Why we continue to contribute to a non-deductible IRA

Personal finance

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Doing taxes every year always makes me reflect on our investment vehicles and allocation strategy. I certainly don’t have it all down pat, but one particular area that I’ve been looking at is our IRA situation, particularly given the recent change in rules that by lifting the income limitation that was previously in place.

We’ve decided that in our case, converting to a in 2010 is probably not ideal (one reason being that, we live in CA and may not be here our entire lives, so it’s not clear there’s a benefit to paying that extra ~10% tax). In all fairness, the varieties and possible combinations of IRAs that you can possess, convert, and roll over is impressively complex, and it takes a long time (and/or the assistance of a financial planner) to figure out what’s right for your particular situation. If you’re interested in learning about the 2010 Roth IRA conversion, there’s literature-a-plenty to be found, but I found a pretty straightforward explanation about 2010 IRA conversion rules and tax implications that should get you started.

What’s more, we are fortunate (in a sense) to both exceed the limit for being able to contribute to either a Roth IRA or to be able to take a tax deduction for contributing to a traditional IRA. But we’ve decided to continue making yearly contributions to a traditional but for the following reasons:

  1. We are already contributing to other investment vehicles that might have greater payoff, such as a 401K with employer matching, a , and of course bills. We might have debt in the form of a mortgage eventually if we ever manage to find a house to buy, but that’s a different story.
  2. Diversification of investment vehicles: a traditional IRA still has the benefit of having tax-deferred treatment which may be beneficial when owning bonds or other tax-inefficient investments since the interest you receive when investing from a traditional IRA is tax-free until you start making withdrawals from your IRA account at retirement. This allows me to allocate my investments between stocks and bonds in a more tax-efficient manner between different investment accounts.
  3. Now that we can have the option to convert traditional IRAs into to Roth IRAs, this gives us additional flexibility in the future and a possible way to own Roth IRAs while we still exceed the income limit to contribute to one directly.

Again, the conclusion I’ve reached may not be applicable or the best solution for you depending on your circumstances. For example, before contributing to a non-deductible IRA, there may be better options to consider (such as contributing to a 401K that has employer-matching), and if you’re nearing retirement age, a non-deductible IRA might not make sense at all.

There are also risks to this approach. Note that if you incur capital losses in an IRA, you do not get to recognize those when calculating your income taxes or carry them over to the next year as you would with a normal investment account. And finally, a lot of the benefit of any IRA depends on underlying assumptions about where you expect your income tax rate to be when you retire.

One additional piece of advice is to look at your overall portfolio when making investment decisions. For example, most people will tell you that if you are young, you should be investing a large percentage of your retirement portfolio in stocks. But if you have more than one retirement account (such as both an IRA and a 401K, and maybe even a normal savings/investment account), then you should be looking at your overall asset allocation among all accounts rather than just deciding how to invest your IRA or 401K a certain way because it’s considered a “retirement account”. And if those accounts are with different companies, then those advisors won’t have a good picture or understanding of your overall situation if they are only looking at the account you have with them. So, either find a good financial planner or be aware that you are in the best position to make informed decisions about your money.

Any thoughts welcome, especially if you spot any fallacies in my logic above!

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