Are traditional IRAs worse than taxable brokerage accounts at high incomes?

Question

Brokerage accounts are seen as relatively tax-inefficient, since you invest with post-tax dollars, and growth is taxed upon realizing gains. The traditional IRA allows you to deduct contributions and defer taxes until you take distributions in retirement ...

Unless you are covered by a retirement plan from work and make over

• $71,000/year if single, or
• $118,000/year if married filing jointly.

The numbers above come from a table published by the IRS for the 2015 tax year. Above those thresholds, you can still make contributions to a traditional IRA, but those contributions will be post-tax. Distributions are taxed as ordinary income, excluding post-tax principal.

Similarly, eligibility to make direct Roth IRA contributions phases out to zero according to a different table:

• $131,000 if single, or
• $193,000 if married filing jointly.

Looks to me that someone who cannot make direct Roth IRA contributions also cannot deduct traditional IRA deposits from income.

Assume

• investment period is 20 years,
• is some garden variety ETF (VTI/VXUS/etc),
• those investments return 5%,
• the current marginal tax rate is 28%,
• the expected marginal tax rate at retirement is 25%,
• the long term capital gains rate is 15%,
• the entity is not eligible to make Roth IRA contributions, and
• 401k contributions are already maxed out.

A $5000 of gross income contribution into a traditional IRA at retirement might grow to an after-tax sum of:

(5000) * (1 - 0.28) * (1 + (1.05 ** 20 - 1) * (1 - 0.25)) = $8064

Instead, since contributions were going to be taxed anyway, why not put it in a brokerage account? Then you could claim the favorable long-term capital gains rate.

(5000) * (1 - 0.28) * (1 + (1.05 ** 20 - 1) * (1 - 0.15)) = $8659

All I found was this question, and the accepted answer says to still make a traditional IRA contribution, but I still don't see why that would be a good idea. What am I missing here?

Answer 1

Your scenario (which here I won't debate, but just apply the math) is that your marginal rate is 28% when money is earned, and your rate in retirement is 25%.

Traditional IRA - you have $10,000 pretax. It grows to $100,000 and on withdrawal, you lose 25% to tax, $75,000 net.

Traditional IRA (no deduction) - you have $7200, same 10X return $72,000. On withdrawal, $64,800 is taxed at 25%, $16,200 tax. Net $55,800.

Roth IRA - you have $7200, same 10X return $72,000 net.

Post tax (regular broker account) - you have $7200, same 10X return $72,000 of stock and when you sell, there's $64,800 cap gain, $9,720 tax to pay, so $62,280 net.

Keep in mind, the phaseout for a Roth deposit is far higher than that for the IRA deduction. And the "Back Door Roth" permits a quick conversion from the non-deducted IRA to Roth, if you have no pretax IRA money. On prompting from dg99, I'll reference my article Roth IRA Two-Step (Advanced). It makes a few good points. First, you have one Traditional IRA. It may be spread across a dozen accounts, but it's one Individual Retirement Arrangement. It's composed (maybe) of post tax money, and pretax money. Conversions are not pick and choose, the post-tax money is pro-rated for tax purposes.

This is an oversimplification. One can run all the numbers, and make whatever assumptions you wish.

A spreadsheet will let you choose different rates for deposit, growth, and withdrawal. There's also the possibility of making an IRA deposit at a high rate, but converting to Roth somewhere along the way. It's never simple, although examples can be made so.

I agree, for this situation post tax IRA may not make sense.