To IRA or Not to IRA?

Without going into the details, IRA contributions may be deductible, non-deductible, or partially deductible. Assuming that you’re eligible to make a deductible contribution, should you do it? As with all financial decisions, it depends upon the facts.

Let’s assume that you’re married, you’re both 50 years old, neither one of you is an active participant in an employer-sponsored retirement plan, and your marginal federal income tax rate is 25%. Given this scenario, you would be eligible to make deductible IRA contributions of up to $6,000 each, for a total of $12,000. Forgetting about a potential state income tax deduction, assuming you make maximum contributions, you will reduce your income tax liability by $3,000 ($12,000 x 25%). Looking at it another way, the cost of your IRA contributions is $9,000 ($12,000 less income tax savings of $3,000).

Since your spouse and you are both 50 years old, you’re both eligible to make IRA contributions for another 20 years until age 70-1/2. Assuming that you both continue not to be active participants in an employer-sponsored retirement plan, you will be able to make deductible IRA contributions totaling at least $240,000 ($12,000 x 20), excluding potential additional contributions permitted by legislated contribution limit increases. PerĀ Exhibit 1, after making contributions totaling $240,000, 25%, or $60,000 of which was financed by federal income tax savings, resulting in net out-of-pocket total contributions of $180,000 ($240,000 less income tax savings of $60,000), and assuming earnings of 5%, the total value of both of your IRA’s in 20 years is projected to be approximately $417,000.

That’s pretty awesome. Why wouldn’t you implement this plan? Keeping in mind that a deductible IRA plan is a tax-deferral plan, even though you may receive income tax deductions of $12,000 a year, or a total of $240,000 over 20 years, you, and potentially your heirs, will eventually pay income tax on 100% of your contributions. This must occur beginning at age 70-1/2 when you will be required to take minimum withdrawals from your plan that are calculated each year using the value of your IRA on December 31st of the previous year and your current age. Furthermore, the tax rate on your IRA withdrawals may be greater than the rates at the time when you made your contributions, resulting in greater tax liability than the tax savings you received from your contributions.

As an alternative, especially if you have other qualified retirement plans, you may want to consider taking the same $12,000 and instead make nondeductible contributions to a nonretirement investment account. Administratively, this will be easier since, unlike the IRA situation where you must deposit $6,000 into two separate accounts each year assuming you’re married, you can deposit 100% of your contributions into a single account. Furthermore, unlike an IRA which has an annual contribution limit of $5,000 or $6,000 if you are at least 50 years old, there is no cap on the amount of contributions that may be made to a nonretirement investment account.

To the extent that the investments in your nonretirement account don’t produce current taxable income, they will enjoy tax-deferred growth similar to an IRA. Unlike an IRA where withdrawals are taxable as ordinary income, withdrawals from nonretirement investment accounts are nontaxable. Instead, the sales of securities needed to produce the withdrawals are subject to capital gains. Assuming the securities that are sold have been held for at least a year, under current tax law, any gains, i.e., the excess of sale prices over purchase prices, will be taxed at favorable long-term capital gains rates which in most cases is 15%. To the extent that there is a loss on any sale, it can be offset against capital gains from other sales. Total capital losses in any year are deductible to the extent of capital gains plus an additional $3,000, with any net excess losses carried forward to future years. The availability of existing capital loss carryovers makes this alternative plan even more attractive (See last week’s post, Sizeable Capital Loss Carryover? Rethink Your Retirement Plan Contributions).

Even though a nondeductible nonretirement investment account plan may be preferable to a deductible IRA plan in certain situations, there is greater discipline associated with implementing and maintaining the former plan. Unlike a deductible IRA plan, the absence of the incentive of an annual tax deduction associated with a nonretirement plan generally requires an automatic contribution plan to be in place to ensure that regular contributions are made to the plan each year.