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Nov 1990

Non-deductible IRAs. (individual retirement accounts)

by Bain, Craig E.

    Abstract- The alternatives to investing in non-deductible individual retirement accounts (IRA) include investments in taxable bonds, tax-exempt bonds, and tax-deferred bonds. All three alternatives defer taxes and allow funds to be accessed more easily. The taxable bond alternative should not be used if the investors are under 59 1/2 years of age, or if they must liquidate the IRA before retirement. The selection of the appropriate investment strategy depends on how the money will be withdrawn.

Clients need advice about investing in non-deductible IRAs. There are alternative investments that defer the taxes, but allow easier access to the funds. Three different types of fixed-return investments are compared in this article. If your clients have to liquidate the IRA anytime prior to retirement or if they are under 59 1/2 years of age, they should not use an IRA invested in taxable bonds. Giving up access to the investment, but having a larger retirement fund must be weighed against having immediate access to the fund without penalty.

Married individuals with adjusted gross incomes (AGI) over $50,000 cannot deduct any portion of the IRA investment if they participate in an employer-sponsored retirement plan. Individuals not eligible to make deductible contributions can make non-deductible IRA contributions, and the earnings on the investments are not subject to taxation until the funds are withdrawn.

There are alternative investments that also defer the taxes on the earnings, like the IRA, but allow easier access to funds. Would these alternatives make sense for your clients?

Individual Retirement Accounts

One of the most popular IRAs is a fixed-return investment such as a long-term CD or bond. Because IRAs are used to accumulate retirement funds, many people are interested in a fixed-dollar amount to be available upon retirement. IRA investments with variable returns, such as stocks, are included in this analysis only if the investor is willing to project a fixed average return.

An IRA account requires the investor to give up access to the funds unless a tax penalty of 10% on early distributions is paid. Those who wish to defer or avoid taxes on the earnings may be willing to give up the access to the account to get the tax deferral.

Other Options

Which fixed return investments, other than IRAs, can be made that avoid or defer the tax on the earnings? Two common investments are tax- exempt bonds (such as municipal bonds) and tax-deferred bonds (such as Series EE U.S. savings bonds). Tax-exempt bonds normally pay a lower rate of interest but the income is non-taxable. Tax-deferred bonds normally earn rates between taxable and tax-exempt bonds, but the income and tax are deferred until redemption.

One approach for deciding between tax-exempt and taxable bonds is to compare the after-tax earnings of the taxable bond with the earnings of the tax-exempt bond, and choose the one with higher earnings assuming everything else, such as risk, is equal. If the taxpayer is in the 28% marginal tax bracket, multiplying the interest rate of the taxable bond by 72% will make it comparable with the tax-exempt bond. The investor then chooses the bond with the higher rate of return. Add the effective state tax rate for your state if it is a factor.

Comparing the taxable bond or the tax-exempt bond with a bond that defers the interest is more difficult, and the use of a spreadsheet program is necessary.

An Example

Assume your married clients wish to invest in a retirement plan, but are active in their companies' pension plans and are above the $50,000 AGI level. They can invest $4,000 a year ($2,000 each) in non-deductible IRAs or other programs for their retirement. Their objective is to have the largest possible amount of cash available or the largest possible annuity for a 10-year period after they retire 20 years from now. Should they invest in taxable bonds (through an IRA), tax-exempt bonds, or tax- deferred bonds?

For this example, average current interest rates are used for each type of investment and only federal income taxes are considered. If applicable, state income tax rates could be added. While the interest and tax rates will change, they usually change in tandem with each other.

Taxable Bonds. If your clients open IRAs, they can defer the interest earned on their bonds until they withdraw funds from the accounts. One major disadvantage of an IRA however, is the 10% penalty for withdrawing funds prior to reaching age 59 1/2. Assuming your clients decide to invest $4,000 annually in corporate taxable bonds at an average current rate of 10%, they would have $252,010 cash available when they retire in 20 years. Your clients can leave the investment in the bond fund (at 10%) and withdraw an annuity of $41,014 a year for 10 years as shown in Part A in Table 1.

If they liquidate the fund at the end of 20 years or take an annuity for 10 years, all of the interest is taxable at the then current rates. An electronic spreadsheet program enables you to easily change any of the parameters (interest rates, amount invested, number of periods, etc.) and determine the results to more effectively advise your clients.

Tax-Exempt Bonds. Instead of using IRAs to defer the tax on the interest, clients could invest in tax-exempt bonds and reinvest the interest in tax-exempt bonds for the next 20 years. Using an average rate of 7.5% for municipal bond funds, they would have $186,210 cash available when they retire in 20 years, as shown in Part B of Table 1. The clients could liquidate the fund taking $186,210 at the end of 20 years or take an annuity of $27,128 for 10 additional years. None of the funds in the account are taxable. The amount available is less than the amount available from the taxable bonds through an IRA. However, the tax on withdrawal of interest on the taxable bonds still must be considered. Also, the clients could have withdrawn funds from their tax-exempt account without incurring the 10% penalty on early withdrawal from an IRA.

Tax-Deferred Bonds. If your clients invest in tax-deferred bonds, the tax on the interest earned will be deferred until the funds are withdrawn and funds can be withdrawn at any time without a surcharge or penalty. Using an average rate of interest of 7.85% on Series EE U.S. savings bonds, they would have $194,167 available when they retire, as shown in Part C of Table 1.

The clients could liquidate the fund taking $194,167 at the end of 20 years. However, $114,167 would be taxable at the then current rates. The clients could withdraw an annuity of $28,741 for 10 years after retirement and the interest portion would be taxable at the then current rates.

Choosing the Best Alternative

Which of these alternatives is best? Comparing the three alternatives involves making an assumption regarding how the money would be withdrawn from the various investment accounts. Table 2 shows a comparison of the three alternatives under two assumptions: 1) a lump-sum settlement at the end of 20 years; or 2) an annuity for the following 10 years.

Under the first assumption, all of the money would be withdrawn from the account and the appropriate taxes paid. Assuming the tax rate is 28%, the taxable bonds purchased through an IRA account would be the superior investment. The $203,847 available after the tax payment is $17,637 higher than the tax-exempt bonds and $41,646 higher than the tax-deferred bonds.

Under assumption two, an annuity amount is withdrawn at the end of each year for 10 years to liquidate the investments. The portion not taxable (the $80,000 investment divided by 10 years of the annuity for the taxable and the tax-deferred bonds) is deducted and taxes are paid on the balance of the cash withdrawn. Again, the IRA with taxable bonds is better, resulting in $4,642 more per year than the tax-exempt ($46,410 in total), and $8,836 more than the tax-deferred bonds ($88,350 in total).

Why the difference? The primary reason is compound interest. The growth of the fund from compounding at 10% is greater than the additional taxes that will be paid starting in 20 years.

Other Considerations

Clients investing in an IRA, however, are giving up access to the fund until they are 59 1/2, unless they pay the 10% penalty for early distributions. You can determine at what point the client could withdraw cash from the IRA, pay the penalty, and still be better off than under the tax-exempt or the tax-deferred plans. Using the data from Part A of Table 1, assume the account was liquidated at the end of any of the 20 years. The results are shown in Table 3.

The "NET AMOUNT" column shows the amount of cash available after paying the tax on the interest earned to that date and the 10% penalty tax for early withdrawals.

The analysis calculating the liquidation value of the tax-deferred investment previously calculated in Part C of Table 1 but now subject to income taxes, is reported in Table 4.

The "NET AMOUNT" column shows the amount of cash available after paying the tax on the interest earned.

The liquidation value of the tax-exempt bonds is the same as the "END- OF-YEAR BALANCE" column in Part B of Table 1, as there is no tax or penalty on withdrawing funds from the account.

Table 5 shows a comparison of the liquidation values at the end of each year for all three types of investment accounts.

If your clients need to liquidate the account anytime prior to year 20 and are under 59 1/2, they are better off not using the IRA with the taxable bond investment. Instead, they should invest in the tax-exempt bonds. At the end of year 20, however, the liquidation value of the IRA with taxable bonds, even with the 10% penalty, is greater than the other two investments. The 10 percent penalty of $17,201 on the IRA account in year 20 is almost equal to the $17,607 benefit derived from compounding at a higher rate. This reinforces the concept that IRAs are best suited for retirement purposes and should not be funded with assets that may be needed prior to retirement. If the clients are more than 20 years from retirement, this could influence their decision as to which type of retirement fund to start.

Although there is no penalty for liquidating the tax-deferred bond investment, the liquidation value is never as high as the tax-exempt bonds or the taxable bonds in the IRA because the interest rates are nearly equal. Most clients will be better off investing in tax-exempt bonds than tax-deferred bonds when the interest rates are approximately the same.


Using electronic spreadsheets to perform the investment analysis, (Lotus 1-2-3 in this article) enables the financial planner to more effectively advise clients on alternative investments. In this example, three different types of fixed return investments are compared and based on the analysis, the clients can then choose the one that best fits their needs. Giving up access to the investment, but having a larger retirement fund (as with an IRA) must be weighed against having a smaller retirement fund and having immediate access to the fund balance without penalty. Tabular Data 1 to 5 Omitted

Gordon D. Pirrong, DBA, Associate Professor of Accounting, Boise State University, Boise, ID, and Craig E. Bain, PhD, Assistant Professor of Accounting, Boise State University, Boise, ID

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