Why wouldn't you fund a traditional IRA?

[drb111]

I saw on another thread that some folks would say that after tax $$ in a tradional IRA is not always a good idea? However, none of those folks ever spoke up and gave a reason why.

I max out 401k and my income exceeds limits for ROTH, so I still place my annual limit into my trad IRA, figuring $$ still grows tax deferred and there are never any taxable events on divs, cap gains or realized gains...

So why would people recommend not funding this vehicle with after tax $$ once 401k has been fully funded?

Thanks for the help

 

[REWahoo]

Drb111, you might benefit by taking a look at this thread in the board FAQ section: http://www.early-retirement.org/for...ld-i-convert-my-ira-401-k-roth-not-30664.html

 

[youbet]

I did the same thing you're doing. Max the 401k and then fund a non-deductible IRA. But, you do have to consider the fact that cap gains being withdrawn from the IRA will be taxed as ordinary income instead of at the 15% LT cap gain rate. Also, taxes are likely to be higher in the future than the historic lows we enjoy today. I'm RE now so no more IRA contributions, but if I could contribute I'd seriously have to consider those factors.

 

[LOL!]

Here's why:
1. In your tIRA, your gains are taxed at your marginal income tax rate. Outside the IRA, your gains are taxed at the lower long term capital gains tax rate. In both places, unrealilzed gains are tax deferred. So advantage: taxable account.

2. If you die, the gains in the tIRA are taxed at the marginal income tax rate of your heirs. Outside the IRA, yours gains get a stepped up basis and are tax-free to your heirs. Advantage: taxable account.

3. If you need to withdraw or use your money before age 59.5, then the money withdrawn from your tIRA gets a 10% penalty. Outside your IRA, no penalty. Advantage: taxable account.

4. If your investments in your tIRA lose money, you are SOL. Outside the tIRA, you can do tax-loss harvesting and make the IRS pay 33% of your loss. Advantage: taxable account.

 

[mb]

What youbet and LOL! said + index funds (my preference for taxable investments) are usually pretty tax efficient.

MB

 

[youbet]

In the interest of balance and as an addition to my previous post......

I keep fixed income investments in my IRA, lately a GNMA fund, but not always. So, despite the disadvantages of non-deductible IRA's nicely summarized above, there is the advantage of years and years of tax deferred compounding of interest which would have been taxed at the highest bracket during my working years.....

 

[mb]

In the interest of balance and as an addition to my previous post......

I keep fixed income investments in my IRA, lately a GNMA fund, but not always. So, despite the disadvantages of non-deductible IRA's nicely summarized above, there is the advantage of years and years of tax deferred compounding of interest which would have been taxed at the highest bracket during my working years.....

Youbet has a good point. Depending on tax bracket it is a good idea to put bonds and bonds funds in a 401k or IRA.

MB

 

[kaudrey]

Exactly what LOL said.

In planning to retire in my early 50s, I will need access to money that is not tied up until I am 59.5 (yes, I know you can get around this, but I like the flexibility of a regular, taxable account).

 

[Ronnieboy]

Does the disadavantage still apply if you plan on converting the tIRA to Roth in 2010?

 

[jIMOh]

Here's why:
1. In your tIRA, your gains are taxed at your marginal income tax rate. Outside the IRA, your gains are taxed at the lower long term capital gains tax rate. In both places, unrealilzed gains are tax deferred. So advantage: taxable account.

2. If you die, the gains in the tIRA are taxed at the marginal income tax rate of your heirs. Outside the IRA, yours gains get a stepped up basis and are tax-free to your heirs. Advantage: taxable account.

3. If you need to withdraw or use your money before age 59.5, then the money withdrawn from your tIRA gets a 10% penalty. Outside your IRA, no penalty. Advantage: taxable account.

4. If your investments in your tIRA lose money, you are SOL. Outside the tIRA, you can do tax-loss harvesting and make the IRS pay 33% of your loss. Advantage: taxable account.

Present the flip side to this as well

5) dividends and distributions of the tIRA are deferred, you pay taxes on these in a taxable account. Advantage tIRA.

6) rebalancing requires selling of assets. tIRA you pay no taxes on funds sold at a gain. You pay taxes on funds sold in taxable accounts. Advantage tIRA

7) a tIRA can be converted to a Roth IRA. No limits on amount of conversion over a person's life. In a taxable account, you must have earned income to convert a taxable account (sell, pay taxes, then repurchase) in a Roth. advantage tIRA.

The longer the money is invested, the more 5-6-7 outweigh 1-2-3-4.

#7 is the most significant kicker. During retirement it is possible that a person could be in 15% tax bracket, and use the Roth conversion to cap out the 15% bracket (paying 15% tax on conversion amount). This would mitigate #2 and #3 above. Because taxes were already paid on a portion of tIRA, this scenario might win out if

a) retirement is early enough to shift most tIRA assets to a rIRA (shift occurs during retirement)
b) the time the money is invested prior to retirement is significant.

 

[LOL!]

Let's face it, a taxable account should hold tax-efficient investments. And tax-inefficient investments should be held in tax-advantaged accounts.

If (a) I had no more room in my tax-advantaged accounts, (b) was not eligible for a Roth IRA and (c) I needed to have more REIT or CCF assets, then I would not hesitate to open a non-deductible traditional IRA for that purpose.

I cannot take advantage of the 2010 conversion to Roth rules because I have an old tIRA with lots of deferred gains that I do not wish to pay taxes on at my current marginal income tax rate.

 

[jIMOh]

Let's face it, a taxable account should hold tax-efficient investments. And tax-inefficient investments should be held in tax-advantaged accounts.

If (a) I had no more room in my tax-advantaged accounts, (b) was not eligible for a Roth IRA and (c) I needed to have more REIT or CCF assets, then I would not hesitate to open a non-deductible traditional IRA for that purpose.

I cannot take advantage of the 2010 conversion to Roth rules because I have an old tIRA with lots of deferred gains that I do not wish to pay taxes on at my current marginal income tax rate.

I was not trying to change anyone's mind, I was trying to point out the flip side.

I think the flip side I presented wins out with time greater than 15 or 20 years. If someone is 5-10 years from retirement, I think the taxable account situation you laid out is the only situation to consider.

One additional point-

what is most tax efficient going in (401k/ deductable IRA) the least tax efficient coming out.

what is least tax efficient going in (Roth) is the most tax efficient coming out.

taxable accounts are more tax efficient coming out (meaning withdrawing out of account) that many alternatives. The withdraw phase needs to be considered, even if the investment is not tax efficient (during accumulation).

 

[drb111]

I guess I forgot to post a few pertinents...I am in my 30's and am not in a big "pickle" to figure out what to do with an additional $5000. I can either put it in a tIRA or taxable account or not. Regardless, I will keep investing and find a place for it. My taxable account is very tax efficient. One of the last times that the DOW went to 14,000, I went to 25% cash in my tIRA. No taxable event. I'm a long term, equity biased investor, but it was nice to sell some fund shares for a significant gain and not have any tax consequence.