Dear Dr. Don,
Can you contribute to a nondeductible IRA if you are already contributing $21,000 to your SEP IRA?
-- Penny Saved

Dear Penny,
Yes, a SEP IRA is treated as an employer-sponsored retirement plan and does not eliminate the opportunity to make a nondeductible IRA contribution. Essentially, anyone with at least $4,000 of income from employment can make a nondeductible contribution to an IRA account.

Making nondeductible contributions to an IRA account has become a popular retirement funding option for upper-income households since the passage of the Tax Prevention and Reconciliation Act of 2006. That act eliminates the income limit on taxpayers converting traditional IRA accounts to Roth IRA accounts starting in the 2010 tax year.

Bankrate's tax columnist, George Saenz, discussed this approach in greater depth in the column "Does nondeductible IRA make sense?"

Putting aside the Roth conversion option for a moment (Congress could change the law before 2010), remember that the primary tax benefit of a nondeductible IRA contribution is tax deferral on the growth.

However, since the growth will be taxed as ordinary income when it is distributed, taxpayers should also consider the possibility of investing in a taxable account as well. Investing in stocks in a taxable account allows qualified dividend income and long-term capital gains to be taxed at rates that may be substantially below your marginal federal tax rate for income.

Tax-efficient mutual funds can also manage the tax impact of investing in mutual funds. Your tax professional can help you decide between a taxable account and nondeductible contributions to a traditional IRA.

A key element in all these deliberations may be "tax diversification." If all saving is done through taxed-deferred accounts, such as 401(k)s and traditional IRAs, a sudden increase in the tax rate during the retirement years will either lower an individual's after-tax income or require larger distributions -- using up the nest egg more quickly.

The strategic use of Roth IRAs as well as taxable investment accounts can allow the retiree to have more options. Also, tax-deferred accounts are very inflexible if the taxpayer wants to make a large purchase or give a large gift. Any large withdrawal is treated as additional ordinary income, which can result in a higher marginal tax rate.

Thanks to David Littell, professor of taxation and the Joseph Boettner research chair at The American College in Bryn Mawr, Pa., for his assistance in answering this reader's question.

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