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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.

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