How Much Do You
Need in a Roth IRA to Achieve All of Its Benefits?
By Roger & Kevin Katzenmaier
October 16, 1997
Note: When this article was written the
Income Strategy Generator
was called the Investment Scenario Generator
For those individuals
who are using Individual Retirement Accounts (IRAs) for financial
retirement planning, the new Roth IRA poses an important
question. What portion of retirement capital should be in a Roth
vs. an Ordinary IRA?
The value of an
Ordinary IRA can be prematurely reduced due to the minimum
distribution rules post age 70&1/2. This occurs when
mandatory withdrawals become greater than the retirees
income needs which accelerates taxation and reduces investment
capital. Further, in the event of death, the beneficiary of an
Ordinary IRA must pay income taxes on all amounts received from
the IRA. The new Roth IRA does not have these drawbacks. However,
a Roth IRA must be funded with after-tax income.
The Roth IRA also
offers tax-free earnings which is bound to attract many takers.
However, it is important to consider not only the benefits of a
Roth IRA but also the costs associated with getting capital into
a Roth IRA.
Choosing between a Roth vs. an Ordinary IRA is a
complex issue and depends on many variables including: the
availability of funds not held in an IRA, eligibility for tax
deductible contributions to an Ordinary IRA, present vs. future
tax rates, age and individual planning goals. This article is not
intended to explore all of the advantages and disadvantages of a
Roth vs. an Ordinary IRA. Instead, this article will explain how
to avoid mandatory withdrawals in excess of income needs due to
the minimum distribution rules associated with an Ordinary IRA
with only a relatively small amount of capital initially in a
Roth IRA. For many, it is possible to achieve all
of the benefits of a Roth IRA with only a portion of capital
initially in a Roth IRA while also maximizing
tax-deferment of an existing Ordinary IRA.
To achieve the
balance of capital in a Roth vs. an Ordinary IRA, we will use the
Investment Scenario Generator or ISG. The ISG is a powerful software tool which
can be used to simulate a wide range of investment scenarios.
(For information about the unique ISG
methodology, visit www.DefinedWithdrawals.com) Using this tool, we will develop a
two-part plan where during the first phase of retirement, income
will be provided exclusively from an Ordinary IRA in compliance
with the minimum distribution rules. The goal will be to
completely consume capital in the Ordinary IRA before the person
dies. The second phase of the plan will use a Roth IRA to fund
retirement income after the Ordinary IRA has been depleted. This
will free the retiree from the escalating minimum distribution
requirements and allow the retiree to leave remaining capital to
heirs income tax free.
Assume an individual
is retiring at age 60 and expects to live to at least age 80.
Also, assume the individual would like to maintain an after-tax
retirement income from investments of $42,000 annually,
increasing each year by an assumed inflation rate of 3% and with
payments received on a quarterly basis. In addition to providing
the desired retirement income, let's also assume that this
individual's goal is to leave roughly $1,000,000 in todays
dollars to heirs income tax free. How much should the retiree
have in an Ordinary vs. a Roth IRA?
We will plan to fund
retirement income with an Ordinary IRA up to age 80. Withdrawals
will be subject to income tax. Therefore, to achieve the desired
after-tax income of $42,000, we must plan to withdraw this amount
in addition to the amount required for income taxes. This
individual plans for an initial withdrawal of about $55,000 to
cover both the desired income and income taxes. Next, the ISG will be used to determine how much Beginning Capital
is required to provide this income up to age 80 while also
depleting capital in the Ordinary IRA by age 80.
Interest-Bearing Obligations (fixed-rate investments) will
provide an average yield to maturity of 6%, Blue Chip stocks will
provide a total return of 10% (with dividends reinvested to take
advantage of dollar-cost averaging) and the maximum required
Holding Period for Blue Chip stocks will be 10 years.
For those unfamiliar
with the ISG, it employs a unique methodology whereby income is
provided from both the interest and principal of a ladder of Interest-Bearing
Obligations (IBOs) for as long as the assumed stock Holding Periods. This approach gives a
realistic means of providing essentially guaranteed income that
has a unique synergy with market realities and guarantees that
stocks can be held for the long term.
After running a few
scenarios with the ISG, we find that $720,000 will provide
the desired inflation-adjusted income given the above investment
parameters if initially 66% is allocated to IBOs and 34% is
allocated to Blue Chip stocks. Using the Multiple Allocations
feature of the ISG, a fixed allocation of 100%
IBOs was defined for the end of the tenth year so that capital
could be depleted by age 80 (after 20 years) without violating
the assumption that Blue Chip stocks may need to be held for up
to ten years prior to being sold to achieve the assumed total
rate of return.
If market conditions
are favorable, it might be wise to sell Blue Chip stocks earlier
than the assumed Holding Periods and therefore, it is a good idea
to analyze the effect of doing this. Again, using the ISG, we find that if Blue Chip stocks are sold to
replenish IBOs after only 5 years, then about $740,000 is
required to meet the desired income up to age 80. To build in
this measure of safety, we will assume $740,000 total capital in
the Ordinary IRA.
Having determined the
amount of capital that is required in the Ordinary IRA to meet
income needs up to age 80, it is easy to confirm from the ISG annual projections that this plan is in compliance
with the minimum distribution rules for an Ordinary IRA.
Next, we will
determine the desired amount of capital in the Roth IRA to meet
income needs after age 80. Capital in a Roth IRA at age 60 will
have 20 years to grow before it needs to be used to maintain
income. We will assume that for the first 15 years this capital
will be allocated 100% to Blue Chip stocks within the Roth IRA.
But after 15 years, the allocation will be split between Blue
Chip stocks and IBOs in preparation for providing income after
age 80. With the Roth IRA, income withdrawals will be tax free.
Therefore, for the second phase it is only necessary to plan for
the $42,000 desired income--of course adjusted for inflation.
Using the ISGs Custom Income Schedule,
we specify an income of $42,000 in Adjusted-Value Dollars
beginning in the 21st year or after age 80.
We will run an
overall 30 year scenario this time. For the first 20 years,
capital in the Roth IRA is allowed to grow while income is
provided exclusively from the Ordinary IRA. During the last 10
years, income is provided exclusively from the Roth IRA. After a
few tries we find that $250,000 initially invested in the Roth
IRA will provide the desired income and an inflation-adjusted
Ending Capital value of about $1,000,000 if allocated 30% to IBOs
and 70% to Blue Chip stocks in the 15th year and again assuming
maximum Holding Periods of 10 years.
It should be pointed
out that the exact amount left to the heirs depends upon when the
individual dies. The ISG can easily predict
these values. Of course, one could adjust the Beginning Capital
amount in the Roth IRA to plan for alternate outcomes.
In this example, the
individual achieved the desired income, avoided all minimum
distribution rules in excess of income needs and also planned to
have somewhere between $900,000 and $1,000,000 in today's
dollars for heirs at the time of death exclusively in a
Roth IRA not subject to income taxes. It doesnt get much
better! The Roth IRA provides an excellent means to avoid
mandatory withdrawals in excess of income needs and for passing
on wealth income tax free. However, the key point is that for
many, not all capital needs to be in a Roth IRA to achieve all
of its benefits. In this example, $740,000 was initially in an
Ordinary IRA and $250,000 was in a Roth IRA--a 75/25 percent
split. However, those who are not planning to maintain income
from an IRA and/or those those who have significant capital not
held in an IRA which could be used to pay the taxes incurred from
converting an Ordinary IRA to a Roth IRA may benefit from having
a greater percentage of capital in a Roth IRA.
It should also be
pointed out that it is possible to avoid mandatory withdrawals in
excess of income needs using a tax-deferred annuity in a similar
manner. However, the tax-deferred annuity does not allow for
income-tax-free inheritance and includes insurance mortality and
administrative charges that reduce the return from investments.
Remember there may be costs
associated with getting capital into a Roth IRA. But, if you can
afford to invest about 25% of IRA funds in a Roth, you can likely
accomplish both your income and estate planning goals based upon
your desired plans not federal tax rules. Using the ISG and the new Roth IRA, you can make terrific financial