In my last post, I talked about how a non-deductible Traditional IRA can be an effective tool to minimize taxes especially when the assets in the IRA “throw-off” a significant amount of income and the income is taxed at your marginal rate. What if that isn’t the case? Well…that is the topic for this post. What if you were to deposit your Large-Cap Stock Funds into a Traditional IRA? Let’s take a look.
First the assumptions that I’ll use.
- We will use the average return of the S&P 500 from 1950 – 2009
- The total return is 11%
- 3.6% of the total return is from dividends
- The dividends are “Qualified” so they are taxed at 15% (current tax code)
- The marginal tax rate throughout the scenarios is 25%
- IRA distributions are taxed at the marginal rate
- For this illustration ObamaCare Surtaxes are ignored
In the first scenario, you can contribute $5,500 to a tax-deductible Traditional IRA or $4,125 ($5,500 – $5,500 x 25%) to a taxable account. So which one wins? The ability to contribute pre-tax dollars to the Traditional IRA outweighs the lower tax rate paid on the investments in the taxable account every year. After 30 years the after-tax account values are …
- Deductible IRA: $911,266
- Taxable Account: $800,278
So the Deductible IRA puts more money in your pocket.
In the second scenario, you can contribute $5,500 to a non-deductible Traditional IRA or $5,500 to a taxable account. In this case, even though you pay taxes on the dividends as they are paid, the taxable account is worth more than the non-deductible Traditional IRA each year. After 30 years the after-tax account values look like this…
- Non-Deductible IRA: $952,517 (higher than above because the IRA has “basis”)
- Taxable Account: $1,067,038
So, the bottom line? As the Weapons School Instructors used to say, “It depends”. Think about what tax strategy will put the most money in your pocket before you allocate your assets to separate accounts or get someone who can help you figure it out for you.
Curt Sheldon is an Independent Fee-only Financial Planner located in Alexandria VA with clients throughout the US.
He specializes in assisting transitioning Senior Military Officers reach their financial goals.
Amat Victoria Curam 