Extending Scholes/Wolfson for Post-1997 Pension Investments: Application to the Roth IRA Contribution and Rollover Decisions.

The Scholes and Wolfson (1992) (SW) savings vehicle formulas are powerful toots to analyze investment alternatives. However, application of their pension formula to cases where the after-tax investment exceeds statutory limitations on investment size results in overstated after-tax future values. This overstatement occurs because the SW pension equation does not explicitly model tax law restrictions that limit deductible pension investments. We use the SW savings vehicle formulas as investment components and provide a pension formula that explicitly models tax law restrictions. Our pension strategy consists of two distinct components: the pension account and a supplemental account. The supplemental account captures any after-tax investment that exceeds statutory limitations associated with deductible pension plans. We use our investment component perspective to analyze the annual Roth vs. deductible IRA decision. We then extend the SW investment formula approach to analyze the Roth IRA rollover decision. For both decisions, algebraic expressions are derived that are useful in determining the after-tax future value-maximizing decision in most cases.