by William Tolson
(Thursday, June 25, 1998, from The Riviera Review-My Opinions
About Your Money
Articles in the non-profit Riviera Review are not copyright protected. Articles can be
used freely in whole or part by others without reference to source.)
The new Roth IRA is advantageous for many families if the government keeps its promise of tax free distributions. But it's not the right choice for some. And this latter group could be the next field harvested by class action attorneys.
Which is best, the Roth or regular IRA? The answer requires heavy duty analyses because many factors are involved. Software commonly called Roth IRA calculators are available to help crunch the numbers. Many interactive calculators are on the Internet at IRA custodians' web sites. These calculators often show a Roth IRA is the best choice. But this result may be inappropriate for some situations.
Most IRA calculators are relatively simplistic programs, apparently designed for easy use on-line. But the calculations to determine which IRA is best aren't simple—they're very complex. Some of the important factors involved include a person's current and future tax rates, how long the money can grow, is retirement income more important than estate planning, and converting to or starting a Roth. Simplistic programs to answer complex questions are a potentially dangerous mix.
Technically, the calculators' results are mathematically accurate. But practically, their results are not always realistic. They may be giving inappropriate results to many users. Inappropriate because the calculators' assumptions and programming stray from real world situations. And some important input questions are more than difficult to answer.
Most calculators require inputs that are guesses (some prefer estimates) by the average user. And the results are critically dependent on these guesses. Do you know what your tax rates will be from now to when you retire and during retirement?. Or when you'll need to start IRA withdrawals, and how much for how long? Most people would answer—I don't know or I'm not sure.
If you plan a non-IRA investment for retirement, would you put it all in a bond or CD where the growth is taxed annually? Most people would answer—no.
You must supply the difficult to answer inputs and live with a—yes—for the last question to use most of the IRA calculators.
One problem is the simplistic calculators' weaknesses noted above. Industrial strength financial planning programs without these weaknesses that also do IRA comparisons are available. Their inputs are more factual type data—data that require time and effort to get into one pile. And they require many more inputs than the typical IRA calculator. These are the reasons their results are realistic and why you aren't likely to see them on-line. The better programs are easy to use off-line at home but they aren't on-line user friendly.
Another problem is inadequate warnings about the potential for non-real world results because of the calculators' weaknesses. Several calculators are at mutual fund web sites. A typical disclaimer only notes that past performance is no guarantee of future performance. Maybe they dug up a mutual fund prospectus disclaimer and used it for the IRA calculator. A thorough explanation of the calculators' weaknesses and assumptions is needed for the average user and may be prudent for the providers.
The calculators' faults appear to be recognized by the big name financial organizations offering web site and low cost calculators. The San Jose Mercury News published an excellent article written by Mark Schwanhausser on IRA calculator weaknesses. Some negative statements in the article indicate—there may not be a correct result, and—guesses about ones future finances are required. The Internet savvy should get Mr. Schwanhausser's full article at www. rothira.com for in-context details on IRA calculator weaknesses—and their good features. (Editor's Note: This article is no longer available for free on the web. Go to http://www.rothira.com/articleoth.htm for more information.)
What will people do if they believe they've been hurt financially by acting on unrealistic calculator results? Calling an attorney may be the first step. Current calculator disclaimers are wimpy compared to the strong warning on tobacco products. Yet the tobacco companies are sued for hundreds of billions.
And the cost impacts of switching to a Roth when a regular IRA is best can hurt—a lot. Consider someone 52 with a regular $500,000 IRA that is needed for income during retirement. An on-line calculator showed converting it to a Roth would be about $80,000 better than not converting. Another program that was designed for real world financial projections showed the regular IRA would be best by over $300,000 to $700,000 depending on life and income needs. That's a $400,000 to $800,000 swing. Big money and lots of people involved—is this an attorney's dream situation or what?
Conventional wisdom favors making the right decision rather than hoping a wrong one will be reimbursed. So how do you get help with a Roth IRA start or conversion decision? Be leery of on-line calculator results. Find and hire a pro, a CFP or CPA if you've got more than a few thousand in your IRA.
But before hiring anyone, be sure they aren't using a simplistic calculator—too many do. First ask what information they need. Keep looking if they or you have to guess at any critical input questions, e.g. future tax rates, or any whens or how longs. And they should ask a lot of questions, at least 30 or so. The right questions will make you dig into your monthly portfolio statements, home mortgage and other documents for answers. If you don't have to dig, they aren't the right questions and it's best to keep looking.
As always, these are my opinions about your money.
Author:
William Tolson contributes financial planning articles to The Riviera Review. Since
retiring from engineering in 1993, his academic interests have focused on weaknesses in
the methodology implemented in most financial and retirement planning software. The
articles reflect his opinions as to how these weaknesses may adversely affect financial
projections and cause seriously inappropriate investment decisions. He may be reached by
e-mail at WTolson159@aol.com.