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Roth IRA Conversion Calculator
Roth IRA Conversion Calculator
This is the first part of a three-part article on Roth retirement account contributions, Roth IRA contribution calculators, and traditional IRA to Roth IRA conversion calculators and strategies.
The Roth IRA Conversion Media Storm
The Roth IRA conversion and Roth 401k conversion media storm is in full swing. For some, converting traditional retirement account assets into Roth accounts can make sense and can be quite advantageous over a lifetime. For others, Roth conversions are not likely to be favorable to them financially.
Many cynical financial services industry product pushers have used the removal of the $100,000 Roth conversion income restriction for 2010 to develop a range of financial sales gimmicks. However, because only some people are likely to benefit at all from a Roth account conversion, this is an area in which individual investors should tread very carefully.
The only way to determine the answer that is appropriate for your family’s particular financial situation is to run the calculations that project your personal finances across your lifetime — with and without Roth retirement account contributions during your working years — and with or without conversions of your existing tradition IRA account assets. The Roth puzzle for asset conversions, as well as for annual Roth contributions during working years, is one of the most complex decisions that the ridiculously complex US taxation and retirement planning system forces upon individuals. It also creates significant analytical challenges for any well-intentioned financial advisor who attempts to serve individuals and their families, as a true financial planning fiduciary.
Many articles discuss the interplay between three variables: 1) current versus future tax rates, 2) avoiding the taxable “required minimum distribution” requirements of traditional IRAs and 401ks in retirement, and 3) the source and taxability of the available cash that would be needed to pay the up-front tax. While important, these three variables are just a subset of the myriad of personal finance factors that could come into play across a lifetime and that could affect the wisdom of a Roth conversion decision. Furthermore, depending upon an individual family financial planning situation, these three factors may not be the most important financial planning factors that would tip the Roth IRA conversion decision one way or the other for a particular family.
The remainder of this three-part article has various sections that can help you to develop a much better understanding of the Roth conversion decision. These sections also provide you with information about an extremely cost effective and highly functional lifetime financial planning software tool with Roth analysis functionality. This long-range family financial planning software tool provides fully integrated retirement planning software and allows you to do Roth annual contributions and one-time Roth conversion analysis within the context of your own family’s lifetime financial plan. It also allows you to develop your own highly automated lifetime financial plan.
For the average middle class American family, making the appropriate choice between Roth IRAs and traditional IRAs (and/or designated Roth 401k and 403b plans) could be worth tens of thousands of dollars over a lifetime. For some upper middle income earners with annual family incomes exceeding $100,000 per year, the lifetime value of the appropriate Roth retirement account decision could be worth hundreds of thousands of dollars over a lifetime. Yet, it is likely that only a minority of tax payers overall will benefit more by owning Roth retirement account assets rather than traditional retirement account assets.
However, those for whom Roth account assets make sense could obtain a financial benefit that would significantly increase their lifetime net worth. Furthermore, these people could accumulate substantial tax-free assets, which they could pass on to their heirs who, in turn, could also enjoy many years of additional tax-free asset growth. Yet many others, who might choose Roth account investments, would pay substantially more in income taxes at the outset and never realize a return on these higher initial tax expenditures over their lifetimes. For them, their Roth decision would reduce their lifetime net worth, and perhaps reduce their potential retirement assets substantially. Which of these two groups are you in, and what do you need to know to decide?
Roth retirement planning for IRA, 401k, and 403b retirement accounts
If you think that you understand all of the various factors that should be taken into consideration when approaching the “traditional versus Roth” retirement account decision, then you can skip this section and move on to the sections that follow. The sections that follow will focus on “how to” calculate the traditional versus Roth retirement account trade-offs for your family’s lifetime financial planning situation. However, if you would like to read more about these Roth trade-off factors, then you first might wish to spend time reading these articles and then come back to read the “how to” sections that follow.
Roth IRA Retirement Planning — This “IRA, 401k, and Roth IRA Retirement Planning” article summarizes the lifetime financial planning scenarios under which ongoing Roth account contributions and/or conversions of traditional tax-deferred retirement assets to Roth conversion IRA retirement account assets might become more advantageous. It discusses why only a minority of the population is likely to fit this profile. For the others, traditional tax-advantaged accounts contributions would tend to be preferable to Roth accounts in lifetime real dollar net present value terms.
Roth Retirement Plan Contributions — This two-part “Factors that tend to favor Roth tax-advantaged plan contributions (parts 1 and 2)” article provides additional and more detailed information about the factors discussed in the first article referenced above.
Roth Estate Planning Strategy — This “Roth Estate Planning Strategies” article summarizes what can be the icing on top of the cake for those who expect to be substantial retirement asset accumulators. A “higher saving – higher income” proportion of the individual investor population is more likely to build up a substantial estate. For these retirement asset accumulators, the significant tax advantages related Roth account inheritability can introduce an additional dimension to the analytical complexity. Despite the additional complexity, owning estate assets in Roth accounts would allow these retirement asset accumulators to pass on a significant portion their estate to heirs through Roth account inheritability provisions. Furthermore, these inherited Roth accounts would have some very appealing tax-free investment growth features for those heirs.
US Internal Revenue Service Retirement Plan Publications — If you have the time and tolerance, you can learn quite a lot about the retirement plan tax rules from US IRS publications. Here are the two primary publications to start with:
* Publication 560 — Retirement Plans for Small Business (SEP, SIMPLE and Qualified Plans)
* Publication 590 — Individual Retirement Arrangements (IRAs)
Just look for the link to “Publications” on the IRS site to find the .pdf documents that you can download. (Note that the retirement planning calculator software discussed below incorporates the primary federal retirement plan tax rules discussed in these documents. This lifetime investment calculator and retirement calculator software automates and hides the bulk of this retirement account rule complexity. This automation allows you to focus on decision analysis regarding your family’s financial security and lifetime financial planning choices.)
Avoid simplistic Roth IRA calculators
Sadly, the Roth conversion calculators that have been rushed to the market or provided on the Internet recently tend to be overly simplistic and unable to model comprehensively the lifetime financial affairs of your family. Simple tools just cannot model all the moving parts of the Roth retirement strategy decision across your lifetime. Why would any reasonably sophisticated person want to rely upon any software tool that did not measure all relevant factors that could affect their own interests with respect to Roth account contributions and Roth conversions?
The Roth decision dilemma for individuals is that it front-loads ordinary income tax payments — sometimes at quite high total local, state, and federal marginal income tax rates. Yet, the potential and uncertain payoff can only be realized years or decades into the future through tax savings during retirement. To make such an informed Roth account decision intelligently, you need to be convinced that it would likely pay off for your family. You need to have a clear, well-defined lifetime financial plan that you intend to pursue and sustain. Otherwise, making a yes or no decision on Roth accounts is like playing darts in a pitch black room!
With simple Roth conversion calculators, is it really a fair trade-off to users like you, when they lack state and local tax logic, ignore inflation adjustments, do not support differential asset allocation methods, etc. These are just a few of the things that many of the Roth conversion calculations on the market lack.
How about being able to project flexibly your lifetime earned income, passive income, living expenses, and extraordinary expenses in detail? All this matters in determining realistic savings rates, which are bound to vary year to year due to debt payments, housing purchases/changes, educational expenses, income changes, inheritances, etc. What about the differential impact of inflation on income, expenses, debts, taxes, and assets? What about all flavors of taxes (federal, state, and local income taxes, tax deductions, property taxes, Social Security taxes, Medicare taxes, self-employment taxes, short-term and long-term capital gains taxes, etc.)?
All these financial factors are moving parts that will affect your family’s lifetime financial plan. These factors and others will all affect the Roth equation for your particular lifetime financial situation. Whenever any financial decision has a distant payback that justifies near-term investment, what happens in the intervening years will impact that decision positively or negatively. Since you do not have a time machine and all crystal balls are completely opaque, all you can do is to model the decision with the best Roth IRA savings calculator that you can find.
Regarding the Roth account investment decision, if you are not likely to accumulate significant assets for retirement, then it will not matter to you how federal, state, and local marginal income tax rates might change or stay the same in the coming decades. What matters to you in these Roth versus traditional retirement account decisions is whether your family, in particular, will achieve a high enough taxable retirement income stream that would expose you to high enough future taxes to counterbalance having paid greater income taxes many years in the past.
To analyze this decision, you must have a comprehensive planning tool that models your lifetime cash flows related to income, expenses, savings rates, debts, tax deductions, federal state and local taxes of various types, real estate ownership, property, investments, etc. How can you realistically make an appropriate “none, some or all” Roth decision, if the simple software tool you are using does not even model the taxability your projected retirement income?
People might receive retirement income from a wide variety of sources, including Social Security income payments; earned income in retirement; pension income; annuity income; rental income; investment income from cash, bond, and equity assets (held in various proportions in taxable accounts, traditional tax-advantaged accounts, and Roth accounts — subject or not subject to ordinary income taxes, short-term and long-term capital gains taxes — with or without some level of accumulated asset tax basis), etc. Will your future income and the future taxes you would pay justify the front-end taxes required to make Roth account investment?
Roth IRA conversions calculators that you might find for free somewhere on the Internet may only model a few of the factors mentioned above. Inside will be a simplistic investment returns model and a bunch of group average assumptions. These online free Roth IRA investment calculators are designed to jump quickly through their cursory financial analytics to get on to the real purpose of such free retirement calculators. That purpose is to apply an analytical veneer to the front-end of an on-line financial product sales process. Most of these tools tend to lead the user into a sales process, where overly expensive financial products are sold that may not be in the best interests of the user of the tool.
Note that the financial services industry’s use of supposedly “free” online financial planning calculators to troll for retail customers in notorious. I have discussed these subjects elsewhere. Use these links to find more information in these lists of articles:
* Straight answers about personal financial and investment planning are difficult to find
* Controlling investment fees
* Financial advisor fees
* How can individual investors trust, when so much information about investing is rubbish?
Roth retirement investment strategies have a very long payback period
When financial planners, investment advisers, and brokers advise their clients to convert their traditional IRA assets into Roth assets or to make annual Roth contributions rather than make alternative tax-deductible retirement account contributions, are asking for a huge leap of faith. Such proposals suggest that it would more beneficial to pay relatively high total federal, state, and local marginal income taxes on ordinary income now for a greater reward in retirement. This is a lot to swallow for intelligent clients who have the sense to pause to evaluate the situation.
For example, it is hard enough to convince a financial client that it is in their best interests to pay long-term capital gains taxes at significantly lower tax rates than a Roth conversion, for the sake of diversification and portfolio risk reduction. Clients who have highly concentrated equity position often resist exiting them because of the accumulated long-term capital gains tax obligation. Some do not want to pay the taxes, even when the portfolio risk reduction logic is very strong. Some hesitate to pay the capital gains taxes, even when the primary bread winner draws the family’s paycheck from the same firm. But, if and when they do pay the capital gains taxes and sell out of their concentrated position, they can get the risk reduction benefits of diversification immediately.
The Roth decision is an even steeper hill to climb. Current ordinary income tax rates are even higher, and the benefit is not immediate. Offsetting tax reductions are only available in the (distant) future during retirement and these tax savings are uncertain. Furthermore, when modeled with a sophisticated financial projection software tool, you find that only a minority of families might find the Roth account hill to be a very profitable one to climb.
Since the correctness of the Roth decision can only be known in the longer-term future, the Roth account investment decision is one that you really do want to be verified with sophisticated projection modeling. You have no other choice, unless you have the aforementioned time machine or clear crystal ball. You could “just say no,” which would be the correct decision for the majority of people. But, what if you would be one of those higher income and higher asset accumulators in retirement? You could end up paying a lot more to Uncle Sam, have a lot less in retirement, and have a smaller estate to pass to your heirs.
In many US states, combined federal, state, and local marginal income tax rates for high income earners total well above 40% and are closing in on 50%. In deciding about near-term Roth conversions of traditional retirement account assets, these people now are holding two tax-deferred “birds-in-the-hand.” In effect, they are being asked to trade away one of those birds-in-the-hand, when they pay current taxes due on a Roth conversion. In exchange, they will hope eventually to have many more “entirely tax-free Roth birds” in the future during retirement, than they would have had on an after-tax basis were they to follow a traditional tax-deferred retirement account strategy.
To evaluate this trade-off reasonably, these people need to have sufficient faith in the quality of their lifetime financial planning decision to be willing to pay high taxes now and give away one of their tax-deferred “birds-in-the-hand.” The lifetime financial planning tool demonstrating the wisdom of such a move ought to be highly sophisticated, comprehensive, and fully customized. It certainly should fully capable of projecting that family’s particular financial situation over a lifetime. The software should be able to run a range of scenarios easily and convincingly, which demonstrate the wisdom of the Roth decision, particularly since the beneficial expected harvest could be decades into the future!
A $100,000 traditional IRA to Roth IRA conversion example
For example, if you are considering converting $100,000 of traditional IRA conversion to Roth conversion IRA assets without any accumulated tax basis into a Roth account, you could face a combined federal, state, and local income marginal income tax rate of about 45%. (For example, can you say “high earned income in California?”). With a 45% tax rate, you need to come up with $45,000 to pay the taxes for a $100,000 Roth conversion. The remaining $55,000 would grow tax free and not be taxed upon withdrawal or might even be passed to your heirs, if you do not need it. Would the future value of these Roth assets exceed the value of instead leaving that $100,000 in a traditional tax deferred account to grow and then face ordinary income taxes on required minimum distributions in retirement? This is the simplistic analysis.
What about the effect of reducing your taxable assets by $45,000 dollars to pay the taxes on the Roth? Instinctively, most people would say that this is a negative for their lifetime financial plan, because they now have fewer taxable assets. However, with $45,000 fewer taxable assets you would avoid decades of federal, state, and perhaps local tax payments on the taxable returns on those assets. Those taxes would have been paid from some other account of yours and would have reduced your long-term savings rate.
Without the taxes on this $45,000, you might have saved more and funded greater investments. Numerous other factors would also come into play, such as your investment asset allocation strategy, the costs of your investments, and the ongoing taxability of your investment assets, which is dependent upon the tax efficiency of your investments driven by your “investment tax location” strategy. In short, there are a large number of moving parts and variables that could and should be reflected in the model.
A very important “bottom line” conclusion here is that you simply cannot arrive at an optimal Roth investment strategy answer for your family’s situation, unless you first develop an optimal lifetime financial plan for your family. With that optimal plan as your baseline for comparison, you can then evaluate alternative scenarios that involve annual Roth contributions and/or near-term conversions of some or all of your traditional tax-advantaged assets into Roth retirement accounts. In isolation, a simple Roth conversion calculator is far more likely to arrive at an inappropriate decision. It is simply appalling how many personal finance decisions are made using trivial tools.
Would you be willing to pay $45,000 in taxes to do a $100,000 Roth conversion without first using a sophisticated lifetime financial planner software tool? Before making such a big financial decision, would you be willing to spend a few hours first developing a comprehensive financial plan for your family? What if your lifetime financial planning model indicated that your retirement income is more likely to be somewhat constrained and that your taxes in retirement would be relatively modest? Then, you would have a much more solid reason to avoid doing a Roth conversion, plus $45,000 would stay in your account rather than move to Uncle Sam’s coffers.
On the contrary, your comprehensive lifetime financial plan might indicate that, indeed, you could accumulate assets throughout your lifetime and would be much more likely to benefit substantially from doing such a Roth conversion. In that circumstance, you would have invested some hours of your time and a very small amount for software to develop a comprehensive financial plan for your family. As bi-product of this do-it-yourself financial planning effort, you would also understand far more about the implications of a variety of financial strategies for your family — including the wisdom of your decision about Roth investment accounts.
Do-it-yourself Roth IRA conversion analysis software
You might ask: “How I know this?” about optimal Roth IRA, Roth 401k, and Roth 403b decisions customized to the projected financial situations of particular families. The answer is that over the past five years, my company has developed and refined a sophisticated and automated lifetime projection modeling software tool, which is available very inexpensively for home use by individuals who want to develop a lifetime financial plan for their family.
Named VeriPlan — Lifetime Personal Finance Software, this best-in-class personal financial planning software hides the complexity of all the lifetime family financial projection factors that reasonably can be computed for you in the background. While hiding all this computational complexity, VeriPlan also allows the home PC user to change any and all financial data, assumptions, and modeling parameters and instantly develop a new projection scenario.
For the past four years, VeriPlan has had fully integrated Roth analysis features. These Roth analysis features were not just tacked on recently in response to the recent Roth IRA conversions media clamor. Roth tradeoff analysis features were planned and designed into the fundamental architecture of VeriPlan from the outset.
To learn more about VeriPlan, click here —> Personal Financial Planning Software to get to the front page of this website.
Sophisticated and comprehensive personal finance software for families in the real world
I also use the VeriPlan lifetime financial planning software to develop comprehensive financial plans for my financial planning clients. It is a very useful financial decision support tool for testing “what if” scenario alternatives with my clients during highly interactive financial planning meetings.
For several years I have used VeriPlan — including its traditional versus Roth asset analysis functionality — with my clients, when I develop comprehensive plans for them under contract. My ability to provide a fully integrated analysis of traditional retirement account versus Roth retirement account lifetime contributions and/or conversions is a rather straightforward part of the overall process of developing a comprehensive financial plan for each family. I am easily able to develop sophisticated plans and to evaluate quickly whatever alternatives my clients wish to consider. Because VeriPlan automates the complexity of long-term financial planning, we can focus on informed decision-making and evaluate a wide range of alternatives.
Since 2006, the VeriPlan lifetime financial planning software has included fully-integrated and automated functionality that allows the evaluation of Roth versus traditional IRA and 401k account trade-offs on an ordinary home computer. VeriPlan enables you to evaluate a conversion of some or all of your existing traditional IRA account assets into Roth account holdings. This comprehensive financial planner software also provides automated tools that allow you to determine whether traditional retirement plan contributions, Roth account contributions, or some combination of traditional and Roth contributions across the working lifetimes of you (and your spouse) would be more advantageous.
Furthermore, this flexible personal finance PC software can easily model the combination of both a long-term annual Roth contributions strategy plus any one-time decision about whether to convert into Roth accounts some or all of the traditional IRA, 401k, and/or 403b assets that you own currently. With these Roth analysis features, this highly customizable financial software tool automates the lifetime financial planning and decision-making process for individuals and for financial advisors who want to use it with clients.
As the designer of the VeriPlan Personal Financial Planning Software, I can tell you that VeriPlan’s Roth functionality was the last design overlay that was applied to VeriPlan, even though this functionality was planned from the outset in its software architecture. The rest of the software architecture had to be implemented, before all of the trade-offs associated with Roth account investments could be automated. This is simply because the return on a Roth investment decision can only be realized through substantial tax savings during retirement. Along the way toward your retirement and throughout your retirement, all of your other financial actions will affect the magnitude of these tax savings or whether you would realize any tax savings at all.
From my point-of-view, to analyze a lifetime Roth strategy decision with clients without a comprehensive tool like VeriPlan would be like putting a hand starter crank on a Mercedes. The Mercedes represents the richness of your family’s lifetime financial affairs — fully modeled and viewed holistically, using the VeriPlan automated lifetime cash flow projection modeling tool. The hand crank would be any disconnected financial tool that simply cannot reflect important differences between the financial lives of one family and another. Avoid making decisions about your family’s long-term financial welfare based upon simple tools that simply ignore your particular financial situation. Even a free hand crank is worthless with a Mercedes.
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