When it comes to making contributions for retirement, many people won’t fund an IRA if the contribution isn’t tax-deductible. That raises an interesting question: is the primary purpose of an IRA to build savings for retirement – or is it primarily seen as a tax deduction in the current year?
Tax deductibility is certainly a consideration, but there are compelling reasons why an IRA makes sense even if the contribution itself isn’t tax-deductible. But in order to see the reasons why, you have to look at it strictly from the retirement side of the equation.
The earnings are still tax deferred – even if the contribution isn’t
Whether or not you can take a deduction for an IRA contribution in the current year, the earnings on the account are still tax-deferred. This means you make contributions – whether or not they are tax-deductible in the year taken – and the investment will continue to grow, free from taxation.
Even if your contribution is tax deductible, tax-deferred earnings are still incredibly powerful. Let’s say that your combined federal and state income tax rate is 30%. Let’s also say that you can average a 10% return on your investments.
If you invest your money in a taxable account, your net return will be just 7% – the 10% basic return, reduced by 30% for income taxes. But if your money is growing in an IRA, you’ll get the full benefit of the 10% return on your investments.
How does that look over the long-term?
- $10,000 invested over 20 years at 7% will grow to be $38,697
- $10,000 invested over 20 years at 10% will grow to be $67,275
Just as a result of having the tax deferral on investment earnings, you will have nearly $29,000 more in your account after 20 years. That looks almost like free money!
When it comes to retirement assets, more is better
Statistically, most people are under-funded in their retirement plans. Even if you participate in an employer-sponsored 401(k) plan, it still may not provide you with as much money as you will need for the type of retirement that you want.
Employer plans typically limit the amount that you can contribute to the plan by a certain percentage of your income. If you earn $50,000 per year, and the employer will allow you to contribute 10% of that to the plan, your annual contribution will be limited to $5,000.
You can contribute up to $5,500, 0r $6,500 if you are age 50 or older, to an IRA. That means you can more than double your total retirement contributions by combining the IRA with your company plan. The combined 401(k) and IRA contributions will allow you to contribute more than 20% of your income to retirement.
Spreading your retirement across several accounts
We all know about the importance of diversification when it comes to investing. This can and should also apply to the accounts that you invest money in. This is particularly true when your retirement funds are primarily held in a company-sponsored 401(k) plan.
In any employer plan you participate in there will be limitations. For example, your company plan may provide only very limited investment options. There may be a single fund each offered for growth, growth and income, fixed income and cash. The company may also offer its own stock as yet another option, but that does you little good if you have no interest in investing in the company where you also work.
By contrast, an IRA held at a typical online investment account will offer almost limitless investment choices. You can choose the funds that you invest in, and even invest in individual stocks – a practice typically prohibited by 401(k) plans.
The greater investment choices hold potential for a higher return on your investment. It is entirely possible that your IRA could outperform your 401(k) plan in most years.
Having some non-taxable asset distributions in retirement
Let’s assume for a moment that none of your IRA contributions are tax-deductible in the years taken. Is that really a bad thing? Let’s consider the possibilities.
If all of the money you have for retirement is 100% tax-deferred, then you will be subject to income tax any time you pull money out of the accounts. Considering that you will have Social Security income and possibly some sort of secondary job or business income in retirement, the retirement plan withdrawals can put you in much higher income tax bracket.
But if you made non-tax-deductible IRA contributions over the years, that portion of your withdrawals will not be subject to income tax.
The nondeductible IRA contributions are a form of tax diversification in retirement. They will enable you to withdraw at least some portion of your retirement money without it being subject to income tax. This may not completely eliminate tax on all withdrawals – the earnings that accumulated on a tax-deferred basis will be taxable. But at least some of the withdrawals are not subject to tax, and since tax rates rise with income level, the nondeductible portion of your IRA contributions could result in significant tax savings in retirement.
Have you considered making IRA contributions even if they are not tax-deductible?