Q&A: non-deductible retirement contributions.

Q: The limit on how much I can contribute annually into my retirement account, on a deductible basis, is pretty low. Does it make sense to make contributions that are not tax deductible?

A: The short answer is, yes. Although additional contributions may have to come from after-tax income, the money contributed to your retirement account will earn and grow tax-free. Let's look at the tax-deferred income growth from an annual return point of view. In the table below, we show pre-tax equivalent returns of earning 8% in a tax-deferred account. The overall tax rate is an estimate of your total federal and state taxes.

The tax deferral enjoyed on income generated on after-tax retirement account contributions increases your comparable pre-tax return by 66% if you're in a 40% tax bracket, 54% in the 35% tax bracket, and 42% in the 30% tax bracket.

Your Overall   Annual   Pre-Tax          Bonus    Percent
Tax Rate       Return   Equivalent (1)   Return   Increase

40%            8%       13.3%            5.3%     66%
35%            8%       12.3%            4.3%     54%
30%            8%       11.4%            3.4%     43%

(1) Formula: Annual Return of 8% divided by 1.00 less tax rate
(0.40, 0.35, and 0.30).

The higher your tax bracket and tax rate, the more tax-advantageous it is for you to make voluntary contributions. Compare the 40% tax rate column (which yields a pre-equivalent return of 13.3%) with the 30% column (a pre-tax equivalent return of 11.4%). That's 1.9 more percentage points.

Note as well that if your investments earn more than 8%, your pre-tax equivalent return will be higher as well. For example, at the 35% tax rate, the 8% return is equivalent to a 12.3% pre-tax return. Increase the 8% return to 10% and your pre-tax equivalent return increases from 12.3% to 15.4% (10% return divided by .65). That represents an additional 3.1 percentage points on top of the 12.3% rate.

To further illustrate the value of making voluntary contributions, here is the total payoff if you annually invest an additional $2,000 per year into your retirement account (we assume the $2,000 IRA contribution is made at the end of the year).

# of Years                      Total Value at End
of $2K          Sum of the      of Term at 8%
Contributions   Contributions   Annually

10              $20,000         $28,973
20              $30,000         $54,304
30              $40,000         $91,524
40              $50,000         $146,212

Just as with tax-deductible retirement plan contributions, non-deductible contributions compound tax-free every year the money remains in your account. That's why they should be a significant part of your retirement planning.

The long answer? Well, there may be some situations where your excess cash could be better used by paying off high-interest debt, such as credit card debt. Talk to your financial advisor. But always remember: monies held in retirement accounts cannot be seized by creditors, even in bankruptcy. This is especially valuable to people, such as business owners, that take and bare risk.