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Nondeductible IRAs; what are the alternatives?


The Tax Reform Act of 1986 significantly changed the rules regarding individual retirement accounts (IRAs). Many taxpayers can no longer deduct IRA contributions from their gross income, thereby making this method of deferring income less desirable, especially for short-term savings.

Articles in the recent past have explained the new tax laws regarding IRAs and investigated the question of whether a taxpayer should make a non-deductible IRA contribution. Most of this research has concentrated on the number of years a taxpayer must keep funds in an IRA to have the same after-tax dollars as a non-IRA investment, assuming the funds from the non-deductible IRA will be subject to the additional 10% penalty tax due to early withdrawal. These studies have suggested that for many taxpayers the non-deductible IRA is an effective tax saving device based on its tax deferring attribute.

This article evaluates the non-deductible IRA and then compares it with viable alternatives, such as deferred annuities, tax free investments and savings bonds. The data suggests that the non-deductible IRA may not be appropriate for many taxpayers and that there are a number of highly competitive alternatives.

Changes to the IRA Rules


The deduction one can take for an IRA contribution depends on (1) whether the taxpayer is covered by an employer retirement plan and (2) how much income a taxpayer has in a particular year. If a taxpayer is not covered by an employer retirement account, he/she can fully deduct up to $2,000 or 100% of compensation, whichever is less. IF married and filing a joint return, a deduction is allowed only if neither the taxpayer nor the spouse is covered by an employer retirement plan.

IF a taxpayer is covered by an employer retirement plan (one or both if married and filing jointly) the amount that is deductible depends on the annual income of the taxpayer (or taxpayers). If a single taxpayer has over $35,000 adjusted gross income ($50,000 married filing jointly) and is an active participant in an employer retirement plan, then none of the IRA contribution is deductible. If a single taxpayer has between $25,000 and $35,000 adjusted gross income ($40,000-$50,000 married filing jointly) and is an active participant in an employee retirement plan, then only part of the IRA is deductible. Except where indicated, This article concentrates on non-deductible IRA contributions.

Withdrawal of Contributions

IF a taxpayer withdraws from an IRA before age 59-1/2, the premature distribution is subject ot normal taxation plus a penalty of 10% of the taxable portion. IF a taxpayer has made non-deductible contributions, a portion of the distribution is not subject to taxation or penallty--the portion treated as a return of non-deductible contributions.

The law requires taxpayers to combine all IRAs, and any withdrawal will consist of portions from the deductible and non-deductible contributions. The nontaxable amount is based on the ratio of cumulative non-deductible contributions to the total balance of all IRAs. To illustrate, assume a taxpayer has $2,000 cumulative non-deductible contributions and the total balance of all IRAs of $8,000. A withdrawal of $2,000 would consist of $500 (($2,000 / $8,000) X $2,000) excluded from taxable income and $1,500 (($6,000 / $8,000) X $2,000) subject to taxation and penalty if the taxpayer is less than 59-1/2 years old.

As brought out in the didiscussion above, the taxation of withdrawals is influenced significantly by the non-deductible amount of the total IRA accumulation on the date of withdrawal. This fact causes the number of years before the after-tax and after-penalty accumulation of a non-deductible IRA exceeds the after-tax accumulation of a non-IRA investment (breakeven point in years) to be greater for taxpayers with large IRA accumulations from deductible contributions. In this study, the number of years before the non-deductible IRA yields a greater after-tax and after-penalty accumulation than a non-IRA investment is expreseed as the breakeven point.

Non-Deductible IRA

Prior studies have calculated the breakeven point in years for non-deductible IRA contribution under various assumptions. (1,2) These past endeavors have concentrated on making the decision of whether or not to contribute using calculations based on the current year's contribution only.

This article concentrates on the breakeven point based on a series of non-deductible IRA contributions. If an IRA is being considered for short- to intermediate-term savings there will likely be a particular future need for which the taxpayer is saving--such as a child's collecge education. If so, the amount needed in the future would, in virtually all cases, need to be greater than the accumulation of a single IRA contribution.

A taxpayer must decide whether or not to use an IRA to accumulate savings. Assuming a taxpayer wishes to set aside some money each year, the effect of annual contributions needs to be considered. Thus, a taxpayer would be interested in the breakeven point in years, assuming a series of yearly IRA contributions rather than only a single year contribution. The distinction is very important because of the withdrawal policies. The indifference point in years, assuming yearly contributions, is significantly longer than than of a single amount.

Breakeven Points

Exhibit 1 depicts the breakeven points in years for a taxpayer who is in the 28% tax bracket and makes an annual $2,000 non-deductible IRA contribution. Assuming varying investment yields of between 6% and 12%, the breakeven points in years are displayed for taxpayers with current taxable IRA accumulations of $50,000, $25,000 and $0. For example, column 2 shows that a taxpayer who already has a $50,000 taxable IRA accumulation and has an investment yield of 8% would have to wait 31 years to break even.

Column 3 provides similar information for a taxpayer with a $25,000 taxable amount of IRA accumulation. Using an investment yield of 10%, the taxpayer would have to wait 23 years before the non-deductible IRA would be better than the non-IRA investment. Column 4 displays the breakeven points in years for a taxpayer with no past IRA accumulations. Assuming a return of 6%, the breakeven point based on annual contributions is 24 years.

A perusal of Exhibit 1 brings out the fact that the greater the current taxable IRA accumulation, the longer the number of years it takes before the non-deductible IRA provides an after-tax and after-penalty accumulation greater than a non-IRA investment. Based on a 10% yield, the number of years before breakeven changes from 25 to 23 to 15 depends on the taxable amount of current IRA accumulations chaning from $50,000, $25,000 and $0, respectively. The lowest breakeven point is 13 years for a taxpayer without prior IRA accumulations and assuming a 12% investment yield. These results indicate that most taxpayers should not use non-deductible IRA as a short-or intermediate-term savings device.


Considering the diminished value of a non-deductible IRA compared to a non-IRA, it is prudent to discuss alternatives. The major benefit of a non-deductible IRA is its tax deferring ability. Therefore, viable alternatives must possess at least this tax deferring characteristic. Three such alternatives are tax deferred annuities, tax-free investments and savings bonds.

Tax Deferred Annuities

Currently, an unlimited amount of money (normally a $5,000 minimum) can be invested in a deferred annuity where the income is not taxed until withdrawn. This is in contrast with the $2,000 per year limitation for a non-deductible IRA. Both the IRA and the deferred annuity have a 10% tax penalty for withdrawal before age 59-1/2.

The investment options available for deferred annuities are limited compared to a non-deductible IRA. Variable deferred annuities allow switching from stocks, bonds and money market funds. However, the ability to personally select individual stocks or invest in gold, etc. is currently not available with deferred annuities.

Information about deferred annuities is not required to be reported to the Internal Revenue Service. However, if a taxpayer already has a non-deductible IRA from a prior year contribution, the recordkeeping must be done anyway so the incremental reporting effort associated with future non-deductible IRA contributions would be minimal.

The rate of return from a deferred annuity would likely be comparable to that which could be earned in a non-deductible IRA. With similar returns, the breakeven points in years for the deferred annuity vis-a-vis a non-deductible IRA should be the same as the breakeven point for a non-deductible IRA vs. non-IRA investment if the amount put in the deferred annuity each year is the same as the non-deductible IRA contribution and the taxpayer did not have any previous deductible IRAs.

If a taxpayer had made previous deductible IRA contributions, a portion of the IRA withdrawal would be considered coming from the taxable part of the IRA accumulation. Because past IRas (prior to 1987) were tax deductible, the accumulation of prior IRAs would be all pre-tax funds. Thus, prior IRA accumulations, because they are taxable, cause a larger part of a withdrawal to be taxed. Therefore, the non-deductible IRA vs. the non-IRA breakeven point would be greater in terms of years than the deferred annuity vs. the non-IRA investment. In other words, a taxpayer would have to wait more years for the after-tax and after-penalty accumulation of a non-deductible IRA to exceed the after-tax value of a non-IRA investment than would be the case for a deferred annuity, if the taxpayer had prior IRAs.

If a taxpayer had sufficient funds, an amount greater than $2,000 could be put into a deferred annuity. This larger amount, in an early year, would cause the deferred annuity to have a shorter breakeven point vis-a-vis the non-IRA than the non-deductible IRA, which can only build at a maximum of $2,000 per year. Clearly, the deferred annuity has significant advantages over the non-deductible IRA.

Tax-Free Investments

An unlimited amount can be invested in tax-free investments in contrast with $2,000 per year limit for non-deductible IRAs. In addition, there is not a 10% penalty tax for early withdrawal. Obviously, the investment options available for non-deductible IRAs are much greater than investing in tax-free bonds.

There are very little annual reporting requirements for tax-free investments in contrast with the yearly record-keeping for non-deductible IRAs, assuming a non-deductible IRA had not been previously established. Because tax-free investments avoid taxes entirely, theoretically, the tax-free return should equal the after-tax return of a taxable investment of similar risk. However, in reality the tax-free investment rate of return depends on many variables, such as supply and demand.

To assess the desirability of tax-free investments compared to taxable investments the tax-free yield can be converted to a taxable yield equivalent. This is accomplished by using the following formula:

Tax Exempt Yield / 1 - Marginal Tax Rate % = Pre-tax Taxable yield

If the taxpayer can find a taxable investment of comparable quality that yields more than the pre-tax taxable yield (calculated above) then the taxable investment would be better than the tax-free investment. Otherwise the tax-free investment would be preferable.

Savings Bonds

Taxpayers can also invest unlimited amounts of money in EE United States savings bonds, and there is no penalty tax for early withdrawal. Savings bonds earn interest at the rate of 8k% of the average yield on five-year treasury obligations, carry a minimum interest rate of 6.0% if the bonds are held for more than five years, and the income is exempt from state taxes.

While there are no annual reporting requirements, the ratte earned on savings bonds (6.0% minimum) has been traditionally, substantially lower than other investment opportunities. Thus, the desirability for savings bonds is highly dependent on the expected rate or return on other investment options such as stocks. The income of EE U.S. savings bonds can be deferred similar to non-deductible IRAs and deferred annuities.

Starting after 1989, EE U.S. savings bonds will be exempt of tax to the extent the proceeds are used to fund college for the taxpayer or his/her children. Given this, after 1989 EE U.S. savings bonds will be more desirable as a savings device for college.

Comparison Chart

Exhibit 2 is a comparison of the four investment options--non-deductible IRA, deferred annuity, tax-free bonds, and savings bonds. For example, the exhibit shows that all the investment options have tax deferring abilities with the exception of tax-free bonds, which are obviously free of tax. In addition, the differences in investment options are highlighted.

Looking at Exhibit 2, it can be clearly seen that a non-deductible IRA requires yearly reporting to the Internal Revenue Service while the other investment options require virtually no yearly recordkeeping. Only non-deductible IRAs and deferred annuities are subject to a penalty equal to 10% of the taxable amount for early withdrawal. A non-deductible IRA is the only investment option that has a cap on the amount that can be invested in any one year ($2,000).

Exhibit 2 also includes important informaltion regarding when distributions must begin. The chart indicates that the IRA is the only option where the taxpayer is required to begin receiving distributio ns at a specific age. Many taxpayers have found no need for the money and would have let the funds continue accumulating if they were not required to begin distributions at age 70-1/2.

A final issue which may concern high income taxpayers is the 15% excise tax on excess retirement distributions. The law requires that a 15% excise tax be paid on retirement distributions above a certain level. Therefore, if a taxpayer might be subject to this special tax, it would be preferred to avoid adding to the retirement moneys subject to the excise tax. Exhibit 2 reveals that IRA distributions may be considered when computing the excise tax, while the alternatives are not.


Clearly the non-deductible IRA leaves a lot to be desired. Some of the obvious drawbacks include the tax-penalty for early withdrawal, the $2,000 maximum amount that can be invested, the potential 15% excise tax and the required yearly reporting to the Internal Revenue Service.

This article has pointed out several viable alternatives to the non-deductible IRA. Many taxpayers will find that a deferred annuity, tax-free bonds, EE savings bonds, or some other investment opportunity will suit their needs better than a non-deductible IRA. The proper choice is best made by obtaining a thorough understanding of the investment options available and then matching the investment attributes to the taxpayer's needs.

(1) Stern, Jerrold J. "IRAs Under the TRA: A Tax Planning Analysis," The Tax Adviser, April, 1987.

(2) Coppage, Richard E. "IRAs After the Tax Reform Act: To Contribute or Not?" Taxation for Accountants, July, 1987.

Richard E. Coppage, CPA, is an associate professor of accountancy at the University of Louisville in Kentucky. His article have been published in the Journal of Accountancy, U.S. Tax Week and The Tax Adviser.

Sidney J. Baxendale, CPA is an associate professor of accountancy at the University of Louisville in Kentucky.
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Title Annotation:individual retirement accounts
Author:Coppage, Richard E.; Baxendale, Sidney J.
Publication:The National Public Accountant
Date:Jan 1, 1990
Previous Article:Super-frantic-unproductive-nothing-legislation.
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