Background
This document will be revised as more questions are raised. For the most current version of this document either check our Website.
Questions
- How is the opportunity cost of the "rollover tax" handled?
- What should I use for the Cost Of Capital?
- What are some of the program limitations?
- Why can’t I run both Annual Contributions and Rollovers in the same scenario?
- I can buy a program for $10 that does the same thing!
- Can I rollover pension, SEP or SIMPLE IRA funds into a Roth IRA?
- Will this program work when comparing against a non deductible IRA?
Discussions
1. How is the opportunity cost of the "rollover tax" handled?
One of the definitions for Opportunity Cost Of Money is Cost Of Capital or Discount Rate. One of the program’s inputs is After Tax Cost Of Capital. By entering what your client would have earned, adjusted for the tax rate, with the funds that were used to pay the rollover tax for the After Tax Cost Of Capital you account for the Opportunity Cost Of Money.
The program’s Summary Report has columns for a cash analysis and a net present value analysis. The cash analysis is easy to understand and interesting, but is meaningless since it is arrived at by adding cashflows for different years. Adding $100 from 2010 to $200 from 2011 makes no more sense than adding 100 apples to 200 oranges. The net present value analysis adjusts each year’s cashflow by a discount factor arrived at using the After Tax Cost Of Capital. It is the net present value that should be used to determine whether a Roth IRA is better than a Regular IRA.
2. What should I use for the Cost Of Capital?
Now that you are convinced that you should pay attention to the net present value analysis, your next question will be "What After Tax Cost Of Capital should I use?"
Lets go back to the Opportunity Cost Of Money. If your client needs to liquidate assets to pay the tax on the Roth IRA rollover, what opportunities are being lost? Would your client invest those funds in a money market fund earning 5% pre tax? If so, the After Tax Cost Of Capital should be 5%, less the tax on 5%. If your client has a booming business with a 20% rate of return, the After Tax Cost Of Capital should be 20%, less the tax on 20%.
The reason that you should use the "After Tax" rate of return is because the program discounts after tax cashflows to arrive at your net present value.
3. What are some of the program limitations?
We have never seen a "perfect" program. As good as our programs are, they do have limitations. Limitations of this program are as follows:
- The program assumes that all Minimum Required Distributions for those over 70½ are met with the input you have chosen. Calculating Minimum Required Distributions can be very complex, and we have a popular $199 program that does that.
- Distributions are not subject to the early withdrawal penalty.
- IRA funds, if still available at death, are distributed immediately after death.
- IRA contributions and rollovers are made on January 1, and distributions are made on December 31. A full year’s income is calculated on the year’s beginning balance, plus, any contributions or rollovers.
- The tax on rollovers to Roth IRAs in 2010 is spread over 2011 and 2012.
- One tax rate can be used for all pre-retirement years.
- One tax rate can be used for all retirement years.
- The taxpayer qualifies to make a rollover or contribution. Also see (k), below.
- All Roth distributions are Qualified Distributions, and not taxable. When making the inputs, be sure that the Roth IRA distributions start at least five years after the last contribution to the Roth IRA.
- The IRA owner will want to take Roth IRAs out during the same time frame as the owner would withdraw funds from the regular IRA.
- There is no problem with the AGI limit when considering the Roth IRA.
4. Why can’t I combine both Annual Contributions and Rollovers in the same scenario?
Those are two separate decisions. To illustrate this we will use an example that assumes the following:
- The net present value benefit for using a Roth funded with annual contributions is $5,000.
- The net present value cost for using a Roth funded with a rollover contribution is $5,000.
In this example, if one combined the annual contribution results and the rollover results, one gets a net benefit of zero, and you would conclude that there is no difference between using a Roth or regular IRA. However, by keeping these separate, one can correctly conclude that there will be a $10,000 net present value saving to make annual contributions to a Roth IRA and to not rollover the regular IRA to a Roth.
We will admit that it would be a strange set of facts that would give you the result described in the example, but how would you know that if you did not keep the results separate?
- I can buy a program for $10 that does the same thing!
There are Roth IRA Analyzer programs available for $10. They don’t do a net present value or internal rate of return calculation. Thus, they, at best, make a half way attempt to consider the time value of money. They don’t consider estate tax consequences, which may be important. For $10 you get a program that is worthless.
6. Can I rollover pension, SEP or SIMPLE IRA funds into a Roth IRA?
Probably not, but that is not an issue with the program. For the program we assume any amount that you enter as the Rollover Amount qualifies for a rollover. One might be able to rollover the funds to a regular IRA, and then rollover that IRA to a Roth IRA. Please consult the Internal Revenue Code and any IRS pronouncements concerning this.
7. Will this program work when comparing against a non deductible IRA?
Not easily, but there is a workaround. When one considers rolling a non deductible IRA into a Roth, probably only the accumulated income would be subject to the rollover tax. In that situation you could enter the Rollover Amount to be the accumulated income from the non deductible IRA.
If you are considering making annual contributions to either a Roth IRA or a non deductible IRA, you always are better off with a Roth IRA. In both cases the contributions are non deductible, but the accumulated earnings from the Roth IRA will be distributed tax free. If the AGI is too high and a Roth IRA is not permitted, one may have to consider the non deductible IRA.