Since we just made our IRA contributions for 2007 recently and had made a few mutual fund exchanges, I figured this was a good time to post another portfolio snapshot. Since we have so many different accounts now, I changed the presentation layout a bit to clean things up.

Contribution Details
Through the end of 2007, we maxed out the salary contributions of both of our 401k/403b plans and put in $15,500 each. We didn’t qualify for a Roth IRA contribution in 2007, but after exploring the options of a non-deductible contribution to a Traditional IRA, we decided to go for it and put in $4,000 each in early April. For 2008, my wife has contributed about $5,000 so far to her 403b and is on track to max out again. I’m lagging a bit behind, but should catch up later in the year.

YTD Performance
The 2008 year-to-date time-weighted performance of my personal portfolio is -1.96% as of 4/18/08. Although not necessarily a benchmark, the Vanguard S&P 500 Fund has returned -4.77% YTD, their FTSE All World Ex-US fund has returned –3.47% YTD, and their Total Bond Index fund has returned 1.32% YTD as of 4/18/08.

Portfolio Construction Details
We followed the general asset allocation plan outlined here. I went ahead and moved forward to a 85% stocks/15% bonds split since I base it on the formula [115-Age] and I’ll be turning 30 in a few months. Here is an example of how we implemented the asset allocation across multiple accounts, although I’ve since moved some funds around. It’s definitely not an exact science, we just did the best we could with the fund choices available.

You can view all my previous portfolio snapshots here.

Continued from Part 1: Future Roth IRA Rollover. Now we’ll consider what happens if we don’t convert to a Roth.

To recap, an non-deductible IRA everything is the same as a Traditional IRA except that the initial contribution is not tax-deductible. This means that it grows tax free, but all earnings (dividends + capital gains) are taxed as ordinary income upon withdrawal. The original contribution isn’t taxed again.

This is in contrast to regular taxable account, where you can defer taxes on capital gains until you sell. Currently, if you hold stocks or bonds for at least a year before selling, you’ll be taxed at the long-term capital gains (LTCG) rate of 15% or less. Qualified dividends are taxed when received, but are also currently taxed 15% or less. Non-qualified dividends such as from bonds or REITs are taxed as ordinary income.

So which one’s better? I decided to run a few sample scenarios to find out. Here is the IRA scenario spreadsheet I used, which you can play with as well. I’ll be assuming that current tax rules stay the same when you withdraw, which is almost guaranteed not to be the case, but hopefully we’ll get something out of it.

Assumptions
Initial Balance: $4,000 after-tax
Ordinary income tax rate: 25%
Dividend tax rate: 15%
Time Horizon: Lump-sum withdrawal after 30 years

Scenario #1: Buy-and-Hold With Stock Index Funds
Let’s say you invest in an S&P 500 index fund, with very low turnover. You buy and hold until withdrawal. Total annual return is 8%, with 2% being in dividends each year. With a non-deductible IRA, it keeps growing as gets taxed at the end. After 30 years, you’ll end up with $31,188.

With a taxable account, you’ll get taxed 15% on those dividends every year, but the rest is accumulated as long-term capital gains. Upon selling it and paying 15% on those gains, you end up with $32,834. Taxable wins by $1,646 (5%).

If you lower the ordinary tax rate to 15%, then the non-deductible IRA wins by $1,979 ($34,813 vs. $32,834). If you raise your ordinary tax rate to 30%, then the taxable account wins loses by $3459 ($29,375 vs. $32,834). In general, taxable wins out when your tax rate at withdrawal is about 21%.

Scenario #2: Active Trading With Stocks or Stock Funds
Now if you have lots of buying and selling in your portfolio, then you’ll be subject to short-term capital gains every year. Here, if you assume 100% turnover (holding stocks for just under a year) and you still earn 8% annually, taxable will never win regardless of ordinary tax rates. Even at 9% return in taxable vs. 8% return in IRA. The yearly drag of taxes kills your returns, so you should probably seek the shelter of a IRA if you plan on investing in moderate-to-high turnover funds.

Scenario #3: Buy-and-Hold With Bonds or REIT Funds
Holding a bond fund or REIT (real estate) fund is actually similar to Scenario #2, because most of the earnings from bonds and REITs are due to their interest yield or dividend distributions, and those are taxed at the higher ordinary income rates.

Let’s say you have an REIT fund that also gains 8% annually, and 100% of it’s gains are in the form of unqualified dividends. (REITs have a historical average yield of about 6-8%)

At 25% income tax rates, the taxable account just can’t keep up with an final value of $22,974 vs. $31,188 from the non-deductible IRA. That’s a 35% increase in value by going with the IRA. As income tax rate rises, the IRA’s advantage increases. A similar result occurs for bonds, although the difference is smaller due to lower expected returns.

Liquidity or Early Withdrawal Concerns
A significant advantage of taxable accounts is that you can choose to access, or not access, the funds at any time. With an IRA, with a few exceptions you have to wait until age 59.5 to make a withdrawal without penalties. In addition, you’ll be required to make minimum distributions starting at age 70.5 even if you don’t need to. Some early retirees or those that want to leave a legacy might want to just stick with a taxable account.

Summary
Again, all of these are based on guesses as to what future tax laws will be, but for now my very general summary is:

• IRAs have less liquidity and more restrictions in general. So if the expected net returns are equal, I’d pick the taxable account.
• For low-turnover stock portfolios and index funds, the non-deductible IRA might lose out to a taxable account, but not by all that much. As your trading frequency increases, the taxable account gets less and less attractive. On the flip side, a tax-managed mutual fund might make things sway back in favor of the taxable.
• If you plan on holding any significant amount of REITs, bonds, or other tax-inefficient investments, then a non-deductible IRA can have significant tax advantages over holding them in a taxable account.

Since I do have holdings of bonds and REITs in my portfolio and need all the tax-deferred space I can get, it looks like I’ll be contributing to a non-deductible IRA before the April 15th deadline.

As we’ve seen, after you reach a certain income, both Roth IRAs and tax-deductible contributions to Traditional IRAs are no longer available. After you max out your 401(k) or 403(b) plan at $15,500 per year, you start running out of tax-advantaged accounts quickly. One option is to contribute to a Traditional IRA anyways, even though the contribution will not be tax-deductible. Everything else is the same: your money will still grow tax-free, and withdrawals will be taxed at your ordinary income tax rate. You can sock away $4,000 for 2007 and $5,000 for 2008. So should you do it? I have less than three weeks before I need to decide!

There appear to be two primary ways to answer this question:

1. Future Roth Rollover. In 2010, there will no longer be any income restrictions for Traditional-to-Roth IRA rollovers. Could this mean Roth IRAs for everyone?
2. Compare Returns vs. Taxable Account. If you either can’t or don’t wish to convert to a Roth, will your performance at least be better than a regular taxable account?

Future Roth IRA Rollover

According to current laws, in 2010 the income restriction for Traditional-to-Roth IRA rollover will disappear. Since you’ve already paid taxes on your non-deductible IRA contributions, you will only have to pay income tax on the earning portion when you rollover. This can be seen as effectively allowing you a way to contribute to a Roth IRA down the road. Now, instead of having to pay ordinary taxes upon withdrawal, I don’t have to pay any taxes! I even avoid required minimum distributions.

Catch #1: The Law May Change
I have seen no indication that this Roth “back door” was intentional. Some people see this as simply an oversight that a busy (or lazy) Congress simply hasn’t gotten around to changing… yet. For example, the current low 15% long-term capital gains rate is also scheduled to go up in 2011. Others think that the lure of tax revenue now gained through Roth conversions might be appealing and they’ll let it stay. Now I’ve waited until the last minute to make my decision and it’s almost mid-2008, and nothing has changed, so maybe it’ll happen…

Catch #2: Mixing Deductible and Non-Deductible Contributions
Let’s say you have $10,000 in a Traditional IRA, $4,000 of which was a non-deductible contribution, and $6,000 of which was deductible contributions and earnings within the IRA. If you wanted to convert $4,000 of it over to a Roth IRA, you can’t simply pick out the non-deductible contribution. The $4,000 would be pro-rated to be 40% non-taxable and 60% taxable, in the same proportions as your total IRA.
The only way to convert all of your non-deductible contributions would be to convert everything together, which might not be ideal.

One way around this is to first roll over your deductible IRA money into another qualified retirement plan like your 401(k) if they allow such transfers (and you like your investment options). Then make your non-deductible IRA contribution. That way, the deductible and non-deductible parts can be separated. I don’t have any deductible IRA funds, but I think I could rollover into my Solo 401(k) if desired.

Catch #3: More Paperwork
If you make non-deductible contributions, conversions, or withdrawals you must document them each year using with IRS Form 8606. It’s probably a good idea to simply file the form every year so that you don’t end up forgetting and having to pay extra taxes later.

In general, I think the Roth conversion option is great if it’s available, but I am still not convinced it will still be around in 2010. So I’d better make sure that’s a non-deductible IRA is still a decent deal even without that option. To be continued in Part 2…