Why an IRA Makes Sense Even If It Isn’t Tax Deductible

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 a Traditional IRA or a Roth IRA to build savings for retirement – or is it primarily seen as a tax deduction in the current year?…
Advertising Disclosure.

Advertiser Disclosure: Opinions, reviews, analyses & recommendations are the author’s alone. This article may contain links from our advertisers. For more information, please see our Advertising Policy.

The Military Wallet has partnered with CardRatings for our coverage of credit card products. The Military Wallet and CardRatings may receive a commission from card issuers. Some or all of the card offers that appear on The Military Wallet are from advertisers. Compensation may impact how and where card products appear, but does not affect our editors’ opinions or evaluations. The Military Wallet does not include all card companies or all available card offers.

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 a Traditional IRA or a Roth 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?


About Post Author

Get Instant Access
FREE Weekly Updates! Enter your information to join our mailing list.

Posted In:

The Military Wallet is a property of Three Creeks Media. Neither The Military Wallet nor Three Creeks Media are associated with or endorsed by the U.S. Departments of Defense or Veterans Affairs. The content on The Military Wallet is produced by Three Creeks Media, its partners, affiliates and contractors, any opinions or statements on The Military Wallet should not be attributed to the Dept. of Veterans Affairs, the Dept. of Defense or any governmental entity. If you have questions about Veteran programs offered through or by the Dept. of Veterans Affairs, please visit their website at va.gov. The content offered on The Military Wallet is for general informational purposes only and may not be relevant to any consumer’s specific situation, this content should not be construed as legal or financial advice. If you have questions of a specific nature consider consulting a financial professional, accountant or attorney to discuss. References to third-party products, rates and offers may change without notice.

Advertising Notice: The Military Wallet and Three Creeks Media, its parent and affiliate companies, may receive compensation through advertising placements on The Military Wallet; For any rankings or lists on this site, The Military Wallet may receive compensation from the companies being ranked and this compensation may affect how, where and in what order products and companies appear in the rankings and lists. If a ranking or list has a company noted to be a “partner” the indicated company is a corporate affiliate of The Military Wallet. No tables, rankings or lists are fully comprehensive and do not include all companies or available products.

Editorial Disclosure: Editorial content on The Military Wallet may include opinions. Any opinions are those of the author alone, and not those of an advertiser to the site nor of  The Military Wallet.