How we value a Financial Strategy

The math behind our simple number

Investing money effectively without “tax drag” can be overwhelming - there’s way too much information out there. AMA Finance cuts through the noise. By knowing a few financial parameters about you, we can help you prioritize which few things are likely to have the biggest impact.

As an example, AMA Finance claims that a Roth contribution this year has a value of $---- to you. What does that even mean?

What we’re simulating

We run a simulation of your portfolio from now until age 80, tracking the value of your savings. Our simulation is unique in that it models taxes, income, expenses, social security, and many other factors every year, to help understand what’s valuable.

In more detail, every year, we:

  • calculate how much taxes you are paying, both on income, dividends, social security, etc.
  • Add your savings (stated savings + post-tax dividends) into a taxable account.

We compute the value of your portfolio under two scenarios:

  1. All of your post-tax savings goes to your taxable account.
  2. Before directing your savings to a taxable account, this year (and only this year), you contribute $xxxx to a Roth IRA.

And then we compare the portfolio size difference.

For clarity, our graphs only compare the performance of the actual contribution in Roth vs. taxable - this is done by subtracting out a variant portfolio where you spend the Roth contribution this year.

Value calculation

If the Roth strategy produces positive value, we ask the question:

If I elect to put my Roth contribution in taxable rather than a Roth IRA this year, how much additional money must I save (not spend) this year to have the same portfolio value at age 65?

We calculate that money amount using a search algorithm; it is that number that we view as the “value today” of contributing to a Roth. (vs. putting the money in taxable).

Modeling assumptions

We use a “simple model” that lets us calculate your personalized values in real-time and obtain high accuracy without asking you dozens of time-consuming questions.

Income and savings model

  • You have no initial portfolio value
  • Your expenses today are equal to income less taxes less savings
  • Your income and expenses move with inflation.
  • You retire at age 65, where earned income drops to $0.

Social Security

  • Similar assumptions as the Social Security Administration’s Quick Calculator:
    • You’ll have 35 years of your current salary.
    • You take social security at age 70 (ideal if you live to at least life expectancy)
    • Future wage index
  • If filing Married Joint:
    • Your age is the same as your spouse.
    • You earn the same as your spouse.

Retirement Drawdown

  • We follow drawdown guidelines of pulling money from taxable first, then IRA, then Roth.
  • We use the current IRS IRA RMD table to determine IRA/401(k) RMDs starting at age 70.

Portfolio model

One asset with

  • 2% dividend yields
  • 4% stock real growth
  • 2% inflation (only relevant for capital gains taxes, not dividends)

These assumptions give reasonable results for most people, though not all. We’ll expand to ask more detailed questions in the future.

When will our assumptions lead you astray?

For most people, the assumptions above, while never perfectly accurate, do a good job of prioritizing what strategies you should employ. However, in some instances, it won’t.

Specifically, you are likely to need to enter more information to get reasonable results if one of the following are true:

  • You have substantial self-employment income.
  • Your yearly income and expenses are highly volatile/unpredictable.
  • You aren’t a standard US tax payer.
  • Your life expectancy is much shorter than average.
  • You have substantial illiquid assets like a family business or investment property.
  • You have a substantial pension or inheritance coming to you.
  • You expect equity returns to be very different over the next 30+years.

Is your straight-line assumption reasonable?

We have run Monte-Carlo stock return simulations and have found that the average “value realized” of using strategies like a Roth IRA are within 20% of that calculated by our simplified model. (more value is realized by Roth IRAs the better your assets perform)

“value realized” also is similar if rather than looking at portfolio value at age 65, we look at how much Roth IRAs reduce the chance of “portfolio failure” (calculated via Monte-Carlo simulations) - running out of money before you die.