Samsung4321
Recycles dryer sheets
- Joined
- Nov 12, 2021
- Messages
- 376
Actually, unless the net tax rate changes, pay-now and pay-later produce exactly the same result. Here is the gedanken experiment that finally made my understanding of Roth conversions "click:"
Assume a tIRA of $100K, current net tax rate of 30%, future net tax rate of 30%, and portfolio growth of 8%. (The numbers don't really matter but make the experiment clearer IMO.)
So, of the $100K tIRA, consider/mental accounting that a $30K pot belongs to the government and a $70K pot is mine.Case 1, Pay-Now: I give the government its $30K, keep my pot and let it grow in the account at 8%.So the question is only this: Will the government's future take be 30% or will it be some other number. If it is smaller, I win, and I get to keep some of the money that I thought was the government's. If it is bigger, I lose and I should have taken the Pay-Now option.
Case 2, Pay-Later: I invest my $70K and the government's $30K at the 8% rate. Both pots, of course, grow at the same rate and the government's pot is always 30% of the account value. Finally, I give the government its pot. What's left is my pot, having grown at 8%. Exactly the same amount as the Pay-Now option balance.
Before I figured this out, I had some kind of vague notion that by paying later I was earning money by investing the government's money. But as you can see, that is not the case.
Simplifying, same return rate, same time, same tax rate = same result.
Pay Now:
= FV(0%, 1, 0, (1 - 30%) * -1)
= $0.70
Pay Later
= FV(0%, 1, 0, -1) * (1 - 30%)
= $0.70