Your Roth IRA Calculator May Be Lying to You

By Jeffrey Levine, IRA Technical Expert
Follow on Twitter: @IRAGuru4EdSlott

If you’ve ever questioned whether a Roth IRA contribution or conversion was right for you or not, then chances are you’ve wondered if there was a simple calculator that could take all your pertinent data, analyze it, and then, like a “Magic 8 Ball” of Roth planning, spit out a definitive “yes” or “no,” telling you what the correct course of action is.

Unfortunately, that’s generally not going to be the case. Don’t get me wrong, calculators of all types, including Roth IRA calculators, can be wonderful tools and certainly have their place in helping you evaluate the merits of a particular transaction, but at the same time, they are often highly unrealistic when it comes to what actually happens in the real world with real people. Here’s a prime example of what I mean.

In order to make a fair, apples-to-apples comparison, most should-I-have-a-Roth-IRA-or-traditional-IRA software compares the future value of a Roth IRA account to the future value of an IRA account plus the future value of a taxable account that would have otherwise been used to pay the taxes on the Roth money at the time of contribution/conversion.

For example, suppose you are deciding between making a $5,500 traditional IRA contribution for 2014 and a $5,500 Roth IRA contribution, and also, that by making the traditional IRA contribution, you’d save $1,000 in taxes. Most software will compare the expected future value of your $5,500 Roth IRA contribution to the expected future value of your $5,500 traditional IRA contribution plus the expected future value of your $1,000 tax savings invested in a similar manner, but in a taxable account.

Roth IRA-conversion calculators typically incorporate a similar analysis. Then the software simply calculates which of these options is worth more on an after-tax basis when you retire. The calculator’s assumptions on one large financial website read, in part, as follows.

“For Roth IRAs, the analysis assumes that the amount of the contribution grows tax-deferred at your hypothetical rate of return for the number of years you selected until taking your first withdrawal. For traditional IRAs, the analysis assumes that the tax savings from deducting the contribution are invested in a separate, taxable account at your hypothetical rate of return and then added to the value of your IRA at withdrawal.”

That calculation is nice for academic purposes, but in most cases, that’s about all it’s good for. How many people, after running such a calculation and determining it was advisable to opt for the traditional IRA, actually put aside the amount of money they would have used to pay the tax on the conversion and invest it in a similar manner? Would/do you? Each and every year?

That’s what I thought. It simply doesn’t happen. It sounds great, and it’s the only fair way to compare the two options mathematically, but practically speaking, it simply doesn’t add up. Let’s be real. The $1,000 of tax savings is more likely to go toward the purchase of a new car or a family vacation than it is to a non-retirement account investment account that’s still put aside for your retirement. Once that happens, your traditional vs. Roth IRA contribution calculation goes right out the window.

If, on the other hand, you opted for the Roth IRA contribution, you will have essentially saved for retirement an amount equal to the future tax bill you would otherwise have needed to pay on the funds eventually distributed from your traditional IRA.

So in essence, it’s really a forced savings account for your future tax bills, which in many “real world” scenarios, might help you end up with more money for retirement than if you had opted for the traditional IRA and deduction — even if your calculator initially said otherwise.

There are two final points I would like to note. First, I’d like to emphasize that there are a number of really wonderful Roth contribution and/or Roth conversion calculators out there and that the analyses they perform do, in fact, serve a useful purpose.

Second, and perhaps more importantly, I am not saying a Roth contribution and/or conversion is better for everyone. That is definitely not the case. That is still a very personal decision that hinges on your own specific set of facts, circumstances and projections about the future. My hope, rather, is that you consider what assumptions are built into the analyses you’re basing your key decisions on and realize that sometimes the numbers don’t tell the whole story.