No Respect! The Much Maligned Non-Deductible IRA

A lot of Senior Military Officers at some point in their career lifetime find (or think) that they have limited retirement plan options.

While on Active Duty they are most likely not eligible to contribute to a Traditional IRA  and take a tax deduction.  They may be eligible to contribute to a Roth IRA and their spouse may be able to contribute to a deductible Traditional IRA.

After starting their second career their options are often even more limited.  Like while on Active Duty the Senior Military Officer will most likely not be able to contribute to a deductible Traditional IRA.  The retired Senior Military Officer will now often find that he/she will not be able to contribute to a Roth IRA and the officer’s spouse may not be eligible to contribute to a Roth or deductible Traditional IRA either.

But in both cases there is an alternative – the non-deductible Traditional IRA.  But I find that often when the immediate tax deduction is eliminated most people lose interest in the non-deductible Traditional IRA.  That could be a mistake…

Tax deferral is still a powerful tool.  Let’s look at an example.  Here are the assumptions:

• Contributions to non-deductible Traditional IRA start at age 50 and continue to age 65.
• Contributions are maxed out at $6,500 per year
• Distributions are started at age 70 (Required Minimum Distributions start)
• Tax rate during accumulation 36.8% (33% Marginal Bracket + ObamaCare Surtaxes) for funds outside IRA
• IRA distributions are taxed at 33% and 25% (IRA distributions not subject to ObamaCare Surtaxes)
• Capital Gains are ignored and all income is assumed to be taxed at marginal rate (REITs would be a good example)
• Return is 8% and is based on historical data for Vanguard REIT ETF

So, after 20 years (15 years of contributions and 5 years of further appreciation)…

• The taxable account will be worth $198,561 with no further taxes due
• If the IRA is taken out and the marginal rate stays at 33%
  • The account will be worth $292,039
  • Taxes of $62,053 will be due (remember taxes are only due on the earnings)
  • Available cash is $229,986
• If distributions can be stretched to lower the marginal tax rate to 25% then
  • The account will still be worth $292,039
  • Taxes of $47,009 will be due
  • Available cash will be $245,029

In both cases, the non-deductible IRA puts more money in your pocket than paying taxes as you go along in the taxable account.

Capital Gains can potentially change the results since capital gains, in most cases, are taxed at a lower rate than the individual’s marginal tax rate.  So you wouldn’t want to do this with assets that primarily produce capital gains.  That is called Tax Efficient Investing and is a topic for another day.

 

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.