Most people regard themselves as being in this situation. You are allowed to contribute into your 401k or IRA account and defer taxes, and you expect to keep the money there until you retire. Even if you need to take the money out early, you can do this without penalty if you are in a serious situation, such as disability.

Fortunately, this is a relatively easy situation to calculate. Because the money you contribute avoids initial taxes, it is the same formula as that of a tax free bond. Table 1 shows the equivalent interest rates for investing at various rates. In this and subsequent calculations, the tax rate is assumed to be 28%. The effect of state income tax is not taken into account.

                    i n t e r e s t   r a t e s
                  -------------------------------
investment rate      8.0%      9.0%     10.0% 
 
equivalent rate     11.1%     12.5%     13.9% 
 
  Table 1.  Equivalent interest rate for deductible IRA with no penalty at withdrawal
            28% tax bracket

If your investment returns 8%, then your equivalent return is 11.1%. This means that you would have to look for a bank certificate of deposit (CD) that pays 11.1% to do as well as an IRA account that offers 8%. You get a much higher return in trade for having to wait until you retire to use the money.

Non-tax deductible contribution, no penalty at withdrawal

You are in this situation if your workplace has a pension plan and you make so much money at work ($35,000 if single, ridiculously complicated if married) that the IRS does not allow you to deduct any IRA contributions from your taxes. Is it still worth it to put money into an IRA anyway? Table 2 seems to imply yes. If you contribute to an IRA that pays 8%, then withdraw it with no penalty 15 years later, it has an equivalent yield of 9.0%. It sounds worthwhile, but you endure a major inconvenience for little gain. In this situation, it probably makes more sense to invest fully in your work 401k plan and forget about a non-deductible IRA.

   years   i n v e s t m e n t   i n t e r e s t   r a t e s
           -------------------------------------------------
                8.0%      9.0%     10.0%
 
      5         8.3%      9.4%     10.5%
     10         8.7%      9.9%     11.0%
     15         9.0%     10.2%     11.5%
     20         9.3%     10.5%     11.8%
     25         9.5%     10.8%     12.1%
     30         9.7%     11.0%     12.3%

  Table 2.  Equivalent interest rate for nondeductible IRA with no penalty at withdrawal
            28% tax bracket

Tax deductible contribution, 10% penalty at withdrawal

In this case, you put money into your IRA account then decide to remove it before age 59.5 for a non-crisis reason. Table 3 shows that money in an 8% account would get only 6.7% if removed after 5 years. However, it would get 8.9% if kept in the IRA for 10 years. This means that if you want to save for a purchase to be made 10 years from now, then it is slightly more lucrative to put the money in an IRA. Also, you can think of your IRA as an emergency fund, as long as you anticipate your emergencies to be few and far between.

   years   i n v e s t m e n t   i n t e r e s t   r a t e s
           -------------------------------------------------
                8.0%      9.0%     10.0%
 
      5         6.7%      8.0%      9.4%
     10         8.9%     10.3%     11.6%
     15         9.6%     11.0%     12.4%
     20        10.0%     11.4%     12.8%
     25        10.2%     11.6%     13.0%
     30        10.4%     11.7%     13.1%

  Table 3.  Equivalent interest rate for deductible IRA with a 10% penalty at withdrawal
            28% tax bracket

Warning: some states have their own penalty for early withdrawal of IRA accounts.

Non-tax deductible contribution, 10% penalty at withdrawal

If you are in this situation, then you put money into an IRA account even though you made too much at work to get the contribution deducted from your taxes. Then you needed to withdraw the money early and got hit with a penalty. This just isn't your day.

Table 4 shows what kind of return you can expect. If your investment yields 8%, then you will need at least 15 years before your investment looks as good as a conventional 8% investment. Even if you wait 30 years, you will get only 9.0%.

   years   i n v e s t m e n t   i n t e r e s t   r a t e s
           -------------------------------------------------
                8.0%      9.0%     10.0%
 
      5         7.3%      8.2%      9.2%
     10         7.7%      8.8%      9.9%
     15         8.1%      9.3%     10.5%
     20         8.5%      9.7%     10.9%
     25         8.8%     10.0%     11.3%
     30         9.0%     10.3%     11.6%

  Table 4.  Equivalent interest rate for nondeductible IRA with a 10% penalty at withdrawal
            28% tax bracket

In conclusion, if you want to invest in a non-deductible IRA and you have even a hunch that you will have to withdraw the money early, it is probably not worth it.

Final comments

These calculations are done for only a few of the possible situations that people may encounter. Typically, people contribute to a retirement plan over decades, not in a single year. Also, many people are not in the 28% tax bracket. If you are in the 15% bracket, then IRA accounts are not nearly as attractive. Do not forget your state tax bracket and possible state early withdrawal penalty.

In general, you should not bother with IRA contributions if they will not be deductible or they will be withdrawn early with a penalty.

If you are interested in situations slightly different than in the above tables and do not want to interpolate, the computer software is available free, but with no warranty.

You may email questions and comments to alacrity@getrichslow.com

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