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Let's say for whatever reason, I can not take the income deduction for traditional IRA contributions. Also, I am not eligible for a Roth IRA. Perhaps my MAGI is too high.

In this case, if I contribute to a traditional IRA:

  • I'll have paid regular income tax on the money I put in (since I can not deduct it), and
  • I'll pay tax on gains when I take distributions as regular income.

Compared to an ordinary taxable account, this seems like not a great deal, since it doesn't get the benefit of the lower tax rate on capital gains and qualified dividends that a taxable account would.

Is there some additional advantage to the traditional IRA when an income deduction can not be made that I'm overlooking?

Phil Frost
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3 Answers3

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The most common use of non-deductible Traditional IRA contributions these days, as JoeTaxpayer mentioned, is as an intermediate step in a "backdoor Roth IRA contribution" -- contribute to a Traditional IRA and then immediately convert it to a Roth IRA, which, if you had no previous pre-tax money in Traditional or other IRAs, is a tax-free process that achieves the same result as a regular Roth IRA contribution except that there are no income limits. (This is something you should consider since you are unable to directly contribute to a Roth IRA due to income limits.)

Also, I want to note that your comparison is only true assuming you are holding tax-efficient assets, ones where you get taxed once at the end when you take it out. If you are holding tax-inefficient assets, like an interest-bearing CD or bond or a stock that regularly produces dividends, in a taxable account you would be taxed many times on that earnings, and that would be much worse than with the non-deductible Traditional IRA, where you would only be taxed once at the end when you take it out.

user102008
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The simplest answer is that you can convert the IRA to a Roth, and since it was already taxed, pay no tax on conversion.

If, in your hypothetical situation, you happen to have an IRA already in place, you are subject to pro-rata rules on conversions, e.g. your balance is total $40K, $10K 'not deducted', a conversion is 75% taxed, convert $20K and the tax is on $15K of that money. But, there also might be a time when you are able to transfer IRA money into a 401(k), effectively removing the pretax deposits, and leaving just post tax money for a free conversion.

JoeTaxpayer
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This is ideal placement for your allocation to income investments or those with nonqualified dividends: bonds, REITS, MLPS, other partnerships, and so forth. These are all taxed at income rate, generally throw off more income than capital gains, so you get the deferment without losing the cap gains rate.

user662852
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