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Consumption Tax Effect on Roth Conversion

Have been running the ESPlanner numbers on an IRA conversion to a Roth to take advantage of the lifting of the income limits in 2010. One of my key assumptions has been that income tax rates will have to increase substantially in the future, which generally makes the conversion option look good. But what if instead a federal consumption tax is imposed, such as the Fair Tax that Dr Kotlikoff has researched and supported, or some other version of a Value Added Tax? Is there a way to model a new consumption tax in ESPlanner, in particular as to how it affects a Roth conversion decision (not to mention determining such a tax's impact on our overall personal consumption situation). I just read yesterday that a prominent economist was "concerned" about the increasing prospects for a new Value Added Tax and its affect on prices and growth. And I saw that the Tax Governance Institute reports that 75% of senior business execs expect a US VAT within 10 years, with most of them expecting a new VAT tax within 5 years. So there seems to be something in the wind on this. We are a retired couple and 80% of our wealth is in tax deferred accounts, so this Roth decision is paramount for us this year.


Peter, This is a valid concern. A 15 percent VAT needs to be modeled as reducing your living standard each year by 15 percent. I.e., you need to multiply consumption as well as your living standard by .85 to understand where you'll really be with respect to your real purchasing power and real living standard.

I'm not sure that a VAT would affect the Roth vs. Non-Roth issue. Money coming out of a Roth that is spent will get hit by the VAT. And money that comes out of, say, a traditional IRA, will get hit by the income tax and then by the VAT.

best, Larry


I think the VAT would affect the Roth/no Roth conversion decision only when I'm assuming an increase in future tax burden (income tax plus VAT). If I assume the full increase in our future tax burden flows through the income tax only (no VAT), which ESPlanner is nicely designed to handle and is the way I had been modeling higher taxes, then that makes the ROTH conversion look better than if I assume some of that same total increased tax burden flows through a VAT.

The approach I used to model the VAT effect I think is consistent with your suggestion. I compared converting $500k to a Roth over three years (2009, 2011 and 2012) under two was that Fed and state income taxes increase 40% in 2015 with no VAT. The second was that fed income taxes remained stable and the same incremental tax burden increase was captured in a new VAT in 2015. It's been a while but I think I calculated the new VAT burden on ESP consumption as 40% x 23%, or about 9% (I think 23% is the approximate VAT needed to fully replace replace the federal income tax) I modeled this in ESPlanner by increasing the living standard index to 109 in 2015 and all years thereafter. (also increased special expenses by 9%) For us the result was about 2.5% living standard increase from the Roth conversion assuming no future VAT, and a zero impact if we assume all tax increases are through a VAT. So it appears that the conversion is still the way to go for us, even though a VAT vs no VAT world has a significant impact on our achievable living standard using a Roth conversion.