by Dr. Gobind Daryanani
The following copyrighted article is available exclusively on the Roth IRA Web Site:
It's hard to keep up with the abundance of Roth IRA Calculators (close to 50) now available on the world wide web. However, the many calculators naturally fall into a small number of classes. This article categorizes the web-based free calculators and defines the features and pitfalls of each of these classes.
Category A: Lump Sum Calculators
The most common free web calculator is the lump sum calculator. The term lump sum refers to the assumption that all of the funds are withdrawn in the year of retirement, in one lump sum. In this category of calculators you enter your current IRA assets, your annual contribution, current tax rate, retirement tax rate, years to retirement and assets growth rate. The calculator will compare the assets you have at retirement age if you left the funds in a Traditional IRA versus if you converted to a Roth IRA.
Most calculators will give you a choice of paying conversion taxes from an outside fund or from within the IRA. In the case of the Traditional IRA analysis, these outside funds (also called opportunity lost $) are kept in a taxable account and are added to the Traditional IRA asset at the time of withdrawal—this is to provide a fair comparison with the Roth IRA analysis. An alternate approach used by some calculators is to subtract the opportunity lost dollars from the ending Roth IRA asset. The results from this group of calculators are similar. The one difference in result depends on whether the opportunity lost dollars are added to the Traditional IRA account or subtracted from the Roth IRA account. The most common approach is to add to the Traditional IRA account. The results from different lump sum calculators (that add opportunity lost dollars) are all very close. The calculators that subtract the opportunity lost dollars show lower asset values.
Most of the calculators will give you a choice of paying conversion taxes over 4 years or in one year. Note that the Technical Corrections Act of 1998, which was passed by the House and the Senate, allows one to pay all the taxes in 1998 or take a 4-year spread.
An advantage of the lump sum calculator is that they are easy to program and are well suited to a web-based on-line application. But this simplification comes at the expense of a number of pitfalls. First, very few people will withdraw all their funds in one year—thus it does not reflect most real-life situations. A related problem is the selection of withdrawal tax rate. If you are going to withdraw all assets in one lump sum, the withdrawal tax rate entered will have to be increased to reflect the size of the withdrawal. For example, a $200,000 lump sum withdrawal will need to use an average tax rate of 37% (for Federal plus State tax, assuming a 5% state tax).
A second problem is that these calculators do not consider minimum required distributions (MRDs). Ignoring MRDs make the Traditional IRA look better. Thus, the difference between the Roth IRA and the Traditional IRA appears to be much smaller than if you had considered MRDs. Another way of saying this is that the lump sum calculators give you a conservative (low) view of the advantage of the Roth IRA. What this means is that if the lump sum calculator suggests a 10% advantage with the Roth IRA, a higher end, MRD-based calculator will indicate a greater difference (in the range of 15% to 20%, depending on the assumptions). Thus the lump sum calculators understate the value of the Roth IRA.
The following is a non-exhaustive list of companies' web sites that use lump sum
calculators: www.schwab.com, www.fidelity.com, www.clark.com, www.datachimp.com,
www.vanguard.com, www.strong-funds.com, www.aim.com, www.martial.com, www.dreyfus.com,
www.marshall.com, www.numen-lumen.com, www.invesco.com, www.finplan.com, www.etrade.com,
and www.statefarm.com.
(Click here for Roth IRA Web Site links to lump sum
calculators.)
In summary, it is possible to use the lump sum calculators to get a direction: to use the Roth IRA or not. The value of the Roth IRA account will be correct. However, the value of the Traditional IRA will not be as accurate as a more realistic minimum distribution based calculator. Lump sum calculators will suggest a conservative benefit for the Roth IRA.
Category B: Flat Annuity Calculators
The second class of free calculators uses an annuity model for comparing assets. The additional question they ask is "Over how many years do you want to withdraw the IRA/Roth assets?" These calculators start with the assets that you would have at retirement and calculate the fixed amount that you would get per year, so that your assets are totally depleted at the end of the desired period. So, if you enter a 20-year period for the withdrawals, the calculator will tell you the flat amount you would get for each of the 20 years for the Roth versus the Traditional IRA case. The calculations are more difficult. Remember that the assets are growing at some rate that you have specified during the withdrawal years; and the program has to include this in the calculation of the fixed annual withdrawal that will reduce the account to exactly $0 at the end of the 20 years. This annuity model is representative of how most people will be withdrawing funds and is a more realistic approach than the lump sum model.
The free annuity-based calculators available on the web do not include minimum required distributions. If your annuity is larger than the minimum required withdrawal, the annuity-based calculator will provide you with the correct withdrawal amount. In general, if your withdrawals start at age 65 and the annuity period is 20 years, the non-MRD annuity calculator will provide correct withdrawal amounts.
However, if you choose a long withdrawal period (say 25 or more years), or if your annuity withdrawals start after age 70½, the annuity calculators that do not consider MRDs will indicate a greater asset value for the Traditional IRA withdrawals than the more accurate MRD based calculators. In this case, again, the Roth IRA advantage will be understated.
Note that the annuity-based calculator can be reduced to a lump sum calculator by setting the annuity period to 1. So, you can use the annuity calculator to obtain the asset value with a lump sum withdrawal.
A discrepancy of the annuity-based calculators is that they all assume a flat withdrawal amount. In reality, most people will want to withdraw a gradually increasing amount each year to keep up with inflation. If you consider a 20-year withdrawal the buying power of $30,000 in year 20 will be approximately ½ of the buying power in year 1. So, once again, these calculators can be used to get a direction: use the Roth or not, but do not give you a realistic measure of retirement withdrawals (since they are not indexed).
The following is a non-exhaustive listing of sites that provide free web-based flat
annuity calculators: www.quicken.com, www.waterhouse.com, www.penfed.com,
www.smartcalc.com, www.psecu.com, and www.newenglandfunds.com.
(Click here for Roth IRA Web Site links to flat annuity
calculators.)
An enhancement of annuity-based calculators, which includes MRDs and assumes a gradually increasing withdrawal each year (indexed annuity withdrawal) is described in the author's book, Roth IRA Book: An Investor's Guide. This book provides easy look-up tables for 11 typical client profiles from ages 25 to 85 using the more complete MRD indexed annuity model. (Click here for information on ordering the book or click on the banner at the top of this page.) This is the first book that is based on the Technical Corrections Act of 1998, which has been passed by the House and the Senate, and is due to be signed by President Clinton on July 21, 1998.
Author:
Dr. Gobind Daryanani has written several articles on Roth IRA calculators available on the
Roth IRA Web Site (http://www.rothira.com)
and is the author of the book, Roth IRA Book: An Investor's
Guide.
A complete analysis of web-based calculators, as well as professional pay-calculators and full service brokerage house internal calculators, is detailed in the author's 300-page report "Market Analysis of Roth IRA Calculators."