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© Copyright Sundown Software Systems,
1997
The Taxpayers Relief Act of
1997 contains a controversial provision called the Roth IRA.
It is controversial because the IRS has not published the regulations
for it and because no one has yet figured out what, if any, its
advantages are. ORP has been modified so that it can contribute
to the controversy although probably not to the resolution. |
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Very briefly,
a Roth IRA is a savings account that is funded with after-tax
dollars but returns are accumulate and are withdrawn without
paying any Federal Income Tax. There are restrictions:
- Contributions are limited
to $2,000 per year for a single person, $4,000 for a married
couple. Contributions phase out at $95,000 income for a single
person, $150,000 for a married couple.
- Distributions are penalized
if taken before age 59 ½.
- Distributions cannot begin
until five years after the first contribution..
- An existing IRA can be rolled
over into a Roth IRA for wage earners of $100,000 or less.
- There is no minimum withdrawal
level that begins at the age of 70 or any other time, as there
is with a conventional Tax-deferred Account.
For more information about
the Roth IRA see:
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Looking at the Roth
IRA with ORP |
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The Roth IRA
is a different ORP model component than the regular Tax-deferred
Account. Additional columns have been added to the current ORP
reports to report on the Roth IRA, and an additional Roth IRA
account report has been added.
Three new parameters have
been added to ORP to include the Roth IRA into the model. They
are:
- Planned annual contributions
to the Roth IRA before retirement:
The contribution restrictions noted above are enforced by ORP
except that it is up to user to determine if her Adjusted Gross
Income is below the specified limit. Note that these are after-tax
dollars so if it is planned to replace 401K contributions with
Roth IRA contributions be sure to allow for paying income taxes
while figuring the contribution.
- Initial Roth IRA account
balance: Since the Roth
IRA is brand new, the initial account balance is really a roll
over from an existing IRA. Remember to allow for taxes while
computing the roll over balance. (Taxes may be paid across four
years, which eases the pain a bit.)
Leaving both of the parameters
blank in the ORP parameter screen will omit the Roth IRA component
from the model. |
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ORP model
runs made to date indicate there is little difference between
a regular IRA and a Roth IRA, all other things being equal. This
can be seen analytically:
V = (1-t)*b*(1+r**y) is the
value of a regular IRA at year y, earning at rate r, starting
with before-tax balance b and paying tax rate t at the time of
distribution.
R = (1-T)*b*(1+r**y) is the
value of a Roth IRA at year y, earning at rate r, starting with
before-tax balance b and paying tax rate T at the time of the
contribution.
Clearly, if t = T then V =
R and whole thing is a wash.
But this is not the whole
story. There are several situations where the Roth IRA can profitably
be substituted for a regular IRA or used to enhance a regular
IRA. No more will be said about this since this in the area of
financial advice and the expertise of this site is mathematical
programming, not financial planning.
Careful examination of the
optimizers internal results for several Roth IRA models
leads to the observation that the optimizer finds the regular
IRA and Roth IRA to be substitutable. The optimizer finds that
there are many different forms to the optimal solution; many
branches that lead to the same result. This sometime shows up
in the ORP model solution where the results will swing back and
forth between distributions from the two accounts. What this
means is that a particular years distribution can be satisfied
from either account or from a combination of the two accounts
without changing the final result - the amount of money available
for spending over the term of retirement. |
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The three
additional parameters described above, when used in conjunction
with the other ORP parameters can be used to answer questions
about the Roth IRA.
Be sure to include the tax
consequences when switching from a regular IRA to a Roth IRA.
Taxes must be paid from a rolled over balance before becoming
a Roth IRA beginning balance. Taxes must be paid before dropping
a regular IRA contribution in favor of a Roth IRA contribution.
Tax considerations can be
omitted when supplementing retirement savings with additional
contributions to a Roth IRA.
Use the retirement tax rate
parameter to account for reduced taxable income during retirement
caused by taking money out a Roth IRA instead of a regular IRA. |
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In 1996, Congress
changed the tax law to suspend excess withdrawal penalties on
Tax-Deferred Accounts. The reason for this was, as explained
at the time, to encourage taxpayers to take large Tax-deferred
Account distributions immediately, and pay personal income tax
on them. This would increase current government revenues, at
the expense of down stream revenues. ORP results indicated that
this was not a good idea for most retirees.
Now, in the form of the Roth
IRA, Congress is at it again. Rollovers of regular IRAs into
Roth IRAs will increase immediate government revenues at the
expense of down stream revenues. Several ORP models show that
the main difference between rolling over and not rolling over
comes is higher taxes paid down stream in the non-rolled over
case. Money available for spending remains the same.
Remember that this is all
part of the congressional balanced budget package.
Please share your results
and observations with us so that we might enhance this section
of the web site.
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© 1998-2000, Sundown Software Systems, Inc.
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