by Archie M. Richards, Jr., CFP^®
May 8, 2006

Deductible retirement plans and traditional IRAs aren't as great as most people think.

Here's a comparison between two hypothetical accounts: a traditional IRA and a non-retirement account:

IRA: Beginning at age 46, you set aside $4,000 a year in a traditional IRA. The money compounds at 10 percent a year. Twenty-five years later, when withdrawals are required to begin at age 70½, the IRA is worth $393,388.

Every penny of this is subject to tax on withdrawal. The initial required withdrawal is $14,845.

What's the tax rate? Well, taxable income in a joint account must attain a whopping $336,550 for the top 35 percent tax rate to apply. Since the required withdrawals in this hypothetical IRA are smaller, we assume an applicable federal tax rate of only 25 percent. This we apply to the ending value of $393,388.

After a reduction of 25 percent, $295,041 remains.

Non-IRA: You want to invest $4,000 a year outside of an IRA. Since no deduction may be taken, each $4,000 of income is first reduced by tax. At the 25 percent bracket, $4,000 is cut to $3,000, which you invest each year in a regular investment account to accumulate for 25 years.

The pre-tax rate of return is the same as for the IRA - 10 percent a year. We assume a tax rate of 15 percent, on the assumption that the investments are held for at least a year, generating long-term gains. Other tax ingredients we count as a wash. Short-term gains, bond interest, and REIT dividends are taxed at 25 percent. But some stocks are held for many years, providing a tax-deferred compounding effect. On balance, a 15 percent tax seems about right. The net, after-tax, annual rate of return is thereby reduced from 10 percent to 8.5 percent.

Okay, the $3,000 annual additions to the non-retirement account compound at 8.5 percent a year for 25 years. The ending value is $236,003, which is available for spending.

To summarize, the ending amount available in the IRA, after tax, is $295,041. In the non-retirement account, the amount available is $236,003, with no further tax. The IRA is 25 percent better.

But several disadvantages of retirement plans don't show up in the above illustration:

• The operating costs of many 401k plans are something like 2 percent higher than the costs of outside investments. Right there, the advantage of 401k plans with no employer matching disappears altogether.

• Inside all retirement plans, rapid trading has no tax disadvantage. Brokers can say to one another, "Go get 'em, tiger. Let's trade!" Many individuals and institutions trade too rapidly in retirement plans. Commission costs and trading losses reduce the returns substantially.

• Retirement plans are not entitled to a stepped-up basis at death. The beneficiaries must pay tax at ordinary rates on all withdrawals. But in non-retirement accounts, the capital gains on securities held at the owner's death are never taxed to anyone. Their tax costs are "stepped up" to the date-of-death values. If the assets are sold at those prices, no gains or losses result.

• IRAs are subject to an immensity of rules, especially regarding their inheritance. Paying advisors who know the rules cuts the net returns.

After factoring in these elements, traditional IRAs and retirement plans don't seem all that hot to me.

Under the following circumstances, however, use a retirement plan anyway:

• If having your money in a retirement plan is the only way to avoid spending it, go with the retirement plan.

• If your employer matches your contributions to a retirement plan, take maximum advantage. Employer matching is like picking up money off the street.

But in general, deductible retirement plans and traditional IRAs don't turn me on. They're a pain in the neck.

Thanks to Mark A. Burns, CPA, of Southbury, Connecticut, for reviewing the intricacies of this column. It has his approval, except that he's more prone to favor deductible plans than I am.