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Calculating Discounted Retirement Asset Value
Posted By Jim On 07/17/2006 @ 5:32 pm In Personal Finance,Retirement | 5 Comments
A lot of bloggers, and those keeping score at home, put their retirement assets in their net worth considerations but one of my friends, Dimitri, asked if anyone actually discounts it because of time and future taxes. Personally, I do not because it complicates the calculation and takes more work than it does right now (Login, copy and paste number) but the idea does have merit. First, a little about discounting cash flows and then a proposal as to how personal finance bloggers (anyone really) can be a tad more accurate on their current net worth with respect to retirement assets.
With respect to discounting, the idea is that you’re assessing the current value of a future sum of money. A dollar today is worth more than a dollar tomorrow because of the time value of money. Simplistically, it’s worth more is because you can invest the money today (earning interest or profit of one day) and because inflation hasn’t taken a tiny piece away yet. That being said, your retirement assets aren’t available to you (unless you take the 10% penalty) until you are
64.5 59.5 (thanks qw!), and even then only a portion is available to you, so it’s current value is lower than the dollar amount.
Reduce Asset Value by Marginal Tax Rate
This was Dimitri’s original suggestion and is by far the easiest way to be a little more accurate. He suggests that you ignore the fact that you can’t touch the money until retirement and simply decrease its value by your marginal tax rate. At the very least, if you do nothing then you must decrease your pre-tax retirement accounts (IRAs, 401ks) by your marginal tax rate when you compare them with your post-tax retirement accounts (Roth IRAs) so you’re comparing apples to apples.
Why Discounting Really Doesn’t Matter
When you discount your assets, you’re assuming a certain value in the future, hopefully a value greater than your 401(k) balance right now. You reach that value by assuming a rate of return (a popular but overly optimistic one is 10-12%) and then calculating what your asset would be worth when you could take disbursements. Normally, you’d then discount that final asset value by a rate of return, which would still be 10-12%, and so you would arrive at the value you have started with. In reality, it’s not that simple because you would still contribute every year and there’s inflation, but for our purposes your current value is good enough with respect to discounting.
Verdict: Reduce Pre-Tax Retirement Asset Worth by Tax Rate
For a better picture of your pre-tax retirement asset value, I think you should reduce it by your marginal tax rate because at the very least your 401(k) can be compared on even ground with your Roth IRA (for example). While it’s not exactly perfect, it’s good enough.
What do you all think? Good idea? Bad idea? Do you have an alternative that you use? I look forward to reading all and any criticisms, thoughts, rants, anythings on the matter. Thanks!
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