I'm trying to do a realistic comparison of converting or not converting to a Roth and need to know what approach is most commonly used by planning/tax professionals to equalize the performance of the IRA and the taxable accounts.

I realize that when evaluating a Roth conversion it's mandatory that the IRA and the Taxable accounts' pre-tax, composite performances (interest, growth, dividends, distributions, etc.) are the same. That is, if the IRA's overall performance is less than the taxable account, it's an unrealistic bias against the conversion, and if it's more it's an unrealistic bias favoring the conversion. So, for a meaningful evaluation of converting vs. not converting, both accounts must have the same composite performance.

What I'm really struggling with is, what assumptions/changes do others commonly make to the taxable account to equalize the performance of the two accounts?

There are two obvious answers. One straightforward answer is that if the taxable account consists of ONLY stocks and funds- the composite percentage of the stocks and funds growths plus dividends plus distributions should be the same as that for the composite IRA account.

But for my case the taxable account has tax-free, US government paper, corporate bonds and preferred stock, and it's composite performance is less than my IRA account's (I understand that this is a dumb situation that should be fixed regardless of the conversion issue). So what approach is most commonly used/recommended by pros to equalize the composite performance of the two accounts by changes to the taxable account? Should I simply increase the assumed growth of the stocks and funds, or "sell" all of the tax-free, US stuff, and bonds and "buy" more stocks and funds with the proceeds, assume that the taxable account has the same equities as the IRA account, or ?????

Thanks for any help offered.

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Originally posted by Art E:
I realize that when evaluating a Roth conversion it's mandatory that the IRA and the Taxable accounts' pre-tax, composite performances (interest, growth, dividends, distributions, etc.) are the same. That is, if the IRA's overall performance is less than the taxable account, it's an unrealistic bias against the conversion, and if it's more it's an unrealistic bias favoring the conversion. So, for a meaningful evaluation of converting vs. not converting, both accounts must have the same composite performance.

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There may be very valid reasons for having different assumptions for the two pools. If the taxable assets are expected to be used first for early retirement years, college tuition, etc. they might be more conservatively deployed, such as with a significant bond or money market component. If the Roth assets are not likely to be tapped for 20 years, then the investor may perhaps be more aggressive, such as with growth mutual funds. However, the longer the period of time the less likely the two asset pools will be significantly different.

Another issue may be the kind of investments the custodian allows vs what can be undertaken with taxable assets. For example, collectables, privately held stock, IPOs, and real estate may be restricted or just difficult via an IRA/Roth account. For most folks, these will not be issues but the investment opportunities of some may be very different.

You are correct to point out that if you have a built in bias for annual return you are likely to skew the answer based upon the bias built in to those assumptions.

Given the possible difference in planning horizons, life expectancy, estate planning issues, tolerance towards risk, experience with investing, possible residence changes (state tax issues), etc. it is darn hard to generalize. Not every person that poses the question is a 38 year old, married, aggressive investor with a half million in assets and high tolerance for risk.

I always think of the base case as two parallel scenarios of Roth and taxable assets with identical investments, time periods, taxation rules, etc. This scenario is not likely to be realistic, but it is probably the most easily comprehended scenario and a simple place to start.

You mentioned a combination of tax free paper, dividends (prefered stock) and stock. The first issue you face with these is chosing a mechanism for equalizing these investment. I would suggest translating all to after tax returns.

You did not include the many factors to take into consideration when converting a tax deferred plan into a Roth.

You did not include the amount to be converted, your current income and your anticipated income when you begin to draw from the account, your ability to pay the taxes over the 4 year period, the length of period before you will begin to draw from the account or your investing abilities and a present value chart.

These are the factors you need to take into consideration on the conversion.