Case Study 1: Convert $2M for Children

Roth IRA Conversion Case Studies

This case study serves to prove that for high net worth individuals and and savers who won’t outlive their retirement nest eggs, “It’s all about time.”  The graphs in the case study that follows make it simple to see why I came to this conclusion.  However, “simple” is not  a term I’d use to describe the background information one must comprehend to draw this conclusion.   

To access background information relevant to this conclusion, go to: Save to Retire: Pre-tax, After-tax or Roth?; Stretch v. Super-stretchPre-tax v. Roth Estate Tax Issues (considers Income in Respect of a Decedent); Roth 401(k) Case Studies

Case Study 1: 

The variables considered are key to proving the conclusion.  This particular case study considers the variables shown below along with the Federal estate tax related information provided on the deduction for Income in Respect to a Decedent (IRD).

Pre-tax IRA Owner Age/Gender 66/Male
Year/Amount of Conversion/MTR 2010/$2,000,000/35%
Side Fund Contribution for Comparison $700,000 (tax paid on conversion)
Owner Age at RMD start 71
Owner MTRs receiving RMDs 3 shown: 28%, 35%, 42%
Owners Age at Death 82
Spouse Age/Gender at RMD start 80/Female
Spouse Age at Death 87
Spouse MTRs receiving RMDs 3 shown: 28%, 35%, 42%
Spouse Age at Death 87
Children Ages/Gender when RMD start 61/Female; 58/Female; 56/Male
Children MTRs receiving RMDs 15% (their effective MTR considering the IRD deduction)
Children Ages at Death 83; 82; 78
Life Expectancies based on Social Security Table (except for Spouse)
RMDs Payments are based on the applicable IRS tables
Rates of Return on Investments (ROR) 7% blended rate of return for Pre-tax and Roth IRAs (60% stocks earn 8%, 40% bonds earn 5.5%). 5.68% blended rate of return for side fund (60% stocks earn 8% taxed at 15%, 40% bonds earn 4% tax-free).

Roth_1

Commentary What’s the old saying… “a picture says a thousand words;” for the Roth, I’d say… “a picture says a million dollars (or more)!”  

The heirs receive more money if the pre-tax assets are converted to a Roth IRA whether the IRA owner’s MTR decreases, remains static or increases. Keep in mind that this outcome assumes that both the IRA owner and his/her spouse, as the primary beneficiary, receive the required minimum distributions from the pre-tax IRA based on the 3 different MTRs shown, and then reinvest these distributions in the side fund.  The outcome further assumes a conservative MTR of 15% for the children beneficiaries to reflect the available IRD deduction.

The relative outcome of this example is identical as long as: 1) the RORs for the pre-tax and Roth accounts are same; and 2) the blended ROR for the side fund is always lower than these accounts on a net after-tax basis (since it’s still subject to capital gains tax at whatever rate you assume).

This favorable outcome is ultimately achieved because it’s impossible for a taxable side fund to perform as well as the tax-free Roth if one assumes comparable risk factors attributable to the selected investments. For example, a very conservative after-tax investor might earn 4-4.5% in a tax-free bond; whereas, with a comparable level of risk, that same investor could earn 5.5-6% tax-free by investing in a taxable bond within the Roth environment.

It’s the differential in the rates of return on investments in the Roth environment versus anywhere else and the extent of time to compound these additional gains (facilitated by the Roth’s option to super-stretch payments to heirs) that proves that for high net worth individuals and savers who won’t outlive their retirement nest eggs: It’s all about time.”

To access background information relevant to this conclusion, go to: Save to Retire: Pre-tax, After-tax or Roth?; Stretch v. Super-stretchPre-tax v. Roth Estate Tax Issues (considers Income in Respect of a Decedent); Roth 401(k) Case Studies

Copyright © 2009 Barry R. Milberg   All Rights Reserved

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