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When choosing a retirement plan, many beginners immediately turn to free, online retirement calculators. You type in some basic personal information, current income, and retirement goals, and the calculator can tell you how much money to save and which type of retirement plan (traditional or Roth IRA) it recommends. New research coauthored by Gies College of Business professor Josh Herbold, however, sheds some light on the limitations of these online calculators while also offering advice on which calculators are best.

“The biggest misconception is that the calculator is doing more than we think it’s doing,” said Herbold. “It’s really not doing a lot in most cases. Most online calculators are doing just a straight ‘time value of money’ calculation and giving you a future value number. By and large, they’re not accounting for the year-to-year fluctuations in interest rates, and they’re not taking into consideration whether you’re reinvesting your tax deduction or spending it.”

When deciding between a traditional or Roth IRA, Herbold says the two most common factors that online calculators don’t consider are your income limits and investing style. An investor’s income status can affect whether their retirement contributions are tax deductible or even allowable. Above a certain income level, the investor may not even be able to contribute to a Roth IRA. The other factor to consider is how risk averse you are.

“We talk about people being risk averse or risk seeking. If you are going for high-growth investments, those have more variation in the returns. That can affect your overall endpoint,” said Herbold. “Most calculators just use a constant rate of return, say 6% for example, and a high-growth strategy might give you 8% - but some years you’re going to lose money. It’s important to consider your investment style when choosing a plan.”

So which online calculators are best? Herbold recommends using those that employ a Monte Carlo simulation, which incorporates the year-to-year fluctuations in the rate of return. These include calculators from E-Trade, T. Rowe Price, and TD Ameritrade.

“The Monte Carlo calculators will run many different simulated financial projections that include the possible year-to-year variation in returns, and then report back the aggregate or average of those simulations,” said Herbold. “This is far more realistic than a straight ‘time value of money’ calculation, but it may be hard for novice investors to understand the variations in results. Of those three calculators, E-Trade makes that variation the easiest to understand.”

Among the calculators that employ a single estimated rate of return, Herbold recommends Lincoln and John Hancock because of their transparency, flexibility, and ease of comparison between traditional and Roth IRAs. Herbold emphasizes there are no “wrong” options; it’s only about deciding which plan is best for you.

“Saving something is better than not saving anything,” he said. “If a calculator motivates you to start investing, especially early, that’s great. You will be way better off in the long run. Let the power of time and compound interest start working for you sooner. Then when you can, get a seasoned financial advisor to help you put together a more comprehensive retirement plan.”

“Are Online Roth versus Traditional IRA Calculators Useful?” by Tim Manuel (University of Montana) and  Josh Herbold (University of Illinois, Gies College of Business) was published in the November 2019 issue of The CPA Journal