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What is the difference between a Roth IRA and a nondeductible IRA?
-- Bob, Monroe, New Jersey
Let's start with how they're similar. Neither a nondeductible IRA nor a Roth IRA gets you a tax deduction for your contribution. So in both cases you are investing after-tax dollars.
And the contribution limits are the same as well.
These contribution limits also apply to traditional deductible IRAs. And, by the way, the limits are the max you can contribute to all types of IRAs combined in a single year, which, unfortunately, means you can't contribute the max to a Roth IRA, a deductible IRA and a nondeductible IRA.
But the similarities between nondeductible and Roth IRAs end there. After that, the differences between the two are huge.
Vive les differences!
The most important distinction is what happens to your money after you make your contribution. With a nondeductible IRA, your money compounds free of taxes as long as it remains in the account. But once you withdraw your money, your gains are not only taxed, they're taxed at ordinary income rates, which can now run as high as 35 percent.
That's true even if the gains in your account are long-term capital gains that would be taxed no higher than 15 percent if you earned those gains in a regular taxable account. Of course, only your gains are taxed, not your original principal, since even the government realizes that taxing that money twice wouldn't be fair.
With a Roth, on the other hand, you pay no tax on any part of your withdrawals, including gains. Which means you're earning a totally tax-free return. That gives a Roth a big -- no, make that a HUGE -- advantage over a nondeductible IRA.
Let's say, for example, you invest $3,000 to a Roth IRA this year and earn 8 percent per year for the next 20 years. At the end of that time, you would have $13,983 in your account, totally free from income taxes.
Had you invested that same three grand in a nondeductible IRA, on the other hand, you would have $13,983 in your account, but you would owe tax on the $10,983 gain. Assuming a 25 percent ordinary income tax rate, you would owe $2,746, leaving you with $11,237, much less than in the Roth.
That kind of difference can really add up when you're making many contributions over a period of many years.
Now, in this little example, I've assumed that in both cases you qualified for each type of account and kept your money in both accounts long enough to gain the full tax advantages of both accounts and avoid possible penalties.
In fact, there are a bunch of rules and regulations you must be sure not to run afoul of if you want to get the most out of such accounts. I won't go into them here because they're too damned long and boring, but for details on things such as income eligibility, withdrawal rules and such, click here. There's also a very good explanation of the ins and outs of Roth IRAs at the Guide to the Roth IRA at the Fairmark site.
Go for the Roth
Essentially, though, if you're looking for a place to stash long-term retirement savings, I can't think of a good reason to do a nondeductible IRA if you can do either a traditional IRA or Roth IRA. (For evaluating a traditional vs. Roth, click here.
In fact, I'm not that big a fan of nondeductible IRAs in general. Why? I don't like paying tax on my investment gains -- especially long-term capital gains -- at high ordinary-income tax rates.
So if you do a Roth IRA or a traditional IRA and you've funded your 401(k) and you still have money left over, I'd probably skip the nondeductible IRA and buy an investment such as some good growth stocks or tax-managed mutual funds that generate most of their returns through unrealized capital gains, or buildup in their share price.
This way, you're not taxed until you sell the investment -- which means until then you're effectively creating your own tax deferral -- and as long as you hold these investments more than a year, you qualify for long-term capital gains rates, which max out at 15 percent, a good 20 percentage points below the top rate on ordinary income.
So by all means consider a Roth or a traditional IRA. But I wouldn't be so quick to jump into a nondeductible IRA.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Mondays.