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We've maxed out the 401(k) and aren't eligible for a Roth or traditional IRA. How else can we save?
September 23, 2005: 4:21 PM EDT
By Walter Updegrave, CNN/Money contributing columnist

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NEW YORK (CNN/Money) - I contribute the max to my 401(k) and my wife and I aren't eligible for a Roth or traditional IRA, so we're looking for additional ways to save for retirement. I know I can make a non-deductible contribution to an IRA, but I don't think that option make sense for me since the money will just be taxed as ordinary income when I withdraw it.

I'm thinking a better strategy would be to buy ETFs in a brokerage account and then hold them long-term so the gains are taxed at the 15 percent tax for long-term capital gains. In fact, I'm even considering investing borrowed money in ETFs to leverage my gain much the way people do by taking out a mortgage on their home. What do think -- is this a good way to go?

-- John Donaghey, Mill Valley, Calif.

I was with you right up until you brought buying on margin -- that is, investing borrowed money -- into the picture. Then you lost me.

Although I wouldn't say making nondeductible contributions to an IRA (or 401(k) for that matter) is a terrible thing to do -- it's certainly better than not saving the money at all -- I'm not a big fan of it for precisely the reason you point out. There are alternatives that offer the same potential for gain, but better tax treatment.

When you make a nondeductible contribution to an IRA, you eventually pay tax on the gains at ordinary income rates. Granted, you do get the benefit of avoiding taxes while your money remains in the IRA. But with ordinary income tax rates going as high as 35 percent these days, you can be giving up a pretty good share of your gains when you pull them out.

If you buy an investment that has the potential to deliver the major portion of its return in the form of long-term capital gains -- which is something most ETFs, index funds, tax-managed funds and even plain old growth stocks can do -- you reap the advantage of having the bulk of your investment gains taxed at the tax rate for long-term capital gains. And that can be a sizeable advantage since the maximum tax on long-term capital gains is now just 15 percent.

A significant difference in taxes

That difference in tax rates can translate to a significant chunk of extra cash. Let's say, for example, that next year you contribute $5,000 to a nondeductible IRA (the maximum $4,000 plus a $1,000 catch-up contribution for people 50 and older) and earn an annualized 8 percent on that contribution.

After 10 years, your five grand would have grown to $10,795. And for simplicity's sake, let's assume you withdraw that entire amount and pay tax at the maximum rate on ordinary income, 35 percent. So subtract $2,028 in taxes, and you've turned your $5,000 into $8,767 in spendable cash.

Now, let's suppose that instead of investing your five large in the nondeductible IRA, you put it into an ETF or tax-managed fund that earned the same 8 percent annual return and also paid its entire return in the form of long-term capital gains.

At the end of 10 years, your five thou would be worth $10,795, just as with the nondeductible IRA, except that instead of a 35 percent tax rate, you would face the top long-term capital gains tax rate of 15 percent. So in this case you would subtract $869 in taxes, leaving you with $9,926 in spending cash -- or $1,159 more than with the nondeductible IRA.

I don't know about you, but I'd rather have that $1,159 in my pocket than give it to the IRS.

Now, in the spirit of full disclosure, I want to note that in real life things might not turn out quite as splendidly as they did in the scenario above. It's possible that the ETF or tax-managed fund might deliver some of its gains in short-term capital gains, which are taxed at ordinary income rates. And there's always the chance that the gap between ordinary income rates and long-term capital gains rates could narrow, making ETFs or tax-managed funds less of a tax bargain.

There's no guarantee this strategy will work. But diversifying your tax exposure makes eminent sense to me. (For more on what I like to call "tax diversification," click here.)

Why risk it?

But why, oh why, do you want to take this perfectly nice sensible strategy and then put it at risk by borrowing? Oh sure, I know that taking out a mortgage is essentially leveraging your investment in your home.

But the difference is that your home lender won't give you a margin call if the value of your home drops. If you borrow for investment purposes, however, and the market value of your investments plummet, your broker will demand that you put more money into your account. And if you don't, the broker has the option of selling your investments right out from under you, which can lock in a loss.

All in all, while investing on margin can certainly magnify your returns -- assuming the investment's rate of return exceeds your borrowing costs -- it adds an element of timing and risk that I suppose could be appropriate for aggressive investors in some situations. But I don't think it's the type of strategy you want to use for your retirement money.

So go ahead with your ETF strategy -- after reading more about them at our ETF center -- but lose the borrowing notion. The money you save on taxes will be reward enough.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."  Top of page

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