Most Popular ArticlesDecember 1, 2009
A case study of the problems posed by Roth conversions
Let’s do away with the erroneous assumptions that a Roth is usually advantageous for the young, when retirement tax rates are going to be as high as or higher than tax rates during earning years and when withdrawals won’t happen for many years. A scenario examining all three of these Roth-favorable conditions is simple to model.
Take a single 30-year old that earns $85,000 a year in moderately taxed Virginia. His combined federal and state marginal rate is 30.75%. He has nothing saved, but he knows he should start saving for retirement. He is considering whether to contribute to the Roth 401(k) his company offers or to a traditional 401(k) with a pre-tax contribution. He plans on retiring at age 65 on an after-tax spending budget of $60,000 a year adjusted for inflation, and he has no estate goals. The taxes on his retirement income will be at the same rate or higher if he funds the traditional 401(k) (depending on RMDs in each year of each simulation which we automatically calculate and tax). Trusting the promise of future Roth exempt status, he likewise is confident that Social Security will pay him his projected $23,464 annual benefit at retirement. To start saving for retirement, he determines that his lifestyle could afford a compromise to his current spending of $5,886 a year. This is what he could save after tax in the Roth 401(k). In the traditional 401(k), that same lifestyle compromise would make the pre-tax contribution $8,500 a year, because he would avoid paying current income taxes of $2,614 on his salary deferral. Both plans assume a balanced asset allocation due to his tolerance for risk and living to age 92, his 80th percentile life expectancy.
This example should be a poster child for the attractiveness of Roth. We have a young person deferring distributions for many years and taxes in retirement that are as high or higher than his current moderate tax rate. The Roth should show a no-brainer advantage, correct?
Well, Exhibit 1 demonstrates that the confidence level of exceeding his goals is HIGHER with the traditional 401(k) deferral than with the Roth. How could this be, when many other financial planning systems would show the Roth as the no-brainer choice for such a situation?
To answer this, I analyzed this case study with our Wealthcare platform. This allowed me to assess the impact of dynamic taxation, by calculating a unique tax rate to apply in each year of each simulation based on the spending goals, forced RMDs and one thousand 62-year simulations. While the paper focused on the median result (the 50th percentile), in Wealthcare we measure confidence in what we call “the comfort zone,” which is the 75th to 90th percentile confidence zone. If results fall below the 75th percentile, we consider that to be too uncertain or “underfunded” and above 90% confidence we consider as needless lifestyle sacrifice or “overfunded,” much like a defined-benefit pension plan funding calculation.
The more realistic dynamic taxation of RMDs in our system, where we measure confidence and our recognition of the price to the lifestyle of the client shows that at high confidence levels the Roth actually is detrimental in this client’s case.
Exhibit 1- 30 Year old Roth versus Traditional Tax Deferred 401(k)
Defenders of needlessly prepaying taxes will say it is erroneous to conclude that this client would leave nothing behind in their estate and that part of the benefit of the Roth is how the assets transfer to heirs by avoiding income taxation on accumulated tax-deferred IRA assets. Of course, if he wanted to leave an estate we would have identified and prioritized this goal, and if he didn’t want to leave an estate our Wealthcare advising process would adjust our advice over time to confidently have his money and blood pressure run out near the same time.
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