401k Well, one major difference is that much more money can be put away for retirement in a 401k plan than in a Traditional IRA. Also ".. for those who have no current IRA with pretax money, a conversion will be tax-free" isn't quite right. Even if all contributions to an IRA were from post-tax money, at the time of conversion, there may well be some untaxed money in there because of gains on the contributions from the day of deposit to the day of conversion. Worse yet, there may be a loss with withdrawal value being less than the basis.... –  Dilip Sarwate Jan 8 '13 at 19:38
    
I should have stated "a conversion, done immediately after deposit" - rates are so low, that a money market will not accrue over 49 cents on $5000 in the few days it takes the paperwork to go through. Else, I think I got it right. –  JoeTaxpayer Jan 8 '13 at 23:03

I'll add this to others:

Having non-deductible portion in your IRA requires additional tax forms to be attached to your tax return, and tracking.

If you plan to have long-term investments in your non-deductible IRA (such as, say, target funds or long-term stock positions that you expect to hold till retirement) it may be better to keep them in a non-IRA account. This is because the income tax on the withdrawals from the IRA is at ordinary rates, and from the regular investment account is at capital gains rate. While the rates can definitely change, traditionally capital gains rates are significantly lower than the ordinary income bracket rates.

So generally I think that having non-deductible IRA deposits is only useful if you're planning a ROTH conversion in a near future.

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What does "If you have long term investments in your IRA ... it may be better to keep them in a non-IRA account..." mean? How can long-term investments within an IRA be kept in a non-IRA account? Did you mean to say that if you want to make investments that (you hope) will increase annually via capital gains (as opposed to dividends), it is better to have them in a taxable account and pay taxes at the capital gains rate year after year rather than have such investments in a tax-sheltered account and pay taxes at your ordinary rate when they are withdrawn many years down the road? –  Dilip Sarwate Jan 8 '13 at 19:28
    
@Dilip reworded. –  littleadv Jan 8 '13 at 19:31
    
+1 - for the last line of this answer. –  JoeTaxpayer Jan 9 '13 at 0:08

There's currently not much reason to keep around a long-term non-deductible Traditional IRA in my opinion -- a Roth IRA is almost strictly better. Think about it: a non-deductible Traditional IRA vs. a Roth IRA of the same amount. In both cases, contributions are after-tax (so no tax deduction). But when you withdraw, for the Roth IRA you don't have to pay tax, and for the non-deductible Traditional IRA, you have to pay tax on the "earnings".

A Roth IRA can be contributed to at pretty much any income level, thanks to the backdoor Roth IRA process (which uses a temporary non-deductible Traditional IRA in the process). So there is not much reason for a long-term non-deductible Traditional IRA.

As for your question, a non-deductible Traditional IRA vs. a taxable account. Well, a non-deductible Traditional IRA is contributed to with after-tax money, and taxed on the earnings only on withdrawal. So the taxation is almost identical to things like stocks and homes, where the gain is not realized until the thing is sold. However, compared to things like savings accounts and bonds, where you get taxed on the interest yearly, it is much better. Every time you get taxed on gains like this, it is taxing gains earned from after-tax money, so if you think of an amount of money as being equivalent to the amount of money it grows to over time (time value of money), then it is taxing money that is (or grown from money that is) already taxed. So it is better to have this only happen at the end at withdrawal than every year.

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+1 - For the "use the non-deducted IRA as backdoor to Roth". –  JoeTaxpayer Jan 9 '13 at 0:07

There are a couple reasons for having a Traditional or Roth IRA in addition to a 401(k) program in general, starting with the Traditional IRA:

  • You have more control over what you choose to invest in versus the company sponsored program. Most companies will only offer a limited set of funds to invest in where as most Traditional IRAs will give you access to all that the market has to offer.
  • You can keep the losses due to administrative expenses low when you select your own funds.
  • You have the option of contributing to the account against you previous years limits up to April 15 of the current year. This means that if you get a significant raise that will affect how much you can contribute, you can max out the previous year while you can.
  • You can roll over funds from a former employer’s 401(k) program into a Traditional IRA which can save in administrative costs in the long run.

With regards to the Roth IRA:

  • Since you are using after tax income you don't have to pay taxes when you go to withdraw from the account when you retire.
  • You can withdraw the taxed funds that you put into the account at a later date in the future without paying taxes, note you do have to pay taxes on the gains though.

Also, both the Traditional and Roth IRA allow you to make a $10,000 withdraw as a first time home buyer for the purposes of buying a home. This is much more difficult with the 401(k) and generally you end up having to take a loan against the 401(k) instead.

So even if you can't take advantage of the tax deductions from contributions to a Traditional IRA, there are still good reasons to have one around. Unless you plan on staying with the same company for your entire career (and even if you do, they may have other plans) the Traditional IRA tends to be a much better place to park the funds from the 401(k) than just rolling them over to a new employer.

Also, don't forget that just because you can't take deductions for the income doesn't mean that you might not need the income that savings now will bring you in retirement. If you use a retirement savings calculator is it saying that you need to be saving more than your current monthly 401(k) contributions? Then odds are pretty good that you also need to be adding additional savings and an IRA is a good location to put those assets because of the other benefits that they confer. Also, some people don't have the fiscal discipline to not use the money when it isn't hard to get to (i.e. regular savings or investment account) and as such it also helps to ensure you aren't going to go and spend the money unless you really need it.

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The OP asks specifically about non-deductible IRA, and I don't think you addressed that much. Roll-over IRA's that you talk about in your last paragraph are deductible (you roll-over the deduction you got for your 401k deposits). –  littleadv Jan 8 '13 at 18:51
    
@littleadv - I'll see what I can do to improve the answer a bit. Not sure I would completely agree with rollover IRAs being deductible even though can roll the deductions forward simply because you already received that tax benefit plus you are gaining benefit of the first time home buyers withdraw. –  rob Jan 8 '13 at 18:58
    
Thanks for the detailed answer. One question - maybe I'm misunderstanding what you're saying, but you said with respect to a Roth IRA, "you do have to pay taxes on the gains though" - I thought the entire point of the Roth IRA is that you put in after-tax money, and pay no taxes on the gains? –  Jer Jan 8 '13 at 19:33
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@Zippy I don't think its possible. They cannot change laws retroactively. They can cancel the benefit for new deposits, but what's there - gets the treatment. That unless the Constitution gets amended to allow that, of course. –  littleadv Jan 9 '13 at 0:11
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@Zippy Greeks have a government pension, and the government defaulted on its obligation. That could happen in the US for the SSA benefits, for example. But that is not a retroactive change of tax benefits. Roth accounts have been taxed already. Worst that can happen is that the Roth benefit itself (tax-free distributions of earnings) will be repealed, and you'll be in the same boat as non-deductible IRA distributions. But even that I doubt if can happen. The examples in the article are of retroactive changes over very short periods of time, at most mere years. Not decades. –  littleadv Jan 9 '13 at 0:38

if you have a work-sponsored retirement plan

A 401k plan counts as a work-sponsored retirement plan. If you are a highly compensated employee (this is $115,000 for 2012), even your 401k contributions are limited.

Given that, is there any difference at all between having a traditional IRA and a normal, taxable (non-retirement) investment account?

You should consider a Roth IRA if you are making too much for a traditional IRA. When you make even more, then you can't contribute to a Roth, but can only contribute post-tax money to a traditional IRA.

Use Form 8606 to keep track of non-deductable contributions over the years. Publication 590 is the official IRS explanation of what is deductable or not.

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