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401k situation :

  • Both my partner and I have employer that provide 401(k) coverage and the employer matches certain percentage. We max out these options

  • My 401k plan doesn’t give my much flexibility/ options when it comes to investing

Question:

  • I file my return as “married and filing jointly” and won’t get a deduction for an IRA account due to income limitations

  • I have a taxable brokerage account that use.

  • Would investing $5,000 per person ($10,000 per year) in an IRA versus the brokerage account have any advantage, even if I don’t get any deductions for the current year income tax ?

2 Answers 2

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So you are asking about the advantages of making a non-deductible (i.e. after-tax) Traditional IRA contribution. There are two aspects.

First, as HartCO's answer mentioned, one advantage is that you can use it as an intermediate step in a "backdoor Roth IRA contribution", i.e. make a non-deductible contribution to Traditional IRA, and then immediately convert all of it to Roth IRA. This circumvents the income limit to make a direct contribution to Roth IRA, because both steps (non-deductible contribution to Traditional IRA, an conversion to Roth IRA) do not have income limits. Assuming you have no pre-tax funds in any Traditional/SIMPLE/SEP IRAs (and will not rollover any money into pre-tax funds for the rest of the year), this conversion will consist of all after-tax funds, and there will be no tax on the conversion. The end result will be basically the same as a regular Roth IRA contribution.

If, on the other hand, you leave the after-tax money in Traditional IRA long-term, then any gains will be considered pre-tax (i.e. the after-tax amount, the "basis", doesn't change as the value of the IRA changes). When you withdraw it, you will be taxed on the gains part as regular income. One difference with a regular taxable account is that any transactions within the IRA are not taxed. So whereas if you buy and sell stocks all the time in a taxable account, you would be taxed on each sale, and if you hold interest-bearing assets, you would be taxed on the interest every year, if you buy and sell or get dividend or interest in the IRA, you don't get taxed on it. It just goes into the value of the account and you are taxed on all the gains when you withdraw. So in some sense it is like an asset that you buy and hold all the way until retirement, getting taxed when you sell it at the end, except that if you were to hold an asset until retirement, a taxable account is better, because the gains are taxed as long-term capital gains and not regular income.

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There are two types of IRA, Traditional and Roth. A Traditional IRA can be effectively funded with pre-tax dollars (due to a deduction that has an income limit as you are aware) and in retirement you'd withdraw and pay tax as if it were income at that time. A Roth IRA is funded with post-tax dollars and in retirement there is no tax on the withdrawals. There are income limits on the Roth IRA (phases out from 204k to $214k MAGI in 2022), but there's a workaround (backdoor) where you contribute to a Traditional IRA (with no deduction) and then promptly roll the funds over to a Roth IRA.

The advantage of a Roth IRA is tax-free growth vs the capital gains you face in your taxable brokerage account. Maxing out a Traditional IRA or Roth or backdoor Roth contribution should be the highest priority after maxing out employer match on 401k, paying off high interest debt, and maybe maxing out an HSA contribution (if good investment options exist in it and you don't mind some hassle).

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  • Thank you for your response. I don’t qualify for a Roth IRA due to income limits. Am I eligible to open a Roth IRA and just use for rollover (not directly contribute) Jul 31 at 16:29
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    You can, but you need to either rollover from another Roth account (IRA or 401k), or pay taxes if you roll over from a traditional account (IRA or 401k).
    – littleadv
    Jul 31 at 16:31
  • @littleadv: "or pay taxes if you roll over from a traditional account" They wouldn't pay taxes in conversion if they only had after-tax money in Traditional IRA (as would be the case in a proper backdoor Roth IRA contribution).
    – user102008
    Jul 31 at 18:09
  • @user102008 the conversion is taxable if it comes from the traditional IRA. I don't know how much balance they already have there, or how much gains on after tax contributions they'll have when making the conversion, so I really can't say that they wouldn't pay taxes in conversion.
    – littleadv
    Jul 31 at 18:36
  • @littleadv: Right but you can't say categorically that "the conversion is taxable if it comes from the traditional IRA" either. If there were no gains (or any other pre-tax money in Traditional IRAs), then there would be no tax during the conversion. And even if there were gains during the short period, it would be tiny compared to the contribution, so the tax would be negligible. So likely all or almost all of the conversion would be non-taxable.
    – user102008
    Jul 31 at 19:27

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