Traditional Versus Roth IRA Decisions
Roth retirement investment strategies have a 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.