Non-Deductible IRA

Non-Deductible IRA or After-Tax Investing

Are there advantages to using a non-deductible IRA?

Should you use a non-deductible IRA or a brokerage (after tax) account for investing? Is there a significant advantage to the tax-deferred growth over time which limits tax drag, or is it much to do about nothing?

Let’s look at a small $10k investment in either a regular investment account or a non-deductible IRA and see what happens over time!

Assumptions, Assumptions

In this case, I looked at someone who is 40 years old and earns $200,000 a year. Living expenses and a 6% pre-tax 401k are deducted. The rest is invested in a brokerage account with or without the use of a non-deductible IRA. She retires at 65 and gets an estimated social security payment starting then.

Everything is invested in a total stock market index fund paying 7% with 2% yearly dividends. This is an example of a tax-efficient investment and and underrepresents the advantages of using a tax-deferred account vs a brokerage account.

So, let’s look at the results.

Results of a non-deductible IRA with a 401k Included

results of non-deductible IRA vs traditional investing

Figure 2 (results of non-deductible IRA vs brokerage investment of $10,000)

Figure 2 shows the results of this 50-year trial of 100% total stock market index fund investing.

First off, look at the advantage of a 401k! In the original example at the top, we had about $7M after 50 years. Here, instead of investing just in a brokerage account, we defer 6% of our salary to a 401k without a match. This provides about an extra $2M of total net worth at the end of 50 years (though you only fund the 401k for 25 years—until retirement). This is why high-income earners use tax-deferred accounts.

Next, we can compare the long-term results of $10,000 invested in either a brokerage account or a non-deductible-TIRA.

At retirement (age 65), there is $14k more due to lack of tax-drag in the TIRA.

At death (age 90), there is $64k more due to continued tax-deferral and just taking RMDs. So, using a 401k to increase the effective tax rate in retirement (and make this just slightly more realistic—it’s still far from a realistic scenario though…), you have $64k more rather than $87k more in my original example. All of this due to putting 10k in a non-deductible TIRA rather than a brokerage account at age 40.

Let’s see why.

Estimated Effective Tax Rate with 401k

Estimated effective tax rate 401k

Figure 3 (Estimated effective tax rate with a 401k) 

At age 70, Required Minimum Distributions kick in an increase the effective tax rate just a little bit.

Yes, deferring income in a 401k does increase taxation of your non-deductible IRA but not by that much. Why is that? Let’s find out.

Tax Brackets while Earning Income and in Retirement

Tax brackets 401k

Figure 4 (Tax brackets without and with a 401k)

As you can see above, a 401k (lower) does decrease slightly the income exposed to the 24/28% tax bracket while working. Note that the income exposed is slightly lower with the 401k than without (on the top). While you are working, you save money at your marginal tax bracket (in this case 24% now and 28% when the Tax Cut and Jobs Act expires in 2025).

Then, after retirement at age 65 and prior to RMDs at age 70, you are in a low tax bracket in both cases. This is the Tax Planning Window and a golden time to do Roth conversions, Capital gain harvesting, etc, but that is fodder for a different blog.

During retirement, then, you are in the 12/15% tax bracket without a 401k, and in the 22/25% tax bracket with.

Remember, 401k goes in at your marginal tax bracket and comes out at your effective tax rate. This is the reason you have $2M more after 50 years.

What about RMDs?

RMDs for the Various non-deductible IRA Examples

RMDs and non-deductible IRA

Figure 5 (Key tax components of taxable income)

Let’s start simple. That’s kind of a joke—I know my stuff is pretty wonky…

Anyway. The above is the example of the non-deductible IRA without a 401k. This is the original example from the top of this blog. You can see while working, there is salary (dark blue) and investment income from the brokerage account (light blue). As a reminder, the TIRA is growing tax-deferred during this time.

At retirement, income is made up of withdrawals from the brokerage account (likely blue), social security (lime green), and there is a sliver of withdrawal from the TIRA (orange). Note, I highlight the income at age 75 and there is only $3,531 of RMDs from the TIRA that is taxed.

Let’s look at what happens with a 401k in the mix.

With 401k and the non-deductible IRA

TIRA without deduction

Figure 6 (Key tax components with 401k)

Well, this is a little different from figure 5. When you add a 401k into the mix, there is more income that needs to be recognized due to Required Minimum Distributions.

Starting at age 70, RMDs kick in. On the top, we have the plan without the IRA, and on the bottom with the IRA. Note where I highlight at age 75 the difference in the withdrawal from the tax deferred account. Due to the IRA, you have to take slightly more from the bottom graph, with a change in the investment income needed to pay bills.

Thus, you are paying tax at the 22/25% tax bracket on just a slight amount more—the RMDs on the non-deductible IRA. As a result of this, however, you do pay less in capital gains because you pull out less from the brokerage account.

Conclusion for Non-Deductible IRA

Small tax differences over 50 years make a big difference in the end. Even a small contribution to a non-deductible IRA provides benefit after a long period of time.

The tax-deferral decreases tax drag. Even when using a very tax efficient total stock market index fund (with 2% yearly dividends exposed to your capital gain rate), there is a difference. If we used tax-inefficient funds (such as REITS, or bonds, or actively managed funds, etc), the difference would be even more pronounced.

In addition, taking Required Minimum Distributions can spread out the pain (tax payments) over time. This is why you should almost never take a lump sum out of your tax-deferred accounts.

Take advantage of every dime of tax-protected space you can. Who knows what the future will be like with tax reform, but even a year or two’s investment into tax-deferred space makes a big difference over decades.

Posted in Investments and tagged .

3 Comments

  1. First,

    I don’t think your first line is an accurate representation of the conclusions of my article which were, and I quote:

    “it does not make sense to invest in a tax-efficient asset class inside a non-deductible retirement account unless you expect to be able to do a Roth conversion (and the sooner the better) or have a significantly lower marginal tax rate at withdrawal….for a very tax-inefficient investment, it is worth using a no-cost non-deductible IRA for any length of time.”

    Second, I don’t follow your math at all. You’re saying you put $10K into a taxable account at 40 and somehow magically by age 65 it’s worth $3.3 Million despite only earning 7% a year? That would require a rate of return of 26%.

    Third, your argument is that there will be “more money left in the tIRA due to the fact that you’re only taking out RMDs.” I’m sure that is true. But that does NOT mean that you have more money to spend by taking that approach. Because those dollars in the tIRA are NOT worth the same as the dollars in the brokerage account, especially to heirs who will get the step-up in basis at death.

    That said, the longer the money grows tax protected, the more advantageous the IRA approach will be. But for a very tax efficient investment, it still may never overcome the effect of being able to withdraw earnings at the lower LTCG rate. Certainly for a less tax efficient investment it’ll eventually come out ahead.

    But it’s really a non-issue for most because they should be doing a Backdoor Roth IRA instead of non-deductible IRA contributions. This is really a discussion for a tiny subset of the physician population and the main point of my article was that investing in variable annuities wasn’t really a great idea.

  2. WCI,

    Sorry I misrepresented your point about non-deductible IRAs. It wasn’t my intention to do so. I think we both agree that investing in variable annuities isn’t a good move for most.

    In this case, there was ongoing investment in the brokerage account yearly in addition to the lump sum funding at 40. I’m sorry I didn’t make the clear, but she had to have funds to retire with at some point, so I was just looking at what 10k does in the non-deductible IRA vs in the brokerage account.

    I think the point is that pulling all of the non-deductible IRA out in a lump sum at 40.8% taxes is about as realistic as my example is realistic…. but as we both agree tax protection is good.

    Thanks for reading,

    FiPhysician

  3. Reviewed. Thanks FI Physician for the analysis. The one thing I like about economics is that it is a social science. Charlie Munger says economists have “physics envy.” It all depends on the client’s personal situation and the assumptions that are made. Appreciate the discussion.

Comments are closed.