by Dr. Gobind Daryanani
The following copyrighted article is available exclusively on the Roth IRA Web
Site:
This is the third of a series of articles on Roth IRA Conversion calculators. This article explains the basis of Vanguard's on-line Roth IRA Conversion calculator: This calculator can be accessed at http://www.vanguard.com.
The retirement scenario addressed by the Vanguard calculator is as follows: An individual currently has $ X in an IRA account. He or she is considering a conversion of all of the dollars to a Roth IRA in either 1998 or 1999. Three situations are analyzed:
1. Do nothing: i.e. leave all funds in the Traditional IRA.
2. Convert (rollover) all the funds to the Roth IRA on 12/31/1998, with the additional taxes for the conversion paid from the IRA account.
3. Convert the funds one day later, on 1/1/1999.
The tax for the rollover is calculated by multiplying the rolled over amount by the tax rate you specify as your current tax rate. The starting balances in these three cases then grow at a rate of return that you specify. You also specify the number of years the account will continue to grow. At the end of this period, all the funds are withdrawn in one lump sum. For the Traditional IRA case the amount withdrawn is taxed at the retirement tax rate that you specify. The Roth IRA ending balances are not taxed.
Example: Joseph, age 51, has $100,000 in his Traditional IRA, which he would like to consider rolling over to the Roth IRA. His current tax rate is 31%. He will withdraw all of the IRA funds at age 70. At this time his anticipated tax rate is 28%. These tax rates include Federal and State taxes.
The following table shows the calculations leading to the ending balance after taxes in the three cases.
| Opportunity Lost | ||||||
| Trad IRA Before tax | Trad IRA After Tax | Tax on Conversion | PV of Tax | Convert 12/31/98 | Convert 1/1/99 | |
51 |
$100,000 |
$7,750 |
$7,750 |
$28,855 |
$31,000 |
|
52 |
$110,000 |
$7,750 |
$7,381 |
$30,846 |
$33,139 |
|
53 |
$121,000 |
$7,750 |
$7,029 |
$32,975 |
$35,426 |
|
54 |
$133,100 |
$7,750 |
$6,695 |
$35,250 |
$37,870 |
|
55 |
$146,410 |
Totals: |
$31,000 |
$28,855 |
$37,682 |
$40,483 |
56 |
$161,051 |
$40,282 |
$43,276 |
|||
57 |
$177,156 |
$43,062 |
$46,262 |
|||
58 |
$194,872 |
$46,033 |
$49,454 |
|||
59 |
$214,359 |
$49,209 |
$52,867 |
|||
60 |
$235,795 |
$52,605 |
$56,515 |
|||
61 |
$259,374 |
$56,234 |
$60,414 |
|||
62 |
$285,312 |
$60,114 |
$64,583 |
|||
63 |
$313,843 |
$64,262 |
$69,039 |
|||
64 |
$345,227 |
$68,696 |
$73,803 |
|||
65 |
$379,750 |
$73,436 |
$78,895 |
|||
66 |
$417,725 |
$78,504 |
$84,339 |
|||
67 |
$459,497 |
$83,920 |
$90,158 |
|||
68 |
$505,447 |
$89,711 |
$96,379 |
|||
69 |
$555,992 |
$95,901 |
$103,029 |
|||
70 |
$611,591 |
$440,345 |
$102,518 |
$110,138 |
||
| IRA After Tax | $440,345 |
$440,345 |
||||
| IRA AT Plus Opp Lost | $542,863 |
$550,484 |
||||
| Advantage of Roth | 12.66% |
11.10% |
||||
Note that the outside funds used to pay for the Roth Conversion tax are added to the Traditional IRA account to make a fair comparison with the other cases. This is often referred to as the opportunity lost (money you would have if you did not convert). Note also that the conversion in 1998 allows the tax burden to be spread over 4 years. When one considers the time value of these tax dollars, the benefit of the 1998 conversion is seen to reduce the required tax from $ 31,000 to $28,555. Vanguard assumes a 5% growth rate for these tax dollars over the four years. With the above assumptions the Roth conversion in 1998 provides a 12.66% advantage, while the conversion in 1999 provides a somewhat lower advantage (11.1%).
The remainder of this article discusses variations on the assumptions made in the Vanguard model. One assumption made is that the tax rate is the same for all years prior to distribution. In the 1999 conversion case all of the $31,000 conversion tax needs be paid in one year: this is expected to increase the tax rate in 1999. When one considers this factor, the 1999 conversion can be shown to be 5-7% worse than the example suggests.
A second significantly different result is obtained if one assumes that the withdrawal from the IRA's does not occur in one lump sum but rather is stretched out over a number of years. If, for instance, the withdrawals from the IRA accounts are limited to the minimum distributions required by the IRS, the Roth conversion can be shown to have a 30 to 50% advantage over the Traditional IRA no-conversion case.
In summary, the Vanguard Roth IRA Conversion calculator does provide a good start towards the consideration of a Roth Conversion. However, like many other web based calculators, it is based on a conservative lump sum scenario: conservative in the sense that other scenarios where one can afford to stretch out the withdrawals show the Roth Conversion to be better than the lump sum scenario. Readers may want to consider using higher-end programs to evaluate a range of scenarios that reflect other retirement scenarios.
If you have a Roth Conversion calculator that you would like to have evaluated please send the information on the calculator to the author at rothinfo@dqi-roth.com.
The author Dr. Gobind Daryanani is the founder of DQI Inc., a company providing Roth Conversion Consulting Services. The company offers a current "Market study report of available software packages for the Roth Conversion". DQI also offers a Roth Conversion Service, which uses the best available software programs to evaluate a wide range of scenarios for clients..