The IRA Type That No One Really Needs
For high-income investors, a backdoor Roth IRA or taxable account will trump investing in a Traditional IRA.
Investing Specialists
It's IRA season, and as usual, investment providers are pushing everyone to fund an IRA before the April 15 deadline for contributions for the 2013 tax year. Individuals whose incomes fall below the thresholds are urged to make a deductible IRA or Roth contribution. And even people whose incomes are too high to qualify for either type of contribution are often advised to contribute to a nondeductible IRA, which carries no income limits on contributions.
The trouble is, the nondeductible Traditional IRA has never been a particularly useful vehicle, even for high-income savers. Instead, its main utility is as a conduit, for those who can't make a direct Roth contribution and intend to convert their Traditional IRAs to Roth. If such a conversion doesn't make sense, investors are almost always better off skipping the IRA wrapper altogether and investing in a taxable account instead. It's not difficult to achieve nearly tax-free compounding within a taxable account--provided you take care with investment selection--and you'll be able to obtain better tax treatment on your withdrawals, to boot.
Other IRA Types Beckon
To be clear, single filers who earn less than $129,000 and married couples filing jointly earning less than $191,000 should always consider making some sort of IRA contribution if they can swing it. With incomes at or below that level, they can make at least a partial contribution to a Roth IRA. They won't be able to deduct their contributions on their tax returns, but they will be able to enjoy tax-free growth of their money and, best of all, tax-free withdrawals in retirement.
Meanwhile, single filers who earn less than $70,000 and married couples filing jointly who earn less than $116,000 and are covered by a company retirement plan at work can choose their IRA type: They can contribute to a Roth, of course, as outlined above. Alternatively, they could choose to contribute to a Traditional IRA and deduct at least part and maybe all of their contribution on their tax return that year.
People with incomes above all of those thresholds can also open a Traditional IRA--the account type carries no income limits on contributions. However, the tax benefits of opening such an IRA and leaving it there are limited. The contribution isn't deductible at higher income levels, and the investment earnings are fully taxed upon withdrawal. That stands in contrast to in-retirement Roth IRA distributions, which are usually tax-free. The sole benefit of opening such an IRA and leaving it there is tax-deferred compounding.
IRA Through the Backdoor
That's not to suggest opening a nondeductible IRA isn't worthwhile for higher-income savers--it very often is. That's because individuals with any income amount can open such an IRA, as mentioned above, and then convert those monies to a Roth IRA. (There are no income limits on conversion any more, either.) This maneuver, often called a backdoor IRA, has grown in popularity since income limits on conversions were lifted in 2010. The beauty of the backdoor Roth is that higher-income individuals--who stand to benefit the most from the Roth's tax-free compounding and withdrawals--can get some assets into the Roth column even if they can't contribute to such an account directly.
The conversion can be a tax-free (or nearly tax-free) maneuver, too. As long as the nondeductible IRA is converted to Roth shortly after the account is opened, the investor would only owe tax on any investment appreciation that has occurred during the IRA's short life.
No IRA for You!
However, there are certain situations when such a conversion isn't advisable. Namely, if an individual already has Traditional IRA assets at the time of the conversion, the taxes due for the conversion year will depend on the ratio of money that has never been taxed (deductible contributions, rollover 401(k) contributions, and investment earnings) to dollars that have already been taxed (nondeductible contributions) in the total IRA kitty. If the new IRA consisting of nondeductible contributions is but a small component of the overall IRA pie--and that's often the case when investors have rolled over 401(k) assets after leaving their employer--the conversion amount will be mostly taxable at the investor's ordinary income tax rate. (This article provides an example.)
In such instances, the investor can work around the conversion-related tax bill by rolling over the taxable IRA assets into a 401(k) or company retirement plan, provided the plan allows it. Then, he can start fresh with a new nondeductible IRA and do the backdoor IRA with limited tax consequences, as previously outlined.
But if the 401(k) plan is lousy, the investor would be better off forgetting about funding a nondeductible IRA altogether and invest directly in a taxable account instead. After all, plenty of investment types enable your money to compound with a limited tax bill from year to year, just as the Traditional IRA does--for example, individual stocks (especially those that don't pay a dividend), broad market index funds, and municipal bonds. And even better, withdrawals from the taxable account carry no strictures and are taxed at your capital gains rate rather than your ordinary income tax rate; capital gains rates max out at 20% whereas the top income tax rate is nearly double that. The Bogleheads Wiki site has a helpful example demonstrating how the taxable investment is apt to be better in the long run than contributing to a nondeductible IRA.
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