Are Nondeductible IRAs Suitable for the Long Haul?

The "backdoor" Roth IRA is under fire.

The maneuver emerged as a loophole in 2010, enabling high-income investors who had heretofore been shut out of direct Roth IRA contributions because of income limits to get some money into the Roth column through "the backdoor." While direct contributions to Roth IRAs remain subject to income thresholds (in 2016, contributions are not allowed for single taxpayers with modified adjusted gross incomes of more than $132,000 or for married couples filing jointly with MAGIs of more than $194,000), income limits on conversions from traditional IRAs to Roth were removed in 2010. That gave high-income investors who had been shut out of direct Roth IRA contributions a workaround: They could contribute to a traditional IRA, then convert to a Roth later on. The conversion is a tax-free maneuver, assuming the investor has no other traditional IRA assets that have never been taxed and the new traditional IRA hasn't gained in value since the contribution was made.

But the maneuver exploits a loophole, and it's one that Congress could very well close, as financial-planning expert Michael Kitces discussed in this video. Indeed, President Obama's budget proposals have twice included provisions that would effectively kill the backdoor Roth IRA by keeping aftertax dollars out of Roth accounts.

While investors can still employ the backdoor Roth IRA maneuver--taking care to mind their p's and q's, as discussed in this article--high-income investors have reason to wonder whether it will be worth investing in a traditional nondeductible IRA if the wrapper can no longer be used as a conduit to a Roth IRA. That's also a relevant question for investors for whom a backdoor Roth IRA isn't desirable due to the pro rata rule. Do the modest tax benefits of a traditional nondeductible IRA outweigh the drawbacks--notably, required minimum distributions and ordinary income taxes on appreciation? The short answer? It depends.

A High-Class Problem Before I go any further, it's important to note that a traditional nondeductible IRA is only worthy of consideration by a small and well-off group: high-income investors who are already contributing fully to other tax-sheltered retirement-savings vehicles such as company retirement plans and health-savings accounts. (Income limits do not apply to those account types.) Investors whose income qualifies them to make either a deductible IRA contribution or a Roth IRA contribution should definitely favor those contributions, as the tax benefits of those wrappers are much better than a traditional nondeductible IRA contribution.

Instead, a traditional nondeductible will only be of interest to investors who are shut out of those other IRA types. For them, the only options for additional retirement savings are to invest in a taxable account or to contribute to a traditional nondeductible IRA. And if the backdoor Roth IRA maneuver goes away, that means they'd be funding a traditional nondeductible IRA for the long haul, not just as a means to a Roth.

Assuming that's the case, here are the key questions to ask before steering contributions to a traditional nondeductible IRA.

Question 1) What Do You Plan to Invest In? Traditional nondeductible IRAs and taxable assets vary in their tax treatment. Investors can only put aftertax dollars into either account type. Traditional nondeductible IRA assets enjoy tax-deferred compounding--that is, as long as the assets remain in the IRA, investors won't be taxed on their investment earnings on them. Investment earnings in a taxable account, by contrast, will be taxed in the year in which they're received, even if they're reinvested.

The two account types also differ in how withdrawals are taxed. Investors are not taxed on withdrawals of contributions from either account; after all, that money has already been taxed. But the portion of the IRA balance that represents investment gains is taxable as ordinary income when the IRA investor takes money out. The taxable investor, meanwhile, is able to enjoy the lower capital gains rates on withdrawals of investment appreciation--currently 15% for most investors and 0% for those in the 10% and 15% tax brackets.

That means that for an investor who plans to invest in tax-efficient, capital-gains-producing assets--a buy-and-hold equity investor, for example--the taxable account may be preferable to an IRA. That's because the investments wouldn't kick off much in the way of taxable income or capital gains on a year-to-year basis, so they wouldn't benefit too much from the tax-deferred compounding conferred by the IRA. Moreover, the taxable investor would enjoy long-term capital gains treatment on withdrawals of investment earnings. By contrast, the investor who holds tax-efficient capital-gains-producing assets inside of a tax-deferred account would be subject to ordinary income tax on withdrawals of investment earnings.

On the flip side, investments that kick off a lot of income or short-term capital gains on an ongoing basis will benefit more from that tax-deferred compounding that comes along with the IRA. Moreover, most of the long-term appreciation from those assets will consist of ordinary income, so the long-term capital gains treatment that the taxable account confers would be less beneficial. Thus, investors who are closing in on retirement who have run out of tax-sheltered receptacles to house income-producing investments may be better off stashing those investments inside of an IRA.

Question 2) Do You Need Flexibility on Withdrawals? A traditional nondeductible IRA is less flexible than a taxable account. Investors are free to pull their money from a taxable account at any time and for any reason, whereas IRA investors will pay a penalty to withdraw their money prior to retirement unless they meet certain conditions. (The tax treatment on those withdrawals is also different, as outlined above.)

By the same token, taxable investors can let the money ride for as long as they like, whereas traditional IRA investors are subject to required minimum distributions. Heirs receive a step-up in basis when inheriting taxable assets, meaning that heirs' cost basis steps up to the security's price at the time of death. A taxable investor also has the opportunity to harvest tax losses, which is cumbersome (at best) in an IRA.

Question 3) How Much Do You Plan to Invest? Contributions to any IRA are capped at $5,500 for investors under 50 and $6,500 for those 50-plus. Thus, heavy savers will have no choice but to invest at least some assets in taxable accounts, even if they decide to fund a traditional nondeductible IRA, too.

Question 4) Do You Need the Legal Protections? IRA assets enjoy better legal protections than taxable assets, so if there's a concern that you could be sued or run into a legal situation that could jeopardize your financial assets, stashing as much as you can in 401(k)s and IRAs is a sensible strategy.

Mark your calendars for the 2016 Morningstar Individual Investment Conference, taking place on April 2 at 9:00 a.m. CST. At this live-streamed event, we'll cover strategies to help you strengthen your investment plan, regardless of age or investing expertise. Register for free today.