Tradition IRA (w/o tax break) vs index funds?

I exceed income limits for traditional IRA deduction but thought I'd open one to take advantage of long-term tax-deferred growth. However, a friend recommends investing in low-cost index funds in a taxable account, as capital gains taxes (currently) are only 15% and that withdrawls from an IRA later on will likely be at a greater rate than this (depending on my future tax bracket). Does this make sense? Is there something he's not factoring in?

I assume you exceed the limit for both a deductible IRA and a Roth IRA contribution.

What your friend suggests makes sense for several reasons. If you invest after-tax money in an index fund, the gain is going to be taxed as capital gains. However, it will not be tax-deferred, the gains will be distributed annually. Some of your gains are going to be short-term (taxed as ordinary income) and some long term (taxed at a maximum of 15%). You will have the flexibility to sell some of the fund and not pay a penalty.

There are other factors to consider in deciding between a nondeductible traditional IRA and an after-tax investment. In a nondeductible traditional IRA, any eventual withdrawals of the gain will be taxed as ordinary income. If your tax bracket at retirement is higher than the capital gains rate, you are paying more tax from the IRA.

Your age is also a factor. If you have enough years to let your IRA sit, eventually the period of tax-deferred growth is going to be a better deal for you than an after-tax investment (but it may be decades depending on your particular tax situation).

There is an option available for the next couple of years that is worth considering. You can contribute your $4k ($5k if age 50 or older) to the IRA, and then in 2010 you can roll it over, tax-free, to a Roth IRA regardless of your income. The income limits for a Roth rollover will be lifted for 2010 only, unless extended. Then as long as you wait five more years, qualified distributions from the Roth IRA will be tax-free.

He is correct. Today the capital gains tax rate is 15%. Since you are investing after tax income into a traditional IRA and are not getting any present tax advantage, does that mean that you will again pay taxes on that money when you withdraw it from your IRA? If so, then your tax bill will far out weigh the taxes due on a taxable account.

The only consideration is that the 15% capital gains rate may not stay. It may definitely change if there is a change in the White House next year. It seems that the Democrats do not like this at all.

Also, if you do not exceed the income limits for a Roth IRA, that is even better. Of course, an index fund inside the Roth might be the best.