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Author: YieldSigns Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 76079  
Subject: Non-Deductible IRA Strategy Date: 2/26/2001 1:28 PM
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My wife and I cannot deduct IRA contributions, for reasons relating to our combined income and my 401(k) contribution. I still want the power of compounded, tax-deferred returns. I have read IRS PUB 590 and I have a call into the IRS, but I wanted to pose broader questions to this board.

(1) Preliminarily, can I make NON-DEDUCTIBLE IRA contributions for both of us for the last calendar year (2000) and this calendar year still (2001)? (This would be a total of $8,000).

(2) If I can, is this the best strategy for capturing tax-deferred returns, or is there a better way.

(3) Finally, what happens if I want to withdraw the NON-DEDUCTIBLE IRA contribution at some point before the minimum retirement age? Assume none of the qualified exceptions for penalty-free withdrawals applies.) I know the $8,000 is not subject to taxation again, but is the withdrawal of the NON-DEDUCTIBLE $8,000 subject to the 10% penalty?

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Author: intercst Big funky green star, 20000 posts Top Favorite Fools Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 28142 of 76079
Subject: Re: Non-Deductible IRA Strategy Date: 2/26/2001 1:53 PM
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YieldSigns asks,

My wife and I cannot deduct IRA contributions, for reasons relating to our combined income and my 401(k) contribution. I still want the power of compounded, tax-deferred returns. I have read IRS PUB 590 and I have a call into the IRS, but I wanted to pose broader questions to this board.

(1) Preliminarily, can I make NON-DEDUCTIBLE IRA contributions for both of us for the last calendar year (2000) and this calendar year still (2001)? (This would be a total of $8,000).

(2) If I can, is this the best strategy for capturing tax-deferred returns, or is there a better way.


If you are not eligible for a deductible IRA, the best way to capture tax-deferred growth is probably in a tax-managed index fund held in a taxable account. Everything you withdraw from an IRA is taxed as ordinary income (max rate=39.6). Most of the earnings from a long-term buy and hold investment in an index fund is taxed as capital gains (max rate=20%.)

(3) Finally, what happens if I want to withdraw the NON-DEDUCTIBLE IRA contribution at some point before the minimum retirement age? Assume none of the qualified exceptions for penalty-free withdrawals applies.) I know the $8,000 is not subject to taxation again, but is the withdrawal of the NON-DEDUCTIBLE $8,000 subject to the 10% penalty?


Yes, unlike a Roth IRA where you may withdraw your tax-paid contributions without penalty, any withdrawal from a traditional IRA is subject to the 10% penalty unless one of the exceptions (age 59.5, substantially equal periodic payments, disability, etc.) applies.

intercst

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Author: TMFPixy Big gold star, 5000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 28144 of 76079
Subject: Re: Non-Deductible IRA Strategy Date: 2/26/2001 2:17 PM
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Greetings, YieldSigns, and welcome. You asked:

My wife and I cannot deduct IRA contributions, for reasons relating to our combined income and my 401(k) contribution. I still want the power of compounded, tax-deferred returns. I have read IRS PUB 590 and I have a call into the IRS, but I wanted to pose broader questions to this board.

(1) Preliminarily, can I make NON-DEDUCTIBLE IRA contributions for both of us for the last calendar year (2000) and this calendar year still (2001)? (This would be a total of $8,000).


Yes, you may make a $2K contribution for yourself and another for your wife for tax-year 2000 providied you do so by April 16. You are also free to contribute another $2K to each of your accounts for tax-year 2001.

(2) If I can, is this the best strategy for capturing tax-deferred returns, or is there a better way.

The only other way is to use an annuity, which may or may not be appropriate for your situation. For most folks, it isn't. For details, see our annuity area at http://www.fool.com/retirement/annuities/annuities01.htm?ref=G02C04

(3) Finally, what happens if I want to withdraw the NON-DEDUCTIBLE IRA contribution at some point before the minimum retirement age? Assume none of the qualified exceptions for penalty-free withdrawals applies.) I know the $8,000 is not subject to taxation again, but is the withdrawal of the NON-DEDUCTIBLE $8,000 subject to the 10% penalty?

In most cases, if all you can use is a nondeductible IRA, then a Roth IRA is your best choice because ultimately everything (i.e., contributions and all earnings) will come out of that vehcile tax-free. It also will allow you to take your original contributions (but not earnings) at any time and at any age free of taxes and penalty. For details and to see what type of IRA is best for you, see out handy-dandy IRA eligiblility calculator at http://www.fool.com/ira/2001/ira.htm?ref=prmptp

Regards..Pixy

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Author: melrosest Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 28495 of 76079
Subject: Re: Non-Deductible IRA Strategy Date: 3/18/2001 9:54 AM
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Hi intercst-

I am very interested in your answer to point #2. Here you are recommending that instead of making non-deductible contributions to an IRA one should use a tax managed index in a taxable account. Is this assuming that when you would withdraw from your IRA that you would be in the highest tax bracket? Do you know where the breakeven tax bracket would be where it would become more advantageous to make the non-deductible contributions to an IRA instead? Does your comment also take into account the cap gains tax on distributions that a tax managed index fund would realize however small they may be?

I am in this exact situation and am trying to determine which I should do. I have no idea what my future tax bracket may be in retirement. Given that, should I lean one way or the other?

Thanks!

melrosest

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Author: jkrou Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 28496 of 76079
Subject: Re: Non-Deductible IRA Strategy Date: 3/18/2001 10:18 AM
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Melrosest:
I think that the idea is that non-deductible contributions will be taxed at your marginal tax rate while gains from a taxable account will only be subject to the lower long term capital gains tax.

Given those two choices, it puts more money in your pocket the majority of the time by choosing the taxable account. Think about it, at the lowest tax bracket (15%) you are paying less for capital gains than income from your IRA; this will hold true all the way up the scale so why would you really want to be making the non-deductible contributions?

Non-deductible contributions do have an advantage of tax free growth if invested in mututal funds while a taxable account would create a taxable event each year held when it distributes its annual gains and dividends. However, in the long run I believe it is better to swallow the annual gains taxed today versus the growing non-deductible which will have higher taxes over their withdrawal period.

Just my thoughts,
Jenn

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Author: intercst Big funky green star, 20000 posts Top Favorite Fools Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 28498 of 76079
Subject: Re: Non-Deductible IRA Strategy Date: 3/18/2001 11:39 AM
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melrosest asks,

Hi intercst-

I am very interested in your answer to point #2. Here you are recommending that instead of making non-deductible contributions to an IRA one should use a tax managed index in a taxable account. Is this assuming that when you would withdraw from your IRA that you would be in the highest tax bracket? Do you know where the breakeven tax bracket would be where it would become more advantageous to make the non-deductible contributions to an IRA instead? Does your comment also take into account the cap gains tax on distributions that a tax managed index fund would realize however small they may be?

I am in this exact situation and am trying to determine which I should do. I have no idea what my future tax bracket may be in retirement. Given that, should I lean one way or the other?


As jkrou explains above, no matter what your tax bracket, long-term capital gains are taxed at a lower rate than the ordinary income tax you pay on an IRA distribution.

Gus Sauter, manager of Vanguard's index fund operations has said that there would not be any capital gains distributions from the Index 500 fund until more than 40% of the asset value of the fund is redeemed. It would take a major panic for anything like that to happen. The odds are very good that you'll never see an involuntary capital gains distribution from a Vanguard tax-managed index fund.

You will pay income taxes on the dividend income from index fund. The Index 500 fund currently has about a 1% yield, so at the 28% tax bracket, you'd only pay about a quarter of 1% of the asset value of the fund in taxes. That's not much more than the 0.17% expense ratio of the fund, and it pales in comparison to the difference between ordinary income taxes and capital gains taxes on the distributions.

intercst



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