The non-deductible IRA.

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IRS “pro rata” rule greatly reduces the benefit of contributing to a non-deductible IRA: Many people believe that if they are unable to make a Roth contribution due to income phase-outs, they can simply make a non-deductible IRA contribution and later convert that contribution to a Roth.  But it’s not that simple.  Under Section 72 of the Internal Revenue Code, a distribution from a retirement plan – and a Roth conversion is a distribution –is assumed to carry the same proportion of pre and after-tax  money in any particular distribution as in the plan as a whole.[1]

For example, if you’ve made a total of $50,000 in deductible contributions to your regular IRAs, and have a total of $5000 in non-deductible contributions that you wish to convert to a Roth, ninety-one percent ($50,000/$55,000) of the conversion will be taxable when you convert.  Thus, $4550 of the $5000 non-deductible contribution will be taxed when converted to a Roth.  Practically speaking, the only time you’ll probably want to convert a non-deductible IRA to a Roth IRA is when your regular IRAs consist primarily of non-deductible contributions.   

A better alternative to the non-deductible IRA: Instead of making a non-deductible IRA contribution that you have no real likelihood of being able to convert to a Roth, you are likely better off simply investing that money outside of the IRA.  Why?  Because nearly all studies show that, for most investors, the most successful approach to investing in stocks and bonds is to simply hold a diversified portfolio of ultra-low-cost index funds over the very long term, with occasional rebalancing.  As such, you’re better off foregoing the non-deductible IRA (in which all the earnings would ultimately be taxed as ordinary income) and instead investing that money in a taxable account, where your long-term investment returns are taxed at the far more favorable long-term capital gains rate.

Of course, buying real estate and benefiting from long-term capital gains treatment would apply as well.  Current long-term capital gains rates – as well as favorable tax treatment for qualified dividends – favor non-retirement accounts over regular (non Roth) IRA and 401(k) accounts.  Not only that, but a taxable account allows you to pass along your investments with a stepped-up cost basis at death – something that cannot be accomplished with a regular IRA, a fact which is too often overlooked.

The only benefit to choosing to make a non-deductible IRA contribution instead of putting that money in a taxable account – and it’s one of dubious value to a “buy and hold” long-term investor – is not being taxed on any trading gains in your non-deductible IRA prior to making withdrawals (the earnings of which, as noted earlier, will be taxed as ordinary income upon withdrawal, no matter how long the securities were held.)   Notwithstanding these considerations, there may be other factors, such as potential protection from creditors that may favor making non-deductible IRA contributions in certain situations.

[1] I.R.C § 72(e)(8)(A),(B),5(D)