3

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?

  • The answer on that question mentions conversion. It doesn't go into detail but I assume the idea is to do a so-called "back door" conversion which allows you get a Roth despite the income limits. Withdrawals would then be tax free. Perhaps @JoeTaxpayer can provide more detail on his answer. – BrenBarn Aug 2 '15 at 21:56
  • Your calculation is incorrect because taxes on non-deductible traditional IRA withdrawals consider your basis to prevent double taxation. More details here. – Craig W Aug 3 '15 at 20:49
  • Doesn't my calculation take the after tax contribution to the non deductible traditional IRA as the tax basis? – Prashant Kumar Aug 3 '15 at 20:57
  • Yeah I guess it does, after taking a closer look. But another thing to keep in mind is an ETF like VTI or VXUS will pay out dividends, which will be shielded from taxes along the way in an IRA versus a taxable account. – Craig W Aug 3 '15 at 22:06
  • That much is absolutely true. Perhaps relatively tax efficient funds like VTI won't cause as much drag compare to tax inefficient ones, like REITs or taxable bond funds, where the tax shield of the IRA will provide more benefit. – Prashant Kumar Aug 3 '15 at 22:09
9

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.

  • Are the IRA contributions are pretax if you cannot take the income deduction for your traditional IRA contribution? – Prashant Kumar Aug 2 '15 at 22:13
  • No. Of course not. – JTP - Apologise to Monica Aug 2 '15 at 22:14
  • Re: "On withdrawal, $64,800 is taxed at say, 25%, $16,200 tax. Net $55,800." Only if you're in the 25% tax bracket. The idea is that most people will be in a lower bracket by the time they have to take RMDs from the account. – jamesqf Aug 3 '15 at 17:43
  • 1
    @jamesqf - the question contained "the expected marginal tax rate at retirement is 25%." - If I were writing an article, I'd go 15%, or offer multiple scenarios. In this case, I was answering the question as asked, and not debating the set-up. – JTP - Apologise to Monica Aug 3 '15 at 18:15
  • 1
    I understand. Keep in mind, There are more than 2 points. Nearly all discussion revolves around the tax when earned and the marginal tax at withdrawal. But, any time along the way, one can convert to Roth at that year's marginal rate. – JTP - Apologise to Monica Aug 8 '15 at 18:25

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.