Sinkorswim

06/18/01 - Rethinking Nondeductible IRA's

By: Frank Armstrong, CFP, AIF

In addition to tax deferral, traditional IRA's offer current tax deductions. Roth IRA's offer tax-free distributions, and generous estate planning opportunities. These compelling advantages are not provided with a non-deductible IRA.

Tax deferral is a powerful wealth accumulation technique. So, at first blush, non-deductible IRA's deferral is an attractive feature, but it comes with several costs that you should consider:

• Loss of capital gains treatment: Accumulation inside the IRA grows deferred, but all distributions are subject to ordinary income tax to the owner. This could double the tax on distributions when compared to the simple liquidation of an asset held for appreciation (i.e. a stock or index mutual fund that would qualify for long term capital gains tax treatment).
• Premature distribution tax penalty: Like other retirement plans, a distribution prior to age 59 ½ may subject the owner to a 10% penalty on top of income tax on the distribution.
• Forced distributions at age 70 ½: Your accumulations will be subject to the Minimum Required Distribution regulations along with all your other Traditional IRA and Pension plans. This distribution pattern may not fit your needs at the time.
• Loss in step up in basis at death: Your IRA will be subject to both estate tax and income tax. Your beneficiaries will pay income tax on any funds that they withdraw, diminishing the value of the account to them.
• Accounting and reporting complications: You may not pick and choose your tax treatment when you take a distribution. Each distribution from any IRA must be pro-rated between non-deductible contributions and taxable amounts for all accounts. At best these tax preparation complications are annoying and frustrating. At worst, they can be costly in terms of additional accountant's fees during retirement.
• Limits on Contributions: Your total contribution is limited to $2000 per person per year.

On the other hand, if instead of a non-deductible IRA, you simply purchased a tax managed index fund you would have capital gains treatment, no premature distribution tax penalty, no forced distributions, a step up in basis at death, simplified tax reporting, and you can put away as much as you like.

So, while I am a big booster of both Traditional and Roth IRA's, my enthusiasm for non-deductible IRA's is severely limited. Without either current deductions or tax-free distributions, the non-deductible IRA looses its pizzazz.

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