Nondeductible IRAs - Not Very Tax-Advantaged
TL;DR because this is a long one:
- Nondeductible IRA contributions to a Traditional IRA often lead to worse after-tax outcomes than simply contributing to a taxable account.
- Backdoor Roth conversions, if you can do them without a major tax impact, are usually ideal from a tax perspective. Direct Roth IRA contributions get the job done too if your income isn't too high.
- There are estate planning and legacy considerations as well. Distributions of pre-tax IRA funds are taxable as income to the beneficiary, while taxable accounts enjoy a "step-up in basis" that can greatly reduce or eliminate capital gains taxes on inherited taxable accounts.
- Inherited IRAs are also subject to required minimum distributions (RMDs) while inherited taxable accounts aren't. This gives more distribution flexibility to taxable accounts.
- You might have made nondeductible IRA contributions without realizing it. You should review your prior tax returns to ensure you have the proper records in order to avoid double taxation on any nondeductible IRA contributions.
What is a Nondeductible IRA?
If you participate in a company-sponsored retirement plan like a 401(k) and your income exceeds a certain threshold, you’re not allowed to make pre-tax IRA contributions. You can still contribute to a Traditional IRA, you just aren't allowed to take a tax deduction on that contribution. This is called a nondeductible IRA contribution, and it’s similar to a Roth IRA in the sense that contributions are made after tax in both cases. The huge and extremely important difference is that the earnings on nondeductible contributions to a Traditional IRA are fully taxable at distribution, while the earnings on Roth IRA contributions are tax-free (for qualified distributions).
A "nondeductible IRA" isn't a different kind of IRA distinct from a Traditional IRA, but you'll often hear people (myself included) referring to an IRA with nondeductible contributions as a nondeductible IRA. Instead of referring to these IRAs as nondeductible IRAs in this post, I'll mostly use the term “nondeductible contributions”, which specifically refers to the nondeductible contributions to a Traditional IRA, and never contributions to a Roth IRA or earnings on nondeductible contributions to a Traditional IRA.
Nondeductible IRAs vs. Roth IRAs
The after-tax difference between the two can be staggering. Imagine this scenario: you and your best friend max out your IRAs each year, but you decide to fund a Roth IRA while they make nondeductible Traditional IRA contributions. Decades go by, you’ve each contributed $50,000 to your respective IRAs, and your account balances are $500,000 each ($450,000 of this are earnings). Assuming a 25% effective tax rate in retirement, if you cashed out your Roth IRA you’d have $500,000 with no taxes on the distribution. On the other hand, the $450,000 in earnings in your friend's Traditional IRA would be taxed at $25%, leaving them with only $387,500 after taxes. This $112,500 difference is solely because of the choice between making Roth IRA or nondeductible IRA contributions decades ago.
All else equal, more money in your pocket is better, so Roth IRA contributions clearly win over nondeductible IRA contributions. The catch is that Roth IRAs have income limits too, and if your income exceeds that threshold, you can’t make Roth IRA contributions directly.
If you find yourself unable to make deductible IRA contributions and unable to make Roth IRA contributions, your three options (assuming you want to invest your money in public markets – no real estate, private equity, or insurance products included) are to 1) invest the money in taxable brokerage accounts, 2) make nondeductible IRA contributions, or 3) make nondeductible IRA contributions and perform backdoor Roth conversions.
A successful backdoor Roth conversion should have minimal tax impact and result in a similar situation to directly contributing to a Roth IRA had you been able to. Therefore, backdoor Roth conversions, when executed properly, should always be better than keeping nondeductible contributions in your Traditional IRA. However, getting it right can be tricky, and getting it wrong can have severe tax consequences. Speak with your tax or financial advisors to understand the tax impact of performing Roth conversions.
Nondeductible IRAs vs. Taxable Brokerage Accounts
Now on to comparing how nondeductible contributions stack up to growing your money in a taxable brokerage account. For this comparison, I’ll be looking at income tax differences and estate planning differences between the two.
- Each scenario is isolated from the complexities of “real life” to provide a high-level analysis without introducing excessive variables.
- The investment strategies and pre-tax performances are identical within a scenario.
- All IRA distributions are assumed to be qualified distributions and not subject to penalties.
- Income taxes are deferred until distribution. Buying and selling positions aren’t taxable events, nor are interest and dividend payments.
- Distributions of earnings and pre-tax contributions are taxed at ordinary income rates. There are no reduced long-term capital gains or qualified dividend tax rates for IRAs.
- Distributions of basis (your nondeductible contributions only; this doesn’t include earnings on your nondeductible contributions) are nontaxable.
- Distributions are not subject to the 3.8% net investment income tax (NIIT).
Taxable Brokerage Account:
- Interest and dividends received are taxable (even if reinvested), and trading can realize short-term and long-term capital gains or losses.
- Distributions or withdrawals aren’t taxable events by themselves – selling a stock at a gain and withdrawing the money will have a tax impact, but it’s the act of selling and not the act of withdrawing that is the taxable event.
- Investment income (interest, dividends, and capital gains) is subject to NIIT if your modified AGI exceeds a threshold amount.
The Best Case for an IRA:
You’re in the 37% tax bracket, all of your investment income is subject to NIIT, and all income generated is interest, ordinary dividends, or short-term capital gains. These types of income are all taxed at ordinary income tax rates, so any income or gains in your taxable account is taxed at 37% plus the 3.8% NIIT – 40.8% total.
IRAs aren’t subject to NIIT, so the taxable distributions are only subject to the 37% ordinary income tax. If the taxable events happened in each account at the same time, the IRA distributions would be subject to 3.8% less in taxes.
In another scenario, you’re in the 37% tax bracket, subject to NIIT, and you invest in a very tax-inefficient way, generating significant income in the taxable account all throughout your working years – all taxed at 40.8%. If we assume your income falls in retirement, you might end up in a lower tax bracket at retirement – maybe 32%. If this investment strategy was executed in an IRA instead and taxed at 32% at the time of distribution only, this represents an 8.8% tax savings (approximately - the lack of year-over-year taxes for the IRA makes it even better).
Neither of these scenarios are particularly realistic. Not having any qualified dividends or long-term capital gains in a taxable account requires a conscious effort to be as tax inefficient as possible. This doesn't really bode well for nondeductible IRA contributions being better than using a taxable account.
The Worst Case for the IRA:
Now say you’re in the 15% capital gains bracket plus NIIT and the 35% ordinary income bracket (there’s no income range where you can be in the 37%/15% brackets at the same time), and all of your investment income is made up of qualified dividends and long-term gains. These types of income are taxed at preferential rates - 15% plus the 3.8% NIIT, or 18.8% total.
If taxable events happened in each account at the same time, the IRA distributions would be taxed at 35%, while gains and qualified dividends in the taxable account would be taxed at 18.8% – a 16.2% tax difference in favor of the taxable account.
Contrasted with the "best-case" scenarios which are difficult to achieve in practice, you might be able to get close to this "worst-case" scenario if you hold equity ETFs or individual stocks that generate minimal dividends and no interest, and you never sell the positions until you’re ready for withdrawal (so there’s minimal tax impact before distribution). The more tax-efficient you can make your taxable portfolio, the worse it makes the nondeductible IRA look.
Fitting into these extreme best-case / worst-case scenarios is pretty unlikely, but it highlights how a so-called “tax-advantaged” retirement account can end up with a significantly worse after-tax outcome than a taxable brokerage account. That’s probably something we wouldn’t expect – a tax-advantaged account being less tax-advantaged than a non-tax-advantaged account doesn’t really make sense.
An Income Tax Sidebar: Double Taxation on Nondeductible IRA Contributions
The IRS assumes all Traditional IRA contributions are pre-tax (or deductible) contributions unless proven otherwise. Yes, the burden of proof is on you. If you can't prove to the IRS that your contribution was already taxed when you contributed it, you'll also be taxed when you distribute it. The same money, taxed twice.
Form 8606 is, among other things, your proof of nondeductible IRA contributions and nontaxable basis. It records and tracks your IRA basis over the years so it isn't taxed again when you take distributions or perform Roth conversions. Don't skip out on filing Form 8606 whenever you make nondeductible IRA contributions. If the IRS decides your alternative recordkeeping is insufficient (remember, you have the burden of proof here), your nondeductible contributions can be taxed again.
If you find you haven't properly filed Form 8606 in prior tax years, best practice is to start from the earliest year you should have filed Form 8606 and work forward from there.
Estate and Legacy Planning
Another consideration is how IRAs and taxable accounts are treated when inherited. If an heir inherits your IRA, they must pay ordinary income taxes on any distributions of pre-tax money. On the other hand, if an heir inherits your taxable brokerage account, the “step-up in basis” resets the cost basis of the positions to their values on the date of your death. That step-up might mean that an heir can liquidate a taxable account they inherited with NO tax impact.
For example, let’s say you have an IRA with $50,000 of nondeductible contributions and a taxable account with a cost basis of $50,000. At the time of your death, each account has grown to $500,000. If the person who inherits your IRA distributes the entire account immediately, they’ll owe income taxes on the $450,000 of earnings. However, if the person who inherits your taxable account distributes the entire account immediately, they’ll have no tax liability since the cost basis of the taxable account “steps up” from $50,000 to the $500,000 value on the date of death.
Additionally, inherited IRAs are subject to required minimum distributions (RMDs), which force heirs to distribute at least a certain amount each year. Taxable accounts aren’t subject to RMDs, leaving heirs with considerably more flexibility on how the account is used.
In these “in a vacuum” scenarios where your options are 1) making a non-deductible IRA contribution and not completing a Roth conversion or 2) contributing to a taxable account instead, the latter is likely to have a better after-tax outcome compared to the former. Of course, if you are able to execute a backdoor Roth conversion on your non-deductible IRA contribution, that almost certainly would lead to the best after-tax outcome compared to the other two options.
I’m not trying to say that IRAs are bad and you shouldn’t contribute to one. However, it’s important to know the potential downsides, especially when it comes to the complicated tax rules for Traditional and Roth IRAs.
You may also have made nondeductible IRA contributions without even realizing it. There's no alert or warning when you're no longer eligible to make deductible IRA contributions. It simply stops showing up as an above-the-line deduction on your tax return. I strongly urge you to review your tax returns and Form 5498s every year to check for nondeductible IRA contributions and corresponding Form 8606s.
If you’ve made nondeductible IRA contributions that are still in your Traditional IRA, don’t panic and perform a Roth IRA conversion. If you have any pre-tax IRA money in there, that could be a tax nightmare. Evaluate your situation and make sure the expected tax impact is what will actually happen according to the tax laws. If in doubt, speak with a tax professional or financial advisor.