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This Document Contains Chapters 13 to 15 Chapter 13 Investing in Mutual Funds, ETFs, and Real Estate Chapter Outline Learning Goals I. Mutual Funds and Exchange Traded Funds: Some Basics A. The Mutual Fund Concept 1. Pooled Diversification B. Why Invest in Mutual Funds or ETFs? 1. Diversification 2. Professional Management 3. Financial Returns 4. Convenience C. How Mutual Funds Are Organized and Run D. Open-End versus Closed-End Funds 1. Open-End Investment Companies 2. Closed-End Investment Companies E. Exchange Traded Funds (ETFs) F. Choosing between ETFs and Mutual Funds G. Some Important Cost Considerations 1. Load Funds 2. No-Load Funds 3. 12(b)-1 Fees 4. Management Fees 5. Keeping Track of Fund Fees and Loads H. Buying and Selling Funds II. Types of Funds and Fund Services A. Types of Funds 1. Growth Funds 2. Aggressive Growth Funds 3. Value Funds 4. Equity-Income Funds 5. Balanced Funds 6. Growth-and-Income Funds 7. Bond Funds 8. Money Market Mutual Funds 9. Index Funds 10. Sector Funds 11. Socially Responsible Funds 12. International Funds 13. Asset Allocation Funds B. Services Offered by Mutual Funds 1. Automatic Investment Plans 2. Automatic Reinvestment Plans 3. Regular Income 4. Conversion Privileges 5. Retirement Plans III. Making Mutual Fund and ETF Investments A. The Selection Process 1. Objectives and Motives for Using Funds 2. What Funds Have to Offer 3. Whittling Down the Alternatives B. Getting a Handle on Mutual Fund Performance 1. Stick with No-Load or Low-Load Mutual Funds 2. Measuring Fund Performance 3. Evaluating ETF Performance 4. What About Future Performance? IV. Investing in Real Estate A. Some Basic Considerations 1. Cash Flow and Taxes 2. Appreciation in Value 3. Use of Leverage B. Speculating in Raw Land C. Investing in Income Property 1. Commercial Properties 2. Residential Properties D. Other Ways to Invest in Real Estate 1. Real Estate Investment Trusts 2. Real Estate Limited Partnerships or Limited Liability Companies Major Topics This chapter introduces students to mutual funds, one of the most popular investment vehicles today. Mutual funds offer attractive levels of return from professionally managed, diversified portfolios of securities. The number of funds increases each year, and the many different fund types available can make selecting the right fund for an investor's particular needs a confusing process. This chapter also helps students understand the role that real estate plays in a diversified investment portfolio, along with the basics of investing in real estate, either directly or indirectly. Therefore, this chapter guides investors to wise choices by covering the following topics: 1. The basic character of mutual funds, and how diversification and professional management are the cornerstones of the industry. 2. The advantages and disadvantages of owning mutual funds. 3. The five major types of investment companies. 4. Cost considerations when buying mutual funds. 5. The kinds of funds available and the variety of investment objectives these funds seek to fulfill. 6. The array of special services offered by mutual funds and how these services can fit into an investment program. 7. How to assess and select funds that are compatible with the investment needs of the individual. 8. How to measure mutual fund performance. 9. Understanding real estate investments. Key Concepts Mutual funds can help an investor achieve the goals of his or her personal financial plan with greater certainty. Understanding how mutual funds operate, the various types of fund offerings, and how to choose the best funds for various needs are necessary before developing a portfolio of mutual funds. Real estate investments can help an investor diversify their portfolio. Understanding real estate investments involves understanding the cash flows from investing as well as the vehicles used to invest. The following phrases represent the key concepts stressed in this chapter. 1. Mutual funds 2. Pooled diversification 3. Professional portfolio management 4. Closed-end and open-end funds 5. Exchange-traded funds (ETF) 6. Unit investment trusts 7. Load, low-load, back-end load, and no-load funds 8. 12(b)-1 fees and other charges 9. Types of mutual funds 10. Variety of fund services available to investors 11. Fund selection 12. Measurements of fund performance 13. Investing in real estate 14. Real estate cash flows and taxes 15. Investing in income property 16. Other ways to invest in real estate 17. Open-end investment company 18. Net asset value (NAV) 19. Closed-end investment company 20. Management fee 21. General-purpose money fund 22. Tax-exempt money fund 23. Government securities money fund 24. Socially responsible fund (SRF) 25. International fund 26. Automatic investment plan 27. Automatic reinvestment plan 28. Systematic withdrawal plan 29. Conversion (exchange) privileges 30. Real estate investment trust (REIT) Financial Planning Exercises The following are solutions to problems at the end of the PFIN 4 chapter. 1. As with any sound investing, the key to answering this question must focus on matching the risk-return characteristics of the investments in a way that is compatible with the Lisa’s individual financial objectives. Mutual funds can be used by individual investors in various ways. One investor may buy a fund because of the substantial capital gains opportunities it provides; another may buy a totally different fund not for its capital gains but instead for its current income. Whatever kind of income a fund provides, individuals tend to use these investment vehicles for one or more of the following reasons: (1) to achieve diversification in their investment holdings, (2) to obtain the services of professional money managers, (3) to generate an attractive rate of return on their investment capital, and (4) for the convenience they offer. Technically, an exchange-traded fund (ETF) is a type of mutual fund that trades as a listed security on one of the stock exchanges (mostly the Amex). Nearly all ETFs are structured as index funds, set up to match the performance of a certain market segment; they do this by owning all or a representative sample of the stocks (or bonds) in a targeted market segment or index. ETFs offer the professional money management of traditional mutual funds and the liquidity of an exchange-traded stock. ETFs have been developed to accommodate investors pursuing narrow market segments. ETFs are set up to protect investors from capital gains taxes better than most mutual funds can. ETFs have lower overhead expenses than most mutual funds because they don’t have to manage customer accounts or staff call centers. This means that ETFs tend to have lower expense ratios than mutual funds. 4. The less risky fund from each pair is as follows: a. The growth-and-income fund—because it seeks its return not only from capital gains (growth) but also interest and dividends (income) and as such, tends to invest in more conservative issues. The current income serves several functions: it boosts total return even when there is little or no capital growth, and it helps stabilize share price because if times turn sour investors may be more willing to purchase income- producing securities than those which rely on growth alone. b. The high-grade corp. bond fund—bonds, especially high (investment) grade bonds, are less risky because debt securities by nature are less risky than equity securities (the company has a legally binding obligation to repay debt whereas equity is a residual—in the event of liquidation, owners get what’s left after debt holders are paid, which is probably zip). However, this doesn’t mean that bonds are risk free. They are particularly interest rate sensitive, and the longer the maturity, the more sensitive the bond. Bond funds can also be more risky than holding individual bonds, because bond funds will be trading securities, and if interest rates rise, bond funds will realize capital losses. If you hold an individual bond until maturity and interest rates rise, you don’t realize a capital loss but have instead opportunity cost. c. The intermediate-term bond fund—maybe. The intermediate-term bond fund will consist of investment grade bonds with maturities of 7–10 years or less. The high-yield municipal bond fund will have securities rated below-investment grade, so the quality of the bonds will be lower and therefore riskier. However, municipal bonds are issued by state and local governments, most of which would not like to see their bonds default, so this is a plus even with the below-investment grade rating. Also, like other bonds, municipals can be issued for a variety of time periods, and the shorter the time to maturity, the less risk. Therefore, shorter term high-yield munis could possibly be less risky than intermediate term corporates. You would need more information on the individual funds in order to make a good choice. d. The balanced fund—anytime you go off-shore (as in an international fund), you add more risk (currency exchange rates, political risk, possibly lack of information and/or full financial disclosure); moreover, a balanced fund itself is considered to be a fairly conservative investment vehicle as it seeks both capital gains and current income from a mix of both stocks and bonds. 5. There are three sources of return from the ownership of mutual fund shares: realized capital gains, dividends, and price appreciation in the shares. Ben earned a capital gain of $1.83, a dividend of $0.40, and price appreciation of $1.50 ($26.00 − $24.50). Using the approximate yield formula, his rate of return would be: ($26.00 − $24.50) $0.40 + $1.83 + 1 = $ 3.73 = .148 or 14.8% ($26.00 + $24.50) $25.25 2 If the price of the common stock had risen to $30.00, the appreciation in value would have been $5.50 ($30.00 − $24.50), which changes the approximate yield to: ($30.00 − $24.50) $0.40 + $1.83 + 1 = $ 7.73 = .284 or 28.4% ($30.00 + $24.50) $27.25 2 So, yes, Ben would have made over a 20% return if the stock had risen to $30 a share. When using the financial calculator, set on 1 payment/year and End Mode. We will assume that the mutual fund distributed the dividends and capital gains at the end of the year, a total of $2.23 per share ($0.40 + $1.83). The keystrokes on the left show the return if the value of his stock rises to $26 at the end of the year, while those on the right show the return if the value of his stock rises to $30 at the end of the year. 24.50 +/- PV 24.50 +/- PV 2.23 PMT 2.23 PMT 26.00 FV 30.00 FV 1 N 1 N I/YR 15.22% I/YR 31.55% 6. An ETF is like an open-end fund in that the number of shares outstanding can be increased or decreased as investors send in more money or redeem shares. An ETF is also like a closed-end fund in that it trades as a listed security on one of the stock exchanges, and it can be traded at any time of day by placing an order through a broker. The Vanguard 500 Index Fund would most closely resemble a Spider, as this fund tracks the performance of the S&P 500 Index just as a Spider does. For buy-and-hold investors, the two choices would be fairly comparable, although the 500 Index Fund would not be quite as tax efficient as the Spider. For investors who trade more frequently, the Spider would probably be the better choice, as it can be bought and sold during the day. 7. Student answers may vary on the information needed to evaluate the performance of the ETF and will likely present various performance metrics for the EFT. However, they should find the following general information: The QQQ index-based ETF is designed to replicate the performance of the NASDAQ 100 index and compares favorably with other funds in its category. Its R-square is 97.09, which means that it matches the NASDAQ index well, since 100 would indicate a perfect match. The quartile ranking of return as compared with other funds in its category is above 50% for 7 out of the last 10 years. Essentially, the fund’s return is high overall when compared to 16 similar funds. This ETF would appeal to investors wanting consistent exposure to the large non-financial growth stocks that characterize the NASDAQ 100 index, because it replicates the performance of the index well and has relatively low expenses. 8. Approximate Yield: ($23.04 − $23.35) $1.05 + 1 = $ 0.74 = .0319 or 3.2% ($23.04 + $23.35) $23.20 2 When using the financial calculator, set on 1 payment/year and End Mode. We will assume that the mutual fund distributed the dividends and capital gains at the end of the year. 23.35 +/- PV 1.05 PMT 23.04 FV 1 N I/YR 3.17% Note: This is a good problem to use to demonstrate the impact of load charges on investor return; the instructor might want to point out that even though the NAV of the fund increased by $1.54 a share ($23.04 − $21.50), the investor still is faced with a 31¢ loss in value over the year, since you buy at the offer price and sell at the NAV. In this case, even though the NAV went up, the investor had to absorb a $1.85 load charge—the net result: a 31¢ loss. The income is what makes the total return positive. As a point of interest, if this had been a no-load fund, the approximate yield would have been: ($23.04 − $21.50) $1.05 + 1 = $ 2.59 = .116 or 11.6% ($23.04 + $21.50) $22.27 2 When using the financial calculator, set on 1 payment/year and End Mode. We will assume that the mutual fund distributed the dividends and capital gains at the end of the year. 21.50 +/- PV 1.05 PMT 23.04 FV 1 N I/YR 12.05% 9. No Leverage Leverage Owner investment $200,000 $ 50,000 Borrowed Money 0 150,000 Total Investment $200,000 $200,000 Earnings Before Interest and Income taxes $ 30,000 $ 30,000 Less: Interest (8% × 150,000) 0 12,000 Earnings before taxes $ 30,000 $ 18,000 Less: Income taxes (28%) 8,400 5,040 Earnings after taxes $ 21,600 $ 12,960 Return on Investment = Earnings after taxes Amount of owner investment $ 21,600 $ 12,960 $200,000 $ 50,000 10.8% 25.92% By using leverage, she was able to increase her return on her investment. This is due to the fact that the rate of interest was less than her return on investment with no leverage. Answers to Concept Check Questions The following are solutions to “Concept Check Questions” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find the questions on the instructor site as well. 13-1. A mutual fund invests in a diversified portfolio of securities and issues shares in the portfolio to individual investors; mutual funds represent ownership in a managed portfolio of securities. The mutual fund concept, therefore, revolves around diversification. Diversification, which reduces the overall risk borne by the investor, is available through a mutual fund. This, coupled with the fact that mutual funds have professional management, which frees the individual investor from managing his or her own portfolio, makes mutual funds attractive to individuals. 13-2. Individual mutual funds are created by management companies, like Fidelity, T. Rowe Price, Dreyfus, and Vanguard. They also run the fund’s daily operations and usually serve as the investment advisor. The investment advisor buys and sells securities and otherwise oversees the fund’s portfolio. This is normally carried out by the money manager, who actually runs the portfolio; security analysts, who look for viable investment candidates; and traders, who attempt to trade large blocks of securities at the best possible price. In addition, there are fund distributors, who actually buy and sell the fund shares; custodians, who take physical possession of the fund's securities and other assets; and the transfer agent, who keeps track of fund shareholders. 13-3. An open-end investment company is a mutual fund in which investors actually buy their shares from and sell them back to the mutual fund itself. There is no limit on the number of shares an open-end fund can issue, and this is by far the most common type of mutual fund. An exchange-traded fund is a type of open-end mutual fund that trades as a listed security on one of the stock exchanges. The number of shares outstanding can be increased or decreased in response to market demand like other open-end mutual funds. However, unlike open-end funds, investors can buy and sell ETFs at any time of the day by placing an order through their broker. Thus they offer all the advantages of any index fund: low costs, low portfolio turnover, and low taxes. 13-4 The most common types of ETFs available are based on market indexes, such as the S&P 500 (Spiders), DJIA (Diamonds), or NASDAQ 100 (Cubes), and are passively managed. There are also equity sector that allow investors to access specific segments of the market and provide exposure to commodities. ETFs are available composed of investments in real estate or options and derivatives. Style ETFs typically follow either certain market capitalization stocks or the value or growth stocks, tied to indexes. There are even ETFs that track bonds. Customization of ETFs can effectively create short positions for investors. However, the passive indexing of early ETFs is giving way to the creation of actively managed ETFs, like managed ETFs and leveraged ETFs, which seek to outperform rather than track the indexes. For investors, these actively managed ETFs are more risky. 13-5. A load fund is a mutual fund which must be purchased through a broker or other investment advisor. The seller is paid a commission by the mutual fund company for selling its funds. With a front-end load, the commission is assessed when purchases are made into the fund. With a back-end load, the commission is assessed when redemptions are made. Some load funds appear to be no-load funds but actually carry "hidden loads"— no front- or back-end loads, but they have higher annual expenses. Through time, funds with "hidden loads" may prove to be more expensive for the investor to hold than either front- or back-end load funds. A no-load fund does not pay commissions to brokers or investment advisors and may be purchased directly from the mutual fund company. The no-load fund offers an advantage to investors because, by avoiding the commission (which can be as high as 8.5%), they can buy more shares in the fund with a given amount of capital, and therefore, other things being equal, earn a higher rate of return. 13-6. While all funds will have some amount of annual operating expenses, those with "hidden loads" have relatively higher annual expenses and will also probably have 12(b)-1 fees. These 12(b)-1 fees are marketing fees which are often used as an indirect way of charging commissions. A fund cannot label itself as “no-load” if it charges a 12(b)-1 fee higher than 0.25%, but it can label itself as "no-load" even if its other annual expenses are high. 13-7. A back-end load fund charges a redemption fee/commission when the investor sells the fund. (Redemption fees often decline over time and may disappear altogether after 5 or 6 years of ownership). A low-load fund is a type of front-end load fund, but it keeps the load charge very low, usually less than 2 or 3%, while a hidden load is a term used to describe the 12(b)-1 fee and higher annual expenses mentioned in the previous question. There are several ways that investors can determine if a mutual fund carries a load or not. The WSJ and other major papers use letters in their mutual fund quotes to identify various types of fees; for example, "r" means the fund has a redemption charge. Internet sites, such as quicken.com and quote.yahoo.com, provide this information when you search for the various funds. Finally, every fund prospectus must contain a fee table that fully discloses the types and amounts of fees and charges. Many mutual fund companies have a Web site where you can find information about their funds as well as download a prospectus. 13-8. The objective of a growth fund is capital appreciation. Long-term growth and capital gains are the primary goals of such funds, and as a result they invest principally in common stocks that have above-average growth potential. They are usually viewed as long-term investment vehicles that are most suitable for the more aggressive investor who wants to build capital and has little interest in current income. Balanced Funds are so named because they tend to hold a balanced portfolio of both stocks and bonds, and they do so for the purpose of generating a well-balanced return of current income and long-term capital gains. For the most part, they confine their investing to high-grade securities, and are therefore usually considered a relatively safe form of investing. 13-9. International funds invest most or all of their assets in foreign securities. Some limit their portfolio to a particular country or geographical region—Japan, Mexico, Europe, Asia— while others have a broader base of investments. Another type of fund that invests in foreign securities is the global fund, which includes U.S. multinational companies as well as foreign corporations. There are many categories of both international and global funds: stock, bond, money market, growth, aggressive growth, balanced, etc. In general, these funds seek higher returns by capitalizing on changing market conditions abroad and the changing value of the dollar against foreign currencies. International and global funds provide a good way for investors who lack extensive knowledge of international economics to diversify internationally. 13-10. Unlike other mutual funds that invest primarily in one asset category, asset allocation funds invest in several markets. For example, a fund may invest 50% in common stocks, 25% in fixed income securities, 15% in money market securities, and 10% in foreign securities. These funds simplify the task of dividing an investor's assets among the various classifications. Instead of buying separate funds to achieve asset allocation, an investor can find one fund that matches his or her desired allocation plan. Whereas other types of mutual funds have a prescribed distribution among asset classes, asset allocation funds adapt their mix as market conditions change. Investors should monitor these changes to be sure the fund continues to match their personal objectives. Another way to hold various asset classes in one mutual fund is through a fund of funds. Instead of picking individual securities to hold in its fund, a fund of funds holds shares of other funds. This makes for great diversity and capitalizes on the investment styles of other money managers. As an example, the Vanguard STAR fund holds shares from several of Vanguard’s other stock funds, bond funds, and money market funds in its portfolio, and the expenses of these funds are passed on to STAR fund holders on a pro rata basis. 13-11. Even though growth, income, and capital preservation are primary mutual fund objectives, each fund concentrates on one or more particular goal(s). Thus, for people who rely heavily on current income, an investment in an income fund would be the right choice. Investors who do not require the current income and are content with waiting for capital appreciation can benefit from growth funds. These classifications of mutual funds are helpful in determining whether or not the goal of the mutual fund is compatible with one's own investment objective. The SEC requires that the specific objective of a fund be stated in its prospectus, along with how it intends to meet its objective. 13-12. A fund family consists of the different funds offered by the same investment company, like Fidelity, Kemper, or Vanguard. The major advantage of these families is the right to switch among them for little or no charge as investment objectives change or as the investment environment changes. 13-13. Automatic reinvestment plans allow the shareowners to elect to have interest, dividends, and capital gains realized on their holdings automatically reinvested in additional shares. Fractional shares are issued, if necessary, and usually there is no charge on the reinvestment transaction. This keeps investors' capital fully invested, allowing it to earn compounded rates of return. Automatic investment plans, on the other hand, are programs by which investors channel a fixed amount from their bank account directly into a mutual fund at regular intervals, usually monthly or quarterly. These plans provide investors a convenient way to build up their mutual fund holdings over time. Also, many funds offer lower minimum initial investments to investors who enroll in automatic investment plans. 13-14. The most common motives for purchasing mutual fund shares are diversification, professional management, financial return, and convenience. The primary motive for investing in mutual fund shares is the ability to diversify and diminish risk by indirectly investing in a number of different types of securities and/or companies. The fact that a professional manager is paid to make investment decisions is expected to improve the owners' returns. Mutual funds also provide a way to invest in areas that an investor may not fully understand, and in reality, many people do not have the time or inclination to track their own investments. Convenience, provided by the fact that investment company shares can be purchased through a variety of sources, also adds to their appeal. In addition, mutual funds provide their investors with a variety of services, like automatic reinvestment plans, phone or online switching, and conversion privileges. Mutual funds also offer the small investor a way to invest with little start-up capital. In fact, some funds require only a very low or even no minimum initial investment if an automatic monthly draft is made from the investor’s bank account. To keep expenses low, the investor can pick a quality no-load fund and bypass the broker entirely. These funds are easy to get into, easy to get out of, and the investor doesn’t have to worry about whether to take physical possession of the securities or not. 13-15. The mutual fund selection process begins with an assessment of your investment objectives. Key factors to consider include: your reasons for investing, your risk tolerance, the use of the fund (capital accumulation, speculation, conservation of principal), what types of return you require, and services desired. Clearly, answering these questions is essential if you are to select from the universe of thousands of funds those with the investment objectives, operations, and services that meet your particular needs. Research comes next: financial publications (The Wall Street Journal, Investor's Business Daily, Barron’s, Forbes, Fortune, Kiplinger's, and SmartMoney, for example) regularly publish mutual fund reports and rankings, many of which are available online. Other valuable research sources are Morningstar and Weisenberger mutual fund report services, Value Line, and similar companies. The next step is to narrow the field by choosing several types of funds that match your investment and asset allocation objectives and then apply other constraints (load versus no-load, services offered, etc.) to further define potential investment candidates. The final decision should be based on the fund's investment performance. 13-16. A load fund charges a fee, usually up front, to invest in the fund. This fee does not go to the manager to reward him or her for superior performance, but rather it goes to the sales person or broker who sold you the fund. Therefore, the only reasons you would ever want to invest in a load fund is if the sales person or broker adds value to your investment decisions or if the fund offers superior performance above that which can be found in any no-load funds. A no-load fund does not charge the investor a fee, so every dollar gets fully invested. Also, a no-load fund does not have to take as high a risk to earn the same return as a load fund because of its lower expenses. Research has shown that, indeed, load funds do not outperform no-load funds, so that there is generally no advantage to buying load funds. Beware, however, some funds do not charge a front-end load but do charge hefty annual fees, 12(b)-1 fees, and/or redemption fees, and in this case, you might truly do better with a well-managed load fund with low annual fees. Also be careful when you see performance rankings, because many times the load is not reflected in the return. In reality, if you had actually held that load fund, you would not have earned the stated return after adjusting for the load. 13-17. There are three potential sources of return to mutual fund investors: (1) current income (from the dividends and interest earned by the fund); (2) capital gains distribution (from the realized capital gains earned by the fund); and (3) change in the fund's share price. Each of these components has an effect on the total return of a mutual fund. Both dividends and realized capital gains are accumulated and then distributed to fund shareholders. Unrealized capital gains affect return because when the fund's holdings increase or decrease in price, the NAV moves as well. The greater the return from any of these components, the greater the total return to the investor. 13-18. Student preferences for dividends, realized capital gains, or unrealized capital gains will depend on several factors. Dividend and realized capital gain income can be reinvested to achieve fully compounded returns. However, there are tax consequences from each distribution: current income (interest) and short-term capital gains are taxed at the taxpayer’s marginal tax rate; long-term capital gains and dividends are taxed at lower, more favorable rates. Unrealized capital gains (increases in NAV) have no tax implications until the shares of the fund are sold, so payment of taxes on this portion can be delayed. As the taxpayer gets into the higher marginal tax brackets, the tax implications become more and more of a consideration. 13-19. Since a mutual fund is really a large portfolio of securities, it behaves very much like the market as a whole, or a given segment of the market (as bond funds would relate to bond markets). In general, when economic conditions are good and the stock market moves up, mutual funds do well. When the market takes a plunge, mutual funds do poorly, although some portfolio managers do better than others at managing downside risk. 13-20. The behavior of a well-diversified mutual fund or ETF tends to reflect the general tone of the market. So, if the feeling is that the market is going to be generally drifting up, that should bode well for the investment performance of the mutual fund and ETFs. 13-21. a. Cash flow and taxes: An investor’s cash flow, or annual after-tax earnings, depends not only on the revenues generated from a particular piece of property, but also on depreciation and taxes. Depreciation is a bookkeeping entry that is considered an expense for tax purposes even though it involves no actual outflow of cash. Therefore, it reduces your taxable income and your taxes. b. Appreciation in value: Most types of real estate – including everything from raw land to various forms of income-producing properties – have experienced significant growth in value over time. Therefore, an investment evaluation should include expected changes in property value (that is, price appreciation). Price appreciation should be treated as capital gains and included as part of the return from the investment, minus the capital gain taxes paid. c. Use of leverage: Leverage involves the use of borrowed money to magnify returns, which is a big attraction to investing in real estate. Because real estate is a tangible asset, investors are able to borrow as much as 75 to 90% of its cost. As a result, if the profit rate is greater than the cost of borrowing, then the return on a leveraged investment will be proportionally greater than the return generated from an unleveraged investment. 13-22. Speculating in raw land is considered a high-risk venture because the key to such speculation is to isolate areas of potential population growth and/or real estate demand (ideally before anyone else does) and purchase the property in these areas in anticipation of their eventual development. This involves a high degree of uncertainty. 13-23. The major categories of income property include commercial properties and residential properties. The advantages of investing in income properties is that they provide both attractive returns and tax advantages for investors. Disadvantages include the owner of the property being responsible for leasing the units and maintaining the property. Singlefamily homes can be used to generate income by the ability to deduct interest paid on a mortgage from taxes, capital gains exemption when you sell the home, renting out of a second residence, and “flipping houses”. “Flipping houses” involves buying a house, upgrading the property and then selling it for a higher price than you paid, including the cost of upgrades. 13-24. a. Stock in real estate related companies offers investors the benefits of real estate ownership – both capital appreciation and current income – without the headaches of property management. These are investment companies that invest money in various types of real estate and real estate mortgages. It is like a mutual fund in that is sells shares of stock to the investing public and uses the proceeds, along with borrowed funds, to invest in a portfolio of real estate investments. b. Real estate limited partnerships or limited liability companies are organized to invest in real estate. The managers assume the role of general partner, which means their liability is unlimited, and the other investors are limited partners who are legally liable only for the amount of their initial investment. Investors buy units in an LP or LLC, a unit represents an ownership position. These are riskier investment categories than the others discussed above, and appeal to more affluent investors who can afford the typical unit cost of $100,000 or more. 13-25. The basic structure of a REIT is like a mutual fund in that it sells shares of stock to the investing public and uses the proceeds, along with borrowed funds, to invest in a portfolio of real estate investments. The investment consideration associated with a REIT is that income earned by the REIT is not taxed, but the income distributed to owners is designated and taxed as ordinary income while dividends on common stocks normally are taxed at preferential rates of 15% or less. The three basic types of REITs are: 1. Equity REITs 2. Mortgage REITs 3. Hybrid REITs Solutions to Online Bonus Financial Planning Exercises The following are solutions to “Bonus Personal Financial Planning Exercises” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 1. Student answers may vary but should include some of the following points: Investing directly in stocks and bonds means the investor actually owns a specific number of shares, holds a direct interest in the issuing firm (or is a lender to the firm in the case of bonds), and receives income from the issuing firm. The investor is in control of the selection and sale of securities, can select securities with the type of gains desired and can time the realization of those gains. This is particularly important to taxpayers in the higher tax brackets. With mutual funds, the investor deals with an intermediary (the investment company) that acquires the stocks, bonds, and other financial assets for the combined benefit of its stockholders. The fund manager makes the decisions concerning the selection and sale of securities, not the investor. Mutual funds are attractive to people who have limited amounts of capital but want diversification. They also appeal to investors who lack the expertise, commitment, or time to effectively manage a portfolio on their own. 2. This question can be customized by the instructor for additional learning opportunities. The following chart was populated with information found on Exhibit 13.3. It is recommended that students be given specific date for purchase and sales and a list of funds to use for looking up prices and loads. [Note: Price information can be obtained from finance.yahoo.com. Find the fund's ticker and look under "Profile" for fund expense information. You can also pull up the fund family's Web site.] Here is an example of information from four funds in Exhibit 13.3: Fund Type of Load Front Load $ Load Purchase Price NAV or Selling Pr. A Artio Select Opportunities Fund, class A shares (GlbEqA) 12(b)-1 Redemption fee 0% $ 0 36.35 b. Artio Select Opportunities Fund (GlbEqI) None 0% 0 36.73 c. Artio International Equity Fund II (IntlEqII I) Redemption fee 0% 0 10.78 d. Artio U.S. Small Cap Fund (USSmCpA) 12(b)-1 0% 0 10.58 In the Exhibit 13.3: (1) NAV stands for Net Asset Value. This represents the value of one share in this fund. NAV is calculated by taking the total value of the fund's investments, subtracting its expenses and dividing by the number of shares outstanding. (2) Net Chg (Net Change) is the change in the value of one share from the previous day’s market closing. (3) YTD % Ret (Year-To-Date Percent Return) shows the percentage increase or decrease in value for one share since the beginning of the current calendar year. This number assumes reinvestment of any dividends. You might expand the assignment on this with some additional questions. (Answers for our examples are included.) Based on these funds, which Fund has the highest value for one share and which has the lowest value on a particular day? Highest year-to-date return: Artio International Equity Fund II, 12.9% Lowest year-to-date return: Artio Select Opportunities Fund, class A shares, 10.9% Highest 3-year return: Artio U.S. Small Cap Fund, 9.5% Lowest 3-year return: Artio International Equity Fund II, −0.6% There have been numerous changes in the mutual fund industry, and the trend has been away from charging loads. The exhibit in the text denotes some funds having loads while others have none. To illustrate how a front-end load would work, assume XYZ Fund charges a 5.25% front-end load and its quoted NAV is $25.47. NAV = Purchase Price − .0525(Purchase Price) = Purchase Price(1 − .0525) So NAV/(1 − .0525) = Purchase Price = $25.47/0.9475 = $26.88 3. Student portfolios will vary considerably. However, each answer should describe the student's personal financial goals, investment objectives, and risk tolerance, and then relate these factors to the actual fund selection. For example, a student who can tolerate above average risk and is investing for capital appreciation may include aggressive growth, international, and sector funds. More conservative investors may prefer equityand-income funds, blue chip stock funds, and balanced funds. The selection of funds within a category should be based on performance over at least a five-year time horizon, and in both up and down markets. Finally, the services offered may be a factor for some students. Students should consult various research sources during the decision process. 4. Conversion (exchange) privileges—the right to switch from one fund to another—apply to funds within one family. There may be some limitations imposed by the fund family. Some brokerages (Charles Schwab, for example) offer conversion privileges for selected funds from a variety of families. If you have an account at one of these firms, you can switch as long as the fund is on the brokerage's list. Other fund services—automatic investment and reinvestment plans, systematic withdrawal plans, and retirement plans—can be offered by any fund, whether or not it is part of a fund family. The instructor could bring in the paper to show the many fund families, such as Fidelity, Dreyfus, T. Rowe Price, Scudder, Merrill Lynch, Vanguard, etc. Emphasis can be placed on the variety of funds offered by each of these families. Student examples of fund families will vary in their offerings. 5. The instructor may wish to bring in information from a variety of investment company services or the financial media (like Forbes or Barron's). Because this is an outside project, examples have not been included here. Selection of specific funds can be done in a variety of ways, which may include: funds of a certain size; funds of a particular manager; funds with a particular level of recent or long-term performance; funds recommended by a certain publication in a recent article; funds owned by the student or someone the student knows, etc. 6. Using the approximate yield formula, we can find the fund's rate of return for each year as follows: 2014: ($58.60 − $52.92) $1.24 + $3.82 + 1 = $10.74 = .1926 or 19.26% ($58.60 + $52.92) 2 2015: ($64.84 − $58.60) $55.76 $.83 + $2.42 + 1 = $ 9.49 = .1538 or 15.38% ($64.84+ $58.60) 2 $61.72 When using the financial calculator, set on 1 payment/year and End Mode. We will assume that the mutual fund distributed the dividends and capital gains at the end of the year, a total of $5.06 per share in 2014 and $3.25 per share in 2015. The keystrokes on the left show the return for 2014, while those on the right show the return for 2015. 52.92 +/- PV 58.60 +/- PV 5.06 PMT 3.25 PMT 58.60 FV 64.84 FV 1 N 1 N I/YR 20.29% I/YR 16.19% Mile High Growth-and-Income Fund generated a rate of return of almost 20% in 2014 and over 15% in 2015. This appears to be an impressive return record—but to put it in perspective, you should compare it to its comparable market index and to other funds with the same investment objective. Solutions to Critical Thinking Cases The following are solutions to “Critical Thinking Cases” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 13.1 Todd’s Dilemma: Common Stocks, Mutual Funds, or ETFs? 1. The key reasons for purchasing mutual fund shares are: diversification, professional management, returns, and services. Diversification is achieved because each mutual fund share represents an indirect investment in a diversified portfolio of securities. Because professional management is used to select the securities held in the fund, it is expected that the financial returns will be safer and higher than if a person managed his or her own portfolio. Todd should understand, however, that while the fund might be able to outperform what he would be able to do, that certainly does not mean the fund will outperform the market (indeed, over the long-haul, the chances are the fund will do no better than match the market's return). In addition to performance, mutual funds are convenient to buy and they offer a variety of attractive services (see question 2 below). 2. The features usually available from mutual funds include: automatic investment and reinvestment plans, systematic withdrawal plans, conversion privileges, and retirement programs. Three of these would probably be of interest to Todd: (1) the automatic reinvestment plans, which would enable Todd to plow back his dividends and capital gains distributions and, therefore, earn a fully-compounded rate of return; (2) conversion privileges, which would enable Todd to move (probably by phone or online) his money from one fund to another as his objectives or the investment environment changes (Todd would have to confine his moves to the same family of funds unless he has one of the special accounts mentioned in problem 5); and (3) the retirement programs that are available at most funds, which would enable Todd to enjoy the tax-sheltered benefits that accompany IRAs and other retirement programs. 3. If Todd’s goal is strictly the receipt of income, bond funds, preferred stock funds, income-oriented diversified common stock funds, money market funds, or municipal bond funds should be considered. His choice among these income-oriented funds would depend on his risk disposition and the risk-return trade-offs he perceives in each of these types of funds. If Todd is more interested in growth (capital gains), he might choose a growth fund, aggressive growth fund, growth-and-income fund, or sector fund. If he is willing to take the risks, he might also want to consider going offshore with his money by investing in an international fund. Again, the choice among these alternatives will largely depend upon Todd’s investment goals, risk disposition and the risk-return tradeoffs. Todd would probably want to also consider taxes when developing his investment goals. Because he earns a good salary and is single, he is probably in at least the 28% tax bracket. He does not need the investment income and should concentrate on either a growth-oriented fund or one providing tax-exempt income. 4. Todd’s choice between investing in common stocks, mutual funds, or ETFs can only be resolved in light of his own risk-return preferences. In general, an investment in a common stock fund would allow Todd to achieve similar types of returns as those available on common stock investments. The difference between the two is that, while the mutual fund investment will provide diversification and professional management, he will have no choice in the selection of individual securities or the timing of gains. Todd must weigh these factors in light of his own investment objectives in order to decide which alternative is preferred. He should recognize that if he chooses to directly invest in common stocks, he will probably have to devote more of his own time to managing this investment than would be the case if he were to rely on the professional management of the mutual fund. 5. ETFs are similar to mutual funds but offer a degree of flexibility not available from standard mutual funds. More specifically, ETFs offer the professional money management of traditional mutual funds and the liquidity of an exchange traded stock. 13.2 Eileen Ponders Mutual Funds 1. Eileen needs to accumulate capital and needs an investment vehicle that will achieve this goal. Given her lack of investment expertise, mutual funds would be an ideal vehicle. She would gain professional investment management and far greater diversification than if she invested her money directly. Moreover, she could set up an automatic investing plan and also reinvest gains to help her reach her goal of long-term capital accumulation. 2. As indicated earlier in the text, certain prerequisites must be satisfied prior to entering an investment program. Eileen can cover the necessities, but she should be sure that she also has adequate insurance and sufficient liquidity. All or part of the $15,000 can be invested in a money market mutual fund without losing any liquidity, but with a gain in interest. Eileen could use a money market fund to accumulate funds that can later be moved to another fund. 3. Eileen’s specific investment needs are retirement and college education for her child. These are both long-term programs: 12 years until her child goes to college and much longer until retirement. Both objectives favor a conservative growth fund or a growthand-income fund. A good strategy would be to start Eileen with a money market fund. Once she establishes adequate liquidity, she can then move into other types of funds. Using automatic savings and reinvestment services, Eileen should be able to accumulate capital to meet both objectives without undue risk. Because Eileen is probably in the lowest tax bracket, taxes on her investments will be minimal and therefore are not a big consideration. In meeting her retirement needs, she should also investigate an IRA. So long as she is earns less than the amount allowed by law (and she probably does), she can contribute up to $5,500 (as of 2013) to a traditional IRA in addition to any contributions to her employer-sponsored retirement program. Taxes on the contribution (along with earnings on the account) are deferred until she withdraws funds during retirement. She should also consider the Roth IRA (instead of the traditional) because she would pay taxes now on the amount contributed but would never have to pay taxes again on the contribution or the earnings (if left in the Roth IRA until retirement). Since she is probably in a low tax bracket, the taxes she would pay now on the $5,500 contribution would be fairly small. Also, the Roth IRA also offers more flexibility in making early withdrawals and for estate planning purposes. 4. Eileen might want to use indirect investments in real estate to diversify her portfolio. Being a single mother of a young child, she might not have time for direct investments in real estate. Flipping homes might not be a good idea for Eileen as she is not interested in taking a lot of risk and if she doesn’t have the talents needed to choose the properties and/or make good choices about which improvements a property would need, this might not be a good choice. REITs would allow her the advantages of diversifying into real estate without having to maintain the properties herself.   Chapter 14 Planning for Retirement Chapter Outline Learning Goals I. An Overview of Retirement Planning A. Role of Retirement Planning in Personal Financial Planning B. The Three Biggest Pitfalls to Sound Retirement Planning 1. Compounding the Errors C. Estimating Income Needs 1. Determining Future Retirement Needs 2. Estimating Retirement Income 3. Funding the Shortfall D. Sources of Retirement Income II. Social Security A. Coverage B. Social Security Payroll Taxes C. Social Security Retirement Benefits 1. Old-Age Benefits 2. Survivor's Benefits D. How Much Are Monthly Social Security Benefits? 1. Range of Benefits 2. Taxes on Benefits III. Pension Plans and Retirement Programs A. Employer-Sponsored Programs: Basic Plans 1. Participation Requirements 2. What's Your Contribution? 3. Defined Contributions or Defined Benefits 4. Qualified Pension Plans B. Employer-Sponsored Programs: Supplemental Plans 1. Profit-Sharing Plans 2. Thrift and Savings Plans 3. Salary Reduction Plans C. Evaluating Employer-Sponsored Pension Plans D. Self-Directed Retirement Programs 1. Keogh and SEP Plans 2. Individual Retirement Accounts (IRAs) 3. Self-Directed Accounts and Their Investment Vehicles IV. Annuities A. Classification of Annuities 1. Single Premium or Installments 2. Disposition of Proceeds 3. Fixed versus Variable Annuity B. Sources and Costs of Annuities C. Investment and Income Properties of Annuities Major Topics Retirement planning is a key element in personal financial planning. To be done right it should be a part of everyone's financial plans early in his or her life/career. Basically, retirement planning involves a systematic accumulation of capital that can be used in retirement to provide a desired standard of living. The major ideas covered in this chapter include: 1. Retirement goals are a function of your age at retirement and your financial position. 2. Retirement plans should be addressed at least 20 to 30 years before your expected retirement date—the longer you put it off, the harder it will be to meet your retirement goals. 3. Social Security is the basis for most retirement plans, and its basic provisions should be understood. 4. Private and government employer pension and retirement plans are still another important source of retirement benefits. 5. Individuals can also set up their own self-directed retirement plans. 6. Annuities are another major source of retirement funds, as they offer a variety of income streams. Key Concepts Upon retirement, many people are concerned about outliving their assets—a real possibility if a retiree does not have a lot of assets to begin with, or if the level of consumption far exceeds the rate of return on the assets. Because we really do not know how long we will live, a good retirement plan should consider asset preservation and also employ several options for the income continuation. The following phrases represent the key concepts stressed in this chapter. 1. Estimating retirement needs and income 2. Major pitfalls to retirement planning 3. Social Security concepts 4. Social Security retirement benefits 5. Personal earnings and benefit estimate statement 6. Employer-sponsored retirement and profit-sharing plans 7. Vesting 8. Defined contribution plans and defined benefit plans 9. Cash balance plans 10. Salary reduction plans, such as 401(k) plans 11. Self-directed retirement programs: Keogh and SEP plans; IRAs 12. The annuity principle 13. Annuity payment options 14. Fixed versus variable annuities 15. Employee Retirement Income Security Act (ERISA) 16. Vested Rights 17. Noncontributory pension plan 18. Contributory pension plan 19. Qualified pension plan 20. Pension Protection Act 21. Thrift and savings plan 22. Accumulation and distribution periods 23. Survivorship benefits 24. Single premium annuity contract 25. Immediate annuity 26. Installment premium annuity contract 27. Deferred annuity 28. Life annuity with no refund (pure life) 29. Guaranteed minimum annuity (life annuity with refund) 30. Life annuity, period certain 31. Annuity certain Financial Planning Exercises The following are solutions to problems at the end of the PFIN 4 textbook chapter. [Note: Time Value of Money calculations will be shown using both the tables and the financial calculator. Set calculator on End Mode and 1 payment/year.] 1. a. If Abagail earns 8% on savings of $3,000 a year, her retirement fund will total $777,169.56 by age 65. 3,000 +/- PMT 40 N 8 I/YR FV $777,169.56 b. Harold has 30 years to save: $3,000 for 30 years at 8% = $339,849.63 3,000 +/- PMT 30 N 8 I/YR FV $339,849.63 Note: The amount of the nest egg decreases as the number of years invested (N) and the interest rate (I/YR) decreases. Because Harold has ten fewer years to save for retirement thanAbagail, Abagail will have considerably more savings available at retirement. 4. With the 401(k) plan, Bella’s contributions are made with pre-tax dollars that accumulate in a tax-sheltered account. She will not owe taxes until she withdraws funds (typically after age 59 ½). She can contribute up to 25% of her salary, to a maximum of $17,000 (2012). Her employer will match her contributions at the rate of $.25 per dollar. She will be offered a variety of investment options for her 401(k) funds, such as equity and fixed income mutual funds and company stock. How she allocates her contributions among these options is up to her; she must be prepared to choose those best suited for her needs and to monitor their performance so she can make changes if required. If she leaves the firm, she can roll over her contributions to the plan into another 401(k) or a rollover IRA. We are not told the vesting requirements for this plan, but if she stays with the firm until she vests, she will be able to take her employer's contributions with her as well when she leaves the firm. The cost of a contributory plan is shared by Bella and her employer. In this case she can contribute up to 10% of her salary, compared to 25% with the 401(k) plan, and it is matched one for one. So for every $1 she puts in, she will have $2, versus $1.25 for the 401 (k). However, she must remain at the firm for five years to be fully vested in the portion attributable to her employer’s contributions. The company handles the investment decisions for the plan; she will have no say in how her funds are invested. She should also find out how the plan has performed and if it's fully funded. As an example, assume Bella is offered a $20,000/year salary and wishes to contribute the maximum to her retirement plan. With the 401(k), she could contribute a maximum of $5,000 ($20,000 × .25) and her employer would contribute $1,250 ($5,000 × .25) for a total yearly contribution of $6,250. Assuming she is in the 15% tax bracket, her tax savings on her $5,000 contribution would be $750 ($5,000 × .15) which effectively reduces her out-of-pocket amount due to her contribution to $4,250 ($5,000 − 750). With the contributory plan, she could contribute a maximum of $2,000 ($20,000 × .10) which the company would match for a total yearly contribution of $4,000. Her tax savings on her $2,000 contribution would be $300 ($2,000 × .15) which effectively reduces her out-of-pocket amount due to her contribution to $1,700 ($2,000 − $300). This plan would not allow her to build up her retirement account as fast, but it would be more at the employer’s expense, leaving her more current income. With both plans, the employer may cap the amount of contributions they will match. This is something she needs to inquire about, particularly as she expects to receive future salary increases, which would mean she could increase her own contributions and thereby get more in employer matching contributions. However, she will have to stay with her employer until she is vested (5 years for the contributory plan) before she has the nonforfeitable right to the employer's contributions. 6. a. Albert will accumulate the same amount if he makes a $5,000 yearly contribution to either a traditional or a Roth IRA: 5,000 +/- PMT; 25 N; 10 I; FV = $491,735.30. Once the money is contributed and no early withdrawals are made, no taxes are collected while the money remains in its tax-sheltered environment. b. If Albert contributes to a Roth IRA or saves outside a tax-sheltered account, he will have no yearly tax savings due to his contributions. If he contributes to a deductible traditional IRA, he will have a yearly tax savings of $1,500 ($5,000 × .30), so his yearly contribution will have an out-of-pocket cost to him of only $3,500 ($5,000 − $1,500). If he is trying to save outside a tax-sheltered account, his earnings will be subject to income taxes each year. Because dividends and long-term capital gains are taxed at a lower rate and interest and short-term capital gains are taxed at one's regular income tax rate, it is difficult to calculate exactly what the tax bite will be. However, the worst case scenario, tax-wise, would be one in which all growth to the account is in the form of current return. Using this assumption, a taxable account earning 10% per year will earn only 7.0% on an after-tax basis for someone in the 30% tax bracket [.10 × (1− tax rate)]. Comparing a $5,000 contribution made at the end of each year, a taxable account with the above assumption will grow to only $316,245.19 [5,000 +/- PMT; 25 N; 7.0 I; solve for FV], while a tax-sheltered account (whether Roth or traditional IRA) will grow to $491,735.30 (see part a. above), a difference of $175,490.11. Obviously, funds inside a tax-sheltered account will grow to become a greater amount than those in a taxable account. However, remember that all distributions in retirement taken from a traditional tax deductible IRA are subject to one's regular income tax rate at the time of withdrawal. With a taxable account, only the previously untaxed growth portion of each withdrawal will be subject to tax, and any growth due to capital gains will be taxed at the more favorable capital gains rate, if current tax laws remain unchanged. The assumption has always been that one would still be better off paying full taxes on the distributions from the tax deductible account, because retirees are likely to be in a lower tax bracket than they were when they were working. This may not always be the case however, further muddying the waters in making the determination concerning which is the better alternative. In comparing tax savings of a traditional tax deductible IRA and a Roth IRA, as mentioned earlier, Roth contributions are not deductible. Traditional deductible contributions afford a yearly tax savings of $1,500 for someone in the 30% tax bracket. If he were to take his $1,500 yearly tax savings from making a traditional deductible IRA contribution and invest it in a taxable account, after 25 years he would be $94,873.56 better off by having made a tax-deductible (vs. a taxable contribution to a Roth IRA) contribution each year to a traditional IRA [$1,500 +/- PMT; 25 N; 7.0 I; solve for FV]. Again, we are assuming that all growth on the taxable account is due to current return. However, all distributions taken from the traditional deductible IRA are subject to one's regular tax rate at the time of withdrawal, as are the previously untaxed growth portions of withdrawals taken from a taxable account. Distributions properly taken from a Roth IRA are completely tax free. So the higher one's tax rate in retirement (obviously an unknown), the less of their withdrawals they will have to use. Over all, one would probably be better off contributing to the Roth, given that no taxes will be due on distributions and that the Roth offers other attractive features for estate planning purposes. c. When Albert starts to take distributions in 25 years, the entire amount withdrawn from a traditional IRA is subject to taxes. If he takes his $491,735.30 in a lump sum, 30% will be lost to taxes ($147,520.59) leaving him $344,214.71. None of the amount withdrawn from a Roth IRA is subject to taxes, so he would have the entire $491,735.30. Even if he had invested his yearly $1,500 tax savings from making a traditional IRA contribution, the amount this would have grown to $94,873.56 as shown above) would still not be enough to offset the amount lost to taxes in taking a lump-sum distribution. [Please note that if Ralph takes a lump sum distribution, the entire amount is dumped into his current earnings for that year, which could well place him in a higher tax bracket. One of the uncertainties of trying to figure the tax implications at withdrawal for a traditional IRA is that no one knows what the tax structure will be in the future. With a Roth IRA, it won’t matter—unless, of course, the laws change!] d. At this time, the Roth IRA would be a better choice for Albert. Also, a Roth is more flexible during your working years because, as mentioned in #8 above, early withdrawals that are principal only, are not subject to penalty or income taxes. People working beyond the age of 70 ½ can still contribute to a Roth, and no minimum distributions are required from Roths, hence Roths are more flexible for older persons as well. Roths are unique for estate planning purposes, because if one does not need the money from their Roth, they can pass it on to their heirs. The heirs do not have to pay income taxes on withdrawals either, although they must start taking distributions after a time period (they cannot leave the money inside the Roth indefinitely). Inherited traditional deductible IRAs are subject to considerable shrinkage due to taxes, so Roths offer a way to maximize the wealth you can pass on to your loved ones. Maximum allowable annual contributions to IRAs are $5,500 for 2013 for those under 50 and $6,500 for those over 50. This could make a difference in the analysis of which type of IRA to choose. Obviously, those who contribute to a traditional tax deductible IRA would get an even greater annual tax break. However, the Roth has all the advantages mentioned above. The individual would have to decide on a personal basis which IRA would be the better choice. 7. "Converting to a Roth" means, essentially, changing the tax treatment in which your retirement savings are placed. Instead of a tax-deferral available with a Traditional IRA, Roth IRAs represent post-tax contributions. Converting to a Roth means undoing the deferral by paying tax on the accumulated earnings and on any savings contributions for which the person took a deduction. This converts the funds into post-tax money. When considering this conversion, individuals need to decide whether it makes sense to take advantage of the government's one-time only offer to spread the cost of a Roth conversion over two years and what the tax costs and benefits will be. 8. Variable annuities are tax-sheltered investments sold by insurance companies. They are much like an investment in mutual funds, because the variable annuities offer a collection of securities, usually mutual funds managed by the insurance company. You decide how your investment will be allocated among the various choices. The level of risk, as well your return on your variable annuity, will depend on the choices you make. While you cannot direct how the securities will be managed within the various funds, you are usually free to move your assets from one fund to another within the variable annuity and thereby control your level of risk. Answers to Concept Check Questions The following are solutions to “Concept Check Questions” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find the questions on the instructor site as well. 14-1. Retirement planning is a key element in the financial planning process. Retirement planning is a long-term process that involves a strategy of systematically accumulating funds for retirement. Retirement planning captures the very essence of financial planning. It is forward-looking, has an impact on current and future standards of living, and, if successful, can be very rewarding. Both investment and tax planning are important to retirement planning; after all, a key element in retirement planning is the establishment of an investment plan that will meet your retirement goals. This is how you build the savings that you need to use during retirement. Tax planning is also very important, because certain tax rules can enhance the future value of your retirement nest egg. 14-2. The three biggest mistakes that people make in retirement planning are: a. They start too late. b. They put away too little. c. They invest too conservatively. Many people simply do not start thinking about retirement until they are in their 40s or 50s; by then, it may be too late to produce the kind of retirement nest egg they want. As a result, many people just have to make do with less in retirement. Likewise, people do not put enough away for retirement. Americans are not known for their strong savings habits, and it shows in their retirement plans. Obviously, the less put away prior to retirement, the less we are going to have in retirement. Finally, too many people treat their retirement plans like savings accounts rather than investment vehicles by placing most (or all) of their retirement funds in low-yielding, fixed-income securities (like U.S. Treasury securities and bank CDs). As a result, people end up earning dismal rates of return on their money. All three mistakes become doubly important when we introduce compound interest, because compounding magnifies the impact of these mistakes. In compounding, we are essentially letting our money work for us. Naturally, the less there is to work with, the less we will have in the future. And with compounding, it is not just a one-for-one tradeoff; it could be as much as five-for-one, or more. To illustrate, consider two people: one waits until he is 45 before starting a retirement program and then invests $2,000 a year at a very conservative 6%; the other starts at age 30 with $5,000 per year, invested at 10%. They both plan to retire at age 65. Amount of Accumulated Capital: Start at Age 45: Start at Age 30: ($2,000/yr. for ($5,000/yr. for 20 yrs. at 6%) 35 yrs. at 10%) Total invested: $40,000 Total invested: $175,000 Nest egg: $73,571 Nest egg: $1,355,122 As seen here, the differences can be enormous. Obviously, when it comes to retirement planning, it pays to start early, save a lot, and invest your money at reasonably aggressive rates of return. 14-3. Retirement goals and income needs are critical inputs in retirement planning. Your goals—for example, your desired age and lifestyle at retirement—will determine how much annual income you require. Your plan will be different (more aggressive) if you want to retire at 55 rather than 65 or if your lifestyle includes lots of travel and luxuries. These and similar factors will determine the amount of income you need. 14-4. The most important sources of retirement income are Social Security, personal assets (savings, investments, self-directed retirement plans), and employer-sponsored retirement plans. While Social Security may be the most common source, it does not necessarily provide the largest dollar amount. 14-5 The Social Security Act makes available a number of benefits other than the widely known Old Age, Survivor's, Disability, and Health Insurance (OASDHI) program. These include supplementary security income (SSI), unemployment insurance, public assistance, welfare services, and provision for black lung benefits. Today almost all gainfully employed workers in the United States are covered by the system. Three groups excluded from mandatory participation in Social Security are (1) state and local government employees who choose not to be covered; (2) civilian employees of the federal government hired prior to 1984; and (3) certain marginal employment positions, such as newspaper delivery persons under age 18 and full-time college students working in fraternity and sorority houses. By far, the largest group of workers in these excluded classifications is employees of state and local governments. 14-6. Benefit may be reduced if the Social Security recipient is under age 67 and still gainfully employed – perhaps in a part-time job. In particular, given full retirement age is 67, retirees aged 62 to 66 are subject to a so-called “earnings test”, which effectively limits the amounts of income they can earn before they start losing some (or all) of their Social Security benefits. In 2012, that limit was $14,640 per year (this earnings limit rises annually with wage inflation). This rule states that if you’re a Social Security recipient aged 62 through 66, you’ll lose $1 in benefits for every $2 you earn above the earning test amount. 14-7. No; it is reasonable to expect that Social Security will provide the average married wage earner only about 40 to 60% of the wages that he or she was earning in the year before retirement. Social Security should be viewed as a foundation upon which to build retirement income. By itself, it is insufficient to permit a worker and his or her spouse to maintain their preretirement standard of living. Both average and upper-middle-income families must plan to supplement their Social Security retirement benefits with income from other sources. This is especially true because the more a person earns in excess of the Social Security wage base, the lower the percentage of total preretirement wages that will be replaced by Social Security. 14-8. An employee should be familiar with the following features of an employer-sponsored pension plan: a. Participation requirements are the eligibility criteria for participation. Most common are requirements relating to years of service, minimum age, level of earnings, and employee classification. b. Contributory obligations specify who pays into the plan. In a noncontributory pension plan, the employer pays the total cost of the benefits. Under a contributory pension plan, the employee must bear a portion of this cost. Most pensions established by corporations used to be noncontributory, but today the trend is toward contributory plans. c. The vesting rights of the pension are the criteria the employee must meet before he or she can obtain a nonforfeitable right to pension assets accumulated in his or her name. Once these nonforfeitable rights are secured by the employee, they are said to be vested in the plan. The law sets down the rules for vesting and partial vesting. d. Retirement age is also an important feature of the plan. Most pensions specify a retirement age, but there may provision for early retirement. Also, find out if the pension benefits are portable—can you take them with you if you change jobs? e. The method of computing benefits is spelled out in every retirement plan. A defined benefit plan provides a formula for computing benefits that is stipulated in the plan provisions. This type of plan allows employees to determine before retirement how much their monthly retirement income will be. The formula is frequently based on number of years of service and average annual salary, although other formulas are possible. In contrast, a defined contribution plan specifies, how much the employer and/or employees are to contribute to the plan, but says nothing about what the plan benefits will be. That depends on how much the pension plan administrators are able to earn on the plan's investments. f. Finally, you should get a full run-down on what, if any, voluntary supplemental programs the company offers, such as a 401(k) salary reduction plan. 14-9. In cliff vesting, you become fully vested after no more than 3 years of employment. This can be faster than graded schedule, where you are partially vested for several years, but not fully vested for up to a maximum of 6 years. (These are the maximum amounts of time the company plans can take to vest; many company plans will vest sooner.) If you leave a company with cliff vesting before the required years to fully vest, you receive none of the employer account, whereas with graded vesting you will receive a percentage of the employer account. 14-10. Profit-sharing plans permit employees to participate in the earnings of their employer. They may be qualified under the IRS tax code and therefore eligible for essentially the same tax treatment as other types of pension plans. An argument in support of the use of profit-sharing plans is that they encourage employees to work harder because the employees benefit more when the firm prospers. The salary reduction plan, or 401(k) plan, basically gives the employee the option (such plans are normally voluntary) to divert a portion of his or her salary to a companysponsored, tax-sheltered account. Unlike profit-sharing plans, contributions are not dependent upon company profits. The amount diverted to the plan reduces the employee's taxable income and therefore the current tax burden; what’s more, any investment earnings generated within the plan accumulate on a tax-deferred basis. Both profit sharing and 401(k) plans are examples of what would be treated as supplemental retirement programs at most firms; however, it should be noted that at a growing number of firms (especially the smaller ones), a 401(k) may be the only type of retirement plan offered, so in these cases, these plans really are not "supplemental." Profit-sharing plans can be basic plans if they are qualified with the IRS or they can be supplemental. 401(k) plans are usually supplemental. 14-11. You should evaluate the pension plans offered by your employer because they are part of your overall financial plan. What you can expect from your company-sponsored programs affects what you have to come up with on your own. It is best to know where you stand (given your company-sponsored programs) and what, if any, improvements in your retirement and investment plans you need to make to achieve your targeted financial goals in retirement. 14-12. In a 401(k) plan, an individual is able to put up to $17,000 (in 2012) into the plan. If the maximum contribution of $17,000 were made, for a person in the 28% marginal tax bracket it would reduce taxable income by $17,000 and tax liability by $17,000 × .28 or $4,760. In essence, the federal government helps to fund the 401(k) plan by accepting the reduced taxes now and also by allowing the funds in the plan to grow tax deferred until they are withdrawn. Both 401(k) plans and the Keogh plans are tax deferred, not tax free. Income taxes are not paid on the amounts contributed, and the accounts are allowed to grow in a tax-free environment. However, any amounts withdrawn from these plans are subject to income taxes, and if withdrawn early, may be subject to penalties as well as taxes. 14-13. Keogh plans grew out of the Self-Employed Individuals Retirement Act of 1962, which gave self-employed people the right to establish retirement plans for themselves and their employees. Any individual who is self-employed, either full- or part-time, is eligible to set up a Keogh account; the maximum contribution to the account is $50,000 per year (in 2012) or 25 percent of earned income, whichever is less. The annual contributions are fully tax deductible and likewise, all earnings in the account accrue on a tax-deferred basis. Keogh accounts are self-directed and can be opened at banks, brokerage houses, mutual funds, and other financial institutions.. Individual retirement arrangements (IRAs) are similar in many respects to Keogh accounts in that they too are self-directed, they are set up at the same types of financial institutions, and contributions grow on a tax-deferred basis. With both a Keogh and a traditional IRA, you pay no taxes until you start drawing down the funds. If, however, you pull your funds out before you reach age 59 ½ (certain exceptions apply), you will be hit with a 10% penalty in addition to income taxes on the amount withdrawn. There are some major differences, however. To begin with, any gainfully employed individual can have an IRA account, not just the self-employed. However, only certain individuals can deduct their annual contributions from their taxes; specifically, traditional IRA contributions are fully tax deductible only if (1) you are not already covered by a company-sponsored pension plan, or (2) if you are covered by a companysponsored plan, your adjusted gross income is under a given amount. Another difference between a Keogh and IRA has to do with the amount of annual contribution: the maximum IRA contribution is $5,000 (in 2012, if under 50 years old) or $6,000 (in 2012, if 50 years or older), while a contribution of up to $50,000 (in 2012) or 25% of earned income, whichever is less, can be made to a Keogh. In differentiating between a nondeductible IRA and a Roth IRA, a nondeductible IRA is open to anyone regardless of their income level or whether they are covered by a retirement plan at their place of employment. Contributions of up to $5,500 a year in 2013, for those under 50 years old or $6,500 in 2013, for those 50 years or older can be made to this account, but they are made with after-tax dollars. However, the earnings do accrue tax free but are not subject to tax until they are withdrawn after the individual reaches age 59 ½. A Roth IRA is established for the purpose of providing funds for one’s retirement; contributions can only be made if one has earned income (except for the non-working spouse), and the maximum allowable contribution is $5,500 a person in 2013, for those under 50 years old or $6,500 for those 50 years or older in 2013. These contributions are nondeductible/after-tax dollars with all earnings in the account growing tax free and all withdrawals from the account are also tax free, as long as the account has been open for a least 5 years and the individual is past the age of 59 ½. In other words, as long as these conditions are met, you won’t have to pay taxes on any withdrawals you make from your Roth IRA. 14-14. An annuity is the opposite of life insurance. It is the systematic liquidation of an estate, designed to protect against economic difficulties that could result from outliving personal financial resources. (Life insurance, in contrast, is the systematic accumulation of an estate to protect against financial loss resulting from premature death.) The period during which premiums are paid for the purchase of an annuity is called the accumulation period and, correspondingly, the period during which annuity payments are made is called the distribution period. The principal consists of the premiums paid by the person purchasing the annuity, and the interest is the amount earned on these funds between the time they are paid and the time they are distributed. Depending on the terms of the annuity, there may be a survivorship benefit, the portion of the premium and interest that has not been returned to the annuitant prior to his or her death. In each subsequent period, this amount would be available to the beneficiaries who survive should the annuitant pass away. 14-15. The life annuity with no refund would probably result in the highest monthly payment. The payments are determined by the amount of money accumulated in the annuity and the life expectancy of the annuitant(s). 14-16. A fixed rate annuity is an annuity in which the insurance company safeguards your principal and agrees to pay a guaranteed rate of interest on your money. In addition, the (minimum) monthly benefit is set by contract. With a variable annuity, the monthly income provided by the policy varies according to the actual investment experience of the insurer. The amount of money you receive at distribution is directly affected by the type of annuity you have. With a fixed contract the annuitant knows up front exactly what the minimum monthly benefits will be. This interest-bearing, fixed-rate annuity is ideally suited to cautious investors who want to assume only a minimum amount of risk to their principal, although the guaranteed interest rate is usually fairly low. With a variable rate annuity, the amount that is ultimately paid out each month varies with the investment results of the insurance company. Nothing is guaranteed. The bailout provision of a fixed rate annuity allows the annuitant to withdraw from the annuity without paying substantial surrender fees if the rate of return on the annuity falls below a certain level. This provision usually only exists for a limited period of time. 14-17. A fixed rate annuity would probably be most suitable for someone who wants a minimum amount of risk exposure. 14-18. The average returns on variable annuities are usually lower than the average returns on mutual funds. The major cause of such differences in performance is the much higher costs associated with variable annuities. Not only are there load charges (commissions) which mutual funds may or may not have, there are insurance fees, contract charges, and/or maintenance fees on variable annuities that, every year, come right off the top of any earnings (or push investment losses down even further). Typically, a variable annuity will have a front-end load (commissions charged on every contribution), a back-end load for several years (charges on every withdrawal), and yearly maintenance fees which include an insurance (mortality) expense of an extra 1-2%, making the total yearly expenses in many cases close to 3%. Obviously, these fees and charges can drag down returns. On the plus side, the returns on variable annuities are tax sheltered (tax-deferred), whereas they would not be with mutual funds, unless the mutual funds are held in a taxsheltered retirement account. Solutions to Online Bonus Financial Planning Exercises The following are solutions to “Bonus Personal Financial Planning Exercises” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 1. Worksheet 14.1 2. Social Security should not be viewed solely as an investment. It is rather a means of redistributing wealth from those currently working to those currently in need of the social programs provided. It is properly viewed as a social insurance system. A comparison of the return on Social Security to that from other investments is invalid because Social Security provides benefits not found with alternative forms of investing. Social Security is a compulsory social program having an overriding social objective. This objective is the provision of at least a minimum level of benefit protection to all covered workers or their dependents. Social Security, therefore, cannot be evaluated on the basis of what it will return to any specific individual. Finally, it is difficult to realistically compare Social Security to other investment forms because Social Security is a risk-free program which offers secure benefits that are constantly increasing. The system attempts to maintain benefits at levels that will meet the costs of living for eligible members. Based upon these arguments, it seems reasonable to disagree with the statement presented. 3. Maximum 25% contribution: $68,500 × .25 = $17,125. This would be over the maximum allowable amount an employee could elect to defer in a 401(k) of $17,000 (in 2012), so $17,000 would be the most David could contribute (in 2012). Taxable income: Salary $68,500 Less: 401(k) contrib. 17,000 Taxable income $51,500 Tax savings: $17,000 × .25 = $4,250 Actual cost to David: $17,000 − $4,250 = $12,750 4. Student answers will, of course, vary. They should include basic plans that support the goals listed, with specific savings and investment strategies (for example: "Invest the maximum allowed each year in my company's 401(k) plan and allocate 75% to growth stocks and 25% to bond funds.") Solutions to Critical Thinking Cases The following are solutions to “Critical Thinking Cases” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 14.1 Comparing Pension Plan Features: Which Plan Is Best? 1. Analytical Solutions Corporation: The Analytical Solutions Corporation plan is contributory, which means that employees must contribute a portion of each paycheck to the plan. The employee contribution is equal to 5% of his or her wages. The employer contributes an amount equal to each employee's contribution. The employee receives ownership of 100% of the employer's contribution (becomes fully vested) after he or she has participated in the plan for 5 years; partial vesting occurs before then. The employee's own contributions vest immediately. Under this plan, it appears that retirement is mandatory at age 60. Because the plan is a defined contribution plan, an employee cannot determine the size of his or her retirement benefits until he or she retires. This type of plan specifies only the employee and employer's annual contribution. At retirement, the worker will not get a guaranteed amount but will receive whatever level of monthly benefits those contributions will purchase. Precision Manufacturing Company: The Precision Manufacturing plan is noncontributory, which means that the company pays the total cost of all benefits. The employee does not have to contribute to this plan. The employer's contributions to this plan vest immediately. Under this plan, an employee can retire at age 60 or can elect to remain with the company for an additional five- or six-year period, at the end of which retirement is mandatory. The plan is a defined benefit plan since it provides a formula for computing the benefits provided by the plan. The annual benefits will equal 2% of the employee's final annual salary for each year of service with the company. 2. It is difficult to choose one plan over the other. Although the Analytical Solutions plan does not define benefits, it seems likely that it could provide larger benefits than the Precision Manufacturing plan because the employee and employer's contributions amount to 10% of the employee's annual salary. It is probable, but certainly not guaranteed, that these amounts properly invested might offer an employee larger retirement benefits than the defined benefits under the Precision Manufacturing plan. At the same time, it is important to recognize that the Analytical Solutions plan does require the employee to make a contribution. The Precision Manufacturing plan is funded entirely from employer contributions. Although the Analytical Solutions plan does provide for some forced savings, it seems likely that the Precision Manufacturing plan is a better deal since the employer contributions are larger and the benefits are known in advance. Also, the vesting feature of the Precision Manufacturing plan is more favorable, and the employee can retire at an older age under this plan. The older retirement age should allow those who want to increase their benefits to continue in the firm and, therefore, increase the annual retirement benefit by 5-6% of a probably higher final annual salary. This opportunity is obviously quite appealing. In summary, it would seem that based upon the information presented, the Precision Manufacturing plan appears to have more attractive features: noncontributory, older retirement age (if desired) and defined benefits. 3. In either case, the expected and/or defined employer benefits should be added to the projected Social Security benefits to determine the expected monthly (or annual) retirement benefits. These should be compared to the retirement income needed to achieve retirement goals. If the retirement income provided by Social Security and the employer plan(s) is not sufficient to fund future retirement income needs, other sources of retirement income, such as annuities, mutual funds, or other investments, etc., should be developed. If current and projected income is not adequate to fund these additional needs, retirement goals and plans must be made more realistic. It is important to recognize that, although employer retirement benefits are an important consideration when evaluating potential employment opportunities, once employed, a person must accept the benefits provided and, in light of them, develop realistic retirement plans. For most people, Social Security and employer retirement benefits must be taken as given. They should act as a basis upon which additional retirement benefits are built to fulfill the retirement income needs that will permit achievement of one's retirement goals. 4. Annuities can fill annual retirement income gaps between what is needed to achieve one's retirement goals and what will be provided by Social Security and employer plans. They can play a major role in one's retirement program by providing for the systematic liquidation of one's estate and can effectively protect against insolvency resulting from outliving one's estate. A person can purchase a variety of types of annuities. Sometimes the cash value of one's life insurance can be used to purchase an annuity. In other cases, a person can direct periodic savings into the installment purchase of an annuity. Annuities may be purchased with a single payment or through an installment plan. The appeal of annuities lies in the fact that they provide a guaranteed future benefit over a specified period of time. Although the returns they provide are considered low by some, they offer a certain stream of future income which many people find preferable to the uncertainties associated with investment in some alternate media, such as bonds, stocks, or mutual funds. Both the guaranteed nature of the income provided (except in the case of variable annuities) and the lack of administrative effort involved make annuities attractive instruments for persons wishing to create guaranteed streams of future income for retirement purposes. Due to the convenience and lack of risk involved, the expected return from an annuity will generally be less than the returns expected from alternative investment outlets. On the flip side, annuities are not very liquid or flexible because of their loads and typically higher annual expenses, plus the 10% penalty and taxes owed on withdrawals made before 59 ½. Annuities are more attractive for people in higher tax brackets and less so for others. Over a longer time frame, individuals can almost certainly earn more with other investments, enjoy greater flexibility in using their assets, and receive more favorable tax treatment on their long-term capital gains. The choice between annuity investments and the higher risk–higher return do-it-yourself investments is a matter of personal preference largely dependent upon the individual's retirement goals and general disposition toward risk. Because the installment purchase of a deferred annuity represents a forced savings mechanism that can be used to create needed retirement income, it could be an important part of one's retirement plans. 14.2 Evaluating Sophia Ramirez’s Retirement Prospects 1. Required nest egg = Annual income needs / Expected return on investment = $15,000/.06 = $250,000 (Note: this is basically parts L, M, and N from Worksheet 14.1) 2. Future value of $72,600 at 5% rate of return [using Appendix A find Future Value Interest Factor (FVIF)]: $72,600 × FVIF (5%, 8 years) = $72,600 × 1.477 = $107,230.20 Using the financial calculator set on End Mode and 1 payment/year: 72,600+ /- PV 8 N 5 I/YR FV $107,263.27 Future value of $47,400 at 7% rate of return: $47,400 × FVIF (7%, 8 years) = $47,400 × 1.718 = $81,433.20 47,400+/- PV 8 N 7 I/YR FV $81,442.03 Thus, from these two sources, Sophia will have: $188,705.30. 3. Future value of 401(k) contributions at 9% [using Appendix B find Future Value Interest Factor of an Annuity (FVIFA)]): $3,000 ×FVIFA (9%, 8 yrs.), = $3,000 × 11.030 = $33,090 3,000+/- PMT 8 N 9 I/YR FV $33,085.42 4. Sophia needs a nest egg of $250,000; right now she has about $120,000 ($72,600 + $47,400). If she can invest these funds (as per part 3), they will be worth about $188,705.30 when she retires; throw in another $33,085.42 from the future contributions to her 401(k) plan, and she will end up with about $221,790.72 at retirement. That will leave her only about $28,209.28 short of her target. All things considered, that is really not too bad. But she still has a shortfall to make up; that can be handled in one of three ways: 1. She can reduce her standard of living in retirement—not a very good alternative. 2. She can try to earn a higher rate of return on her money—but that could involve more risk than she wants to take. 3. Or, the most attractive alternative: Sophia can try to save a little bit more each month. If she invested $213 per month in a Roth IRA earning 9% for the next 8 years, she would have $28,209 and could meet her goal. (See calculation below.) The Roth IRA would allow her money to grow on a tax-deferred basis, and she would be able to make tax-free withdrawals. With her children out of college and soon on their own, she should have some extra cash to invest and easily meet her goal of retiring in 8 years. [Financial calculator set on End Mode and 12 payments/year.] 28,209.28 +/- FV 9 I 8 N PMT $2,557.85 ÷ 12 = $213.15 Chapter 15 Preserving Your Estate Chapter Outline Learning Goals I. Principles of Estate Planning A. Who Needs Estate Planning? 1. People Planning 2. Asset Planning B. Why Does an Estate Break Up? C. What Is Your Estate? D. The Estate Planning Process II. Thy Will Be Done… A. Absence of a Valid Will: Intestacy B. Preparing the Will C. Common Features of the Will D. Requirements of a Valid Will E. Changing or Revoking the Will: Codicils 1. Changing the Will 2. Revoking the Will F. Safeguarding the Will G. Letter of Last Instructions H. Administration of an Estate I. Other Important Estate Planning Documents 1. Power of Attorney 2. Living Will and Durable Power of Attorney for Health Care 3. Ethical Wills J. What about Joint Ownership? 1. Tenancy in Common 2. Community Property III. Trusts A. Why Use a Trust? 1. Income and Estate Tax Savings 2. Managing and Conserving Property B. Selecting a Trustee C. Common Types and Characteristics of Trusts 1. Living Trusts a. Revocable Living Trust b. Irrevocable Living Trust c. Living Trusts and Pour-Over Wills 2. Testamentary Trust 3. Irrevocable Life Insurance Trust IV. Federal Unified Transfer Taxes A. Gifts and Taxes B. Is It Taxable? C. Gifts and the Estate Plan V. Calculating Estate Taxes A. Computing the Federal Estate Tax VI. Estate Planning Techniques A. Gift Giving Program B. Use of the Unified Transfer Tax Credit C. Charitable Contributions D. Life Insurance Trust E. Trusts F. Valuation Issues G. Future of the Transfer Tax Major Topics While personal financial planning allows one to achieve personal financial goals and accumulate wealth for a variety of purposes, estate planning is designed to provide for the desired and efficient disposition at death of accumulated wealth to heirs and beneficiaries. If estate planning is properly performed, heirs and beneficiaries will receive the maximum distribution of the deceased's remaining assets in accordance with his or her wishes. It is impossible to understate the importance of estate planning in assuring that a deceased's wealth is distributed in the desired manner. The major topics covered in this chapter include: 1. The role of estate planning in the accumulation, preservation, and distribution of an estate in a manner that most effectively achieves an estate owner's personal goals. 2. Guidelines for preparing a will and summary of common features. 3. Requirements of a valid will, procedures for changing, revoking, and safeguarding a will, and estate administration. 4. The need for a power of attorney, living will, and durable power of attorney for healthcare. 5. Forms of joint ownership and their impact on estate planning. 6. The purposes, common types, and characteristics of trusts used in estate planning to provide for the transfer of property from one party to another for the benefit of a third party. 7. Discussion of gift taxes, including determination of the amount of a taxable gift and reasons for making a lifetime gift. 8. Procedures for computing federal estate taxes, and the role of state death taxes in this process. 9. Popular estate planning techniques: dividing, deferring, and using life insurance. Key Concepts The overriding objective of estate planning is to insure the orderly transfer of as much of one's estate as possible to heirs and/or designated beneficiaries. Most estate planning tools and techniques are legally based and, as a result, the use of an attorney in estate planning is essential. The estate planning process frequently involves a number of areas: wills, trusts, gift taxation, and estate taxation. The following phrases summarize the key concepts stressed in this chapter. 1. Causes of estate break up 2. Probate estate and gross estate 3. Absence of a valid will: intestacy 4. Preparation of a will 5. Requirements for and common features of a will 6. Changing or revoking a will 7. Codicils 8. Letter of last instructions 9. Estate administration 10. Power of attorney 11. Living will and durable power of attorney for healthcare 12. Ethical wills 13. Forms of joint ownership 14. Trust relationships and purposes 15. Types and characteristics of trusts 16. Gift tax determination and gifting motives 17. Estate tax computations 18. Estate planning tools and techniques 19. Probate process 20. Testator 21. Executor and Administrator 22. Right of survivorship 23. Joint tenancy and tenancy by the entirety 24. Tenancy in common 25. Community property 26. Grantor, trustee and beneficiaries 27. Living trust 28. Revocable living trust and Irrevocable living trust 29. Pour-over wills 30. Testamentary trust 31. Irrevocable life insurance trust 32. Application exclusion amount (AEA) 33. Unified rate schedule 34. Annual exclusion 35. Gift Splitting 36. Unified tax credit Financial Planning Exercises The following are solutions to problems at the end of the PFIN 4 textbook chapter. 1. Both Dan and Mary should have wills, with the main reason being they need to name the guardian for their children in the event they die in a common accident. Further, Mary should also have a will to protect the family when she dies. True, if Dan predeceases her, the house passes to her through joint tenancy and the insurance proceeds pass to her by contract (supposing that she is the named beneficiary), but then she needs to plan for the disposition of assets at her death. If she and Dan were to die as a result of the same accident and it was determined that Dan died first, she would inherit the life insurance proceeds and all other assets. But since she also dies, then the state laws will determine how the property will pass and the courts will appoint guardians for the children and for the property going to the children (minors have a limited right to receive property outright). With a will, she can express her wishes in these matters as well as specify who should receive any personal property. Both Dan and Mary should review their wills on a regular basis to make sure they continue to reflect their wishes. [They should also consider more life insurance, particularly on Mary. They both work, and in the absence of one of their incomes, the survivor’s earnings may be insufficient to support their mortgage payments, provide a college education for the children, and possibly pay for some additional child care costs while the children are young.] 2. Lists will vary by student. 3. Before accepting the executor's role, you should be willing to assume responsibility for estate administration. This includes inventorying assets, determining their value, paying all debts and taxes, and disposing of assets in accordance with the deceased's wishes. While it helps to be comfortable with personal financial planning matters, the executor can hire legal and financial professionals to help with these duties. (See Worksheet 15.1 as a helpful checklist). 4/5. The wills generated by each student will vary. 6. Mark and Nora’s combined estate is $1.4 million, so it will be possible for them to pass on the entire amount with no estate taxes due (each person currently has a $5 million exclusion, so together they have $10 million). However, they most assuredly need to consult an attorney concerning the best way to handle their estate. Trusts can be used to pass on their estate. Also, Mark and Nora can establish trusts for their children from prior marriages, not only to assure that each receives the assets which should be rightfully theirs, but also that each child is properly provided for should their parents die. If the children are minors, trusts are a good way to manage and conserve the assets. The parents can also specify how the trust assets are to be used. They should also make sure their property is titled in the most appropriate way, depending on if they live in a community property or common law state. It is entirely possible that they can avoid setting up trusts, which can be costly, if their assets are properly titled so as to pass as they wish for them to pass. Also, Mark and Nora will want to specify clearly in their wills the disposition of personal property that they wish to leave to the children (Nora’s family antiques, the jewelry from Mark’s late wife, etc.). They also need to name guardians for their children if they are still minors and executors for their respective estates. 8. Student memo formats may vary, but should include some of the following information regarding Evelyn’s gift to her son Jason and whether he decides to keep the gift or sell it. Giving gifts reduce the taxable estate in two ways. First, any future appreciation of the gifted property is excluded from the estate because the decedent does not own the property on the date of death. Second, if the gift is so large that taxes are due, the money used to pay the tax is also removed from the estate. (There is an exception for gift taxes paid within 3 years of death.) In this exercise the big issue is the impact on Jason’s income taxes. If the gifted property is sold by Jason for a gain, it should be noted that property received by gift has a tax basis equal to its basis in Evelyn’s hands (i.e., a carryover basis). In other words, if the beach house is gifted, the basis to Jason will be $150,000; if passed through the estate, its basis to Jamal will be $500,000. As long as the property is not sold or depreciated, the basis really does not matter until the time of conversion. However, if Jason sells the house, then there is a difference in income tax of $52,500 (15% capital gains rate multiplied by the difference in basis or $350,000) between receiving the property by gift versus through the estate. The same holds true with the stock in Rich Corporation. As a result, if Jason sells both the house and stock at their fair values, the capital gains taxes would be $67,500 [Fair value $1,000,000 − $550,000 basis = $450,000 difference × 15% capital gains rate]. 6. [Instructors: Suggest that students use Worksheet 15.2 to complete this exercise. Remind students that the annual gift exclusion was $13,000 for the period after December 31, 2008. Although the exercise does not mention any funeral administrative, debts or miscellaneous costs, there are probably some costs which instructors may wish to add as additional assumptions.] Worksheet 15.2 on the next page presents a possible solution, given the limited exercise information, for the federal transfer taxes on Brian’s estate (without funeral, administrative, debts or miscellaneous costs assumed). Without additional assumptions, the net federal estate tax due is $6,068,450. Worksheet 15.2 – Exercise 6 – Brian’s estate 10. Answers will vary by student. Answers to Concept Check Questions The following are solutions to “Concept Check Questions” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find the questions on the instructor site as well. 15-1. Estate planning is important because it allows for the transfer of the maximum estate assets after taxes to the deceased's heirs and beneficiaries. Without an estate plan that directs the ultimate disposition of one's accumulated wealth, there is the chance that too little or even none of an estate will be left for one's heirs and beneficiaries to enjoy. By developing and implementing plans during one's lifetime, his or her wealth, or estate, can be accumulated, preserved, and upon death, distributed in the desired fashion. The goal of estate planning is therefore to accumulate, conserve, and distribute an estate in the manner that most effectively accomplishes the estate owner's objectives. The emphasis of estate planning is on achieving personal objectives and meeting the needs and desires of those involved. There are numerous forces which, if unchecked, tend to shrink an estate, reduce the usefulness of its assets, and frustrate the objectives of the person who built it. These include: death-related costs, such as debt repayment, taxes, and administrative expenses; inflationary effects; improper management of assets; lack of liquidity resulting in insufficient cash to pay death costs and other estate obligations; incorrect use of vehicles of transfer causing property to pass to unintended beneficiaries or to the proper beneficiaries in an improper manner or at an incorrect time; and disabilities to the wage earner—often called a "living death"—that result in a massive financial drain. The gross estate includes all the property subject to federal estate tax at a person's death, both probate and nonprobate property. Nonprobate property passes automatically without having to go through the probate process (the legal process of administering the estate of a decedent). Examples of nonprobate property include property held in trusts (the trust holds the legal title to the property), property titled in joint tenancy (the title of the property causes it to pass by operation of law), and life insurance benefits (passes by contract). The probate estate consists of all the other real and personal property that a person owns in his or her name at the time of death for which there is no other mechanism of transfer. The probate property is distributed according to the terms of the decedent’s will or by the state laws of intestate succession if there is no valid will. 15-2. The steps in the estate planning process include: 1. Assessing your family situation, evaluating its strengths and weaknesses, and setting estate planning goals. 2. Gathering comprehensive and accurate data on all aspects of the family. 3. Taking inventory of your assets and determining the value of your estate. 4. Designating beneficiaries of your estate's assets. 5. Estimating estate transfer costs. 6. Formulating and implementing your plan. 7. Reviewing your estate plan at least every 3 to 5 years and revising as circumstances dictate. The objective of the estate plan, of course, is to maximize the usefulness of one's assets during life and to achieve one’s personal objectives after death. Once the estate plan has been implemented, one must keep in mind that it is good only for as long as it fits the needs, desires, and circumstances of the parties involved. As these elements change, the estate plan must also be modified. 15-3. A will is a written, legally enforceable expression or declaration of a person's wishes concerning the disposition of his or her property upon death. A valid will is important because without one, an estate will be distributed in a fashion consistent with certain state statutes, not necessarily according to the wishes of the deceased. When a person dies intestate—without a valid will—the state laws typically "draw the will the decedent failed to make." State law would therefore determine the disposition of the decedent's probate property. Generally, the decedent's spouse is favored, followed by the children, and then other descendants. The statutes typically delineate the order in which descendants receive estate assets. If the deceased leaves no spouse, children, or other descendants, the decedent's parents, brothers, and sisters will receive a share of the estate. Aside from having lost control of the disposition of property to individuals or charities, the person who dies intestate also forfeits the privileges of naming a personal representative to guide the disposition of the estate, naming a guardian for persons and property, and specifying which beneficiaries are to bear certain tax burdens. In addition, estate shrinkage will probably not be minimized due to the loss of certain tax deductions and exclusions. 15-4. The eight basic clauses normally included as part of a will are listed and briefly described below: 1. Introductory clause—states the testator's place of residence and nullifies old and forgotten wills and codicils (legally binding modifications of an existing will). 2. Direction of payments clause—directs the estate with respect to certain payments of expenses. 3. Disposition of property—directs the disposition of personal effects, the passing of money to a specified party, and/or the distribution of residual assets after specific gifts have been made. 4. Appointment clause—used to appoint executors, guardians, and trustees, as well as their successors. 5. Tax clause—allocates the burden of taxes among the beneficiaries. In the absence of this clause, apportionment statutes of the testator's state will allocate the taxes among beneficiaries. 6. Simultaneous death clause—protects the testator in the case of the simultaneous death of his or her spouse. It is designed to avoid double probate of the same assets. The surviving spouse must live for a certain period of time beyond the death of the other spouse in order to be a beneficiary under the will. 7. Execution and attestation clause—provides for the testator's signature as a precaution against fraud. Many attorneys suggest initialing each page after the last line and including a signature in the left-hand margin of each page, which of course should be numbered. 8. Witness clause—contains the signatures of witnesses (whose minimum number is determined by state law) who sign in the presence of each other (and note their addresses on the will) to affirm that the will in question is actually that of the testator. To be valid, a will must be the product of a person with a sound mind; there must have been no undue influence (influence that would remove the testator's freedom of choice); the will itself must have been properly executed according to the laws of the state; and its execution must be free from fraud. Certain conditions are established for judging whether or not a testator is mentally competent. Generally, such capacity is assumed. Types of undue influence include threats, misrepresentations, inordinate flattery, or some physical or mental coercion employed to destroy the testator's freedom of choice. Most state statutes spell out requirements for proper execution of wills in a Will's Act or its equivalent. An ability to demonstrate that a will is that of the testator is also necessary for proper execution. 15-5. In order to change an existing will, a codicil, a simple and convenient, legal means of modifying an existing will, is drawn up. It is used when the will needs only minor modifications and is often a single-page document that reaffirms all the existing provisions of the will except the one to be changed. Where substantial changes are required, the preparation of a new will is usually preferable to a codicil. A will can be revoked either by the testator himself/herself, or in some cases, the law will revoke or modify it automatically. The testator can revoke a will by (1) making a later will that expressly revokes prior wills, (2) making a codicil that expressly revokes any wills, (3) making a later will that is inconsistent with a former will, and (4) physically mutilating, burning, tearing, or defacing the will with the intention of revoking it. Common situations in which the law, under certain circumstances, revokes or modifies a will are (a) divorce, (b) marriage, (c) birth or adoption, and (d) murder. 15-6. a. Intestacy describes the situation that exists when a person dies without a valid will. Some intestacy laws "draw the will the person failed to make" to determine the disposition of the probate property at his or her death. b. The testator is the person making the will, a written document expressing this person's wishes concerning how his or her property is to be distributed at death. c. A codicil is a simple and convenient legal means of modifying an existing will. It is used when a will needs only minor modifications and is often a single-page document that reaffirms all the existing provisions in the will except the one to be changed. d. A letter of last instructions is an informal memorandum separate from a will and expresses thoughts the testator wants to convey and instructions he/she wishes to have carried out that cannot properly be included in his/her will. A variety of directions related to such things as location of the will and other documents, funeral and burial instructions, and explanations of actions taken in the will might be included in the letter. 15-7. The probate process is the legal process of administering the estate of a decedent and distributes all the property that does not pass by some other mechanism (i.e., operation of law or legal contract—see number 15-1 above). The property in the probate estate is distributed according to the terms in the decedent’s will or by the state’s laws of intestate succession if no valid will can be found. The will is brought before the proper governmental unit, often the county court, and the validity of the will is determined. Before property can be distributed, debts, taxes, and claims against the estate must first be satisfied. Property remaining is then distributed according to the terms of the will (if possible—some of the property may have gone toward satisfying debts and/or taxes). If the decedent named a personal representative to manage the probate process in the will and if the court appoints this person so nominated in the will, this person is called the executor. If the decedent did not name a personal representative, died intestate, or the court does not choose to use the person so named in the will, then the court appoints an administrator to represent the estate. Reasons the court may not choose the person named in the will as the representative include: the person may have predeceased the testator, may be physically or mentally incapacitated, or may be deemed unfit (such as serving time in prison). The executor (or administrator) has the responsibility of representing the estate and seeing the probate process through to the end. The executor must collect the assets of the decedent, pay debts and taxes or provide for the payment of debts and taxes that are not currently due, distribute any remaining assets to the persons entitled to them by will or by the intestate law of the appropriate state, and must make an accounting to the court at various times during the probate process. Executors should not only be familiar with a testator's affairs, but they should also exhibit good administrative skills. 15-8. a. A power of attorney is a document naming the person you wish to act as your agent in managing your financial affairs. Powers of attorney can be either durable or nondurable, and state laws vary concerning these powers. In general, a nondurable power of attorney becomes legally invalid when the person issuing the power of attorney becomes incapacitated and is not a practical alternative for caring for the property of the ill or the elderly. An instance of when a nondurable power of attorney would be appropriate would be when someone is leaving the country and wants someone else to manage his financial affairs for him. A durable power of attorney for property (as distinguished from the durable power of attorney for healthcare described below) does allow the person named to act as your agent even if you do become incapacitated. It is a very powerful instrument and much thought should go into selecting someone very honest, trustworthy, and financially astute. A durable power of attorney is appropriate for someone who is ill or elderly and wishes to have someone to handle financial matters on his or her behalf should he or she become incapacitated. b. A living will describes in detail the medical treatments you wish to receive—or not receive—if you become terminally ill. It is very important that you discuss these plans with your physician, write the living will in very specific terms, and comply with state regulations. c. The durable power of attorney for health care also deals with medical care. It authorizes a particular person to make health care decisions if you cannot. Many financial planning experts recommend that you have both a living will and a durable power of attorney for health care. d. An ethical will or legacy statement is an informal document that can be added to the written will and read at the same time. It can take various forms, such as handwritten letters or journals, personal essays written on a computer, or even as video or audiotapes. The ethical will allows the maker a way to share his or her morals, business ethics, life experiences, wit and wisdom with family and friends. 15-9. Joint tenancy with right of survivorship is a type of ownership by two or more parties who share equal rights in and control of the property, with the survivor(s) continuing to hold all such rights on the death of one or more of the tenants. Each joint tenant can unilaterally sever the tenancy. A tenancy by the entirety is a form of ownership between husband and wife recognized in certain states in which the rights of the deceased spouse automatically pass to the survivor. A joint tenancy by the entirety can be severed (while both are alive) only by mutual agreement or terminated by divorce or conveyance by both spouses to a third party. This form of ownership is generally not recognized in community property states, and a few of the common law states no longer recognize it as well. The advantage of joint tenancy, the more common form of joint ownership, is that it offers a sense of family security, quick and easy transfer to the spouse at death, exemption of jointly owned property from the claims of the deceased's creditors, and avoidance of delays and publicity in the estate settlement process. The key disadvantage of joint tenancy is that the jointly owned property cannot be controlled by a will and therefore does not permit the first joint owner to die to control the property's disposition and management upon his or her death. Another disadvantage is that potential tax costs may be incurred in both the creation and the severance of a joint tenancy when the title is not held between spouses (for example, a father and daughter). Tenancy in common gives each co-owner the right to dispose of his or her share of the property as he or she wishes, without consulting the other partner(s). Unlike joint tenancy, in which the parties share equal rights and have rights of survivorship, tenancy in common may involve unequal shares and carries no rights of survivorship. Property titled in this manner likely will be part of the probate estate and pass according to the decedent's will or the state's laws of intestate succession in the absence of a valid will. 15-10. The right of survivorship is when the property which is held jointly passes directly to the surviving tenant(s) upon the death of the other. This passing happens automatically by operation of law and is free from the claims of the decedent's creditors, heirs, or personal representatives. Community property refers to all property acquired by the effort of either or both spouses during marriage while they make their primary residence in a community property state. Separate property is that which is owned by one spouse only. Property acquired prior to marriage or through gift or inheritance is considered separate property of the acquiring spouse. A written agreement is required to change community property to separate property, and vice versa. Unlike joint tenancy with right of survivorship, each spouse can leave his or her half of the community property to whomever he or she chooses. There is no right of survivorship inherent in this form of ownership. Therefore, without proper planning, a surviving spouse could find him or herself in the position of having to share ownership of property with someone else upon the death of the spouse. 15-11. A trust is a relationship created when one party, the grantor (also called the settler or creator) transfers property to a second party, the trustee (an organization or individual), for the benefit of third parties, beneficiaries, who may or may not include the grantor. The trustee holds the legal title to the property in the trust and must use the property and any income it produces solely for the benefit of trust beneficiaries. The trust generally is created by a written document. The grantor spells out the substantive provisions as well as certain administrative provisions. A trust may be living or testamentary and/or revocable or irrevocable. Trusts are created for many reasons, with the most common motives being to attain income and estate tax savings and to manage and conserve the property over a long period of time. A trustee must (1) possess sound business knowledge and judgment, (2) have an intimate knowledge of the beneficiary's needs and financial situation, (3) be skilled in investment and trust management, (4) be available to beneficiaries (specifically, this means the trustee should be young enough to survive the trust term), and (5) be able to make decisions impartially. 15-12. A living (inter vivos) trust is one created during the grantor's lifetime. It can be either revocable or irrevocable and can last for a limited period or continue long after the grantor's death. A revocable living trust is a living trust in which the grantor reserves the right to regain the trust property. The trust property is still in the grantor’s estate because the assets are not a completed gift, and the income off the trust is taxable to the grantor. An irrevocable living trust is one in which the grantor relinquishes title to the property placed in the trust as well as the right to revoke or terminate the trust. Depending on how the irrevocable living trust is set up, the trust assets may no longer be considered a part of the grantor’s estate and thus not subject to estate taxes. However, initially placing the property in the trust may trigger gift taxes, and if the income off the trust is not taxable to the grantor, it will be income taxable to either the trust itself or the beneficiaries. [Trusts and estates have their own schedule for income tax rates, and very little income is required to place these entities in the highest tax bracket.] Many types of trusts exist with various gift, income, and estate tax ramifications, and competent legal advice is needed prior to setting up a trust. 15-13. a. The grantor is a party in a trust relationship who transfers property to a second party, the trustee, for the benefit of third parties, the beneficiaries, who may or may not include the first party. b. A trustee is an organization or individual hired by the grantor to manage and conserve his or her property placed in a trust for the benefit of beneficiaries. c. The beneficiary is an individual who receives benefits—income or property—from a trust or from the estate of a decedent. d. A pour-over will is a provision in a will that provides for estate assets—after debts, expenses, taxes, and specific bequests—to "pour over" into a previously established revocable or irrevocable living trust. The pour-over will assures that property left out of the living trust, either inadvertently or deliberately, will make its way into the trust and thus be administered according to the terms of the trust. e. A testamentary trust is a trust created in a decedent's will. This type of trust does not provide any tax savings for the grantor, because he or she continues to own the property until his or her death. f. The major asset of an irrevocable life insurance trust is life insurance on the grantor; this type of trust is used to keep the proceeds of the life insurance policy out of an estate. The trustee can use the proceeds to pay for estate taxes and/or for the care of the deceased's spouse or children. 15-14. Gifts are generally defined with reference to the consideration received. A transfer for less than adequate and full consideration in money or money's worth is viewed as a gift. If some amount of consideration was received, but less than full consideration, the transfer would be considered a partial gift. A gift is usually considered to be made when the donor relinquishes dominion and control over the property or property interest transferred. a. For gift tax purposes, certain transfers or "gift equivalents" are not counted. The annual exclusion permits tax-free gifts of $13,000 (adjusted for inflation, as of 2012) per donor to any number of donees each year. It is available only for gifts of a present interest in property that the donee has the immediate and unrestricted right to use, possess, and enjoy upon receipt. b. Gift splitting is a method of reducing gift taxes whereby a gift given by one spouse, with the consent of his or her spouse, can be treated as if each had made one half of it. Therefore, with the consent of your spouse, even if it’s all your money or assets, up to $26,000 (as of 2012) can be given to any number of donees during the year. This feature allows married persons in common-law states to receive the same gift tax treatment as married taxpayers domiciled in community-property states. c. Charitable deductions, which are gifts given to a qualified charity (one to which deductible gifts can be made for income tax purposes), are not subject to any gift or estate taxes and have no limits on the amount given. However, there is a limit to the amount of the deduction which can be claimed in any given year on one’s income tax return, depending on the taxpayer’s adjusted gross income and the type of charitable organization. The excess contribution can be carried forward on one’s income tax return. d. An unlimited deduction for gift or estate tax purposes for property given by one spouse to another is called the marital deduction. An individual conceivably could give everything to his or her spouse during life or at death without gift or estate tax cost, provided the spouse is a U.S. citizen. 15-15. When a gift is given, control of the property is relinquished and the property from that point forward is no longer a part of the donor's estate. Property which is no longer in the estate is not subject to estate taxes at death. True, the size of the estate is smaller by the amount of the gift, but because of the gift, the property is already in the hands of the intended recipient. Gift giving allows the donor to minimize estate shrinkage by reducing estate taxes, thereby allowing the donor to maximize the amount of property passed to his/her heirs. Several tax-oriented reasons cause estate planners to recommend making lifetime gifts. These include: Gift Exclusion: Single individuals can give any number of donees up to $13,000 (as of 2012) each year entirely gift tax free. If the donor is married and the donor's spouse consents, the gift tax-free limit is increased to $26,000 (as of 2012) even if the entire gift is made from the donor's assets. If a taxable gift is made, i.e., a gift over the exclusion amount, only the excess portion is subject to gift taxes. Gift Tax Exclusion: Regardless of the size of a gift—and even if it is made less than three years before the donor's death—it typically will not be treated as part of the donor's gross estate. The taxable portion of lifetime gifts (gifts over the exclusion amount) does push up the rate at which the donor's estate will be taxed. Fortunately, when cash or other property qualifies for the annual exclusion, it is not taxable and therefore is both gift and estate tax free in all respects. Appreciation in Value: Appreciation in the value of a gift from the time it is made will not be included in the donor's estate, unless the gift is deemed not to have been a gift because the donor failed to relinquish control of the property. Tax advantage: A lifetime gift results in an income tax deduction (namely, a tax savings of 35% at the top 2011 rate). In addition, such gifts are removed from the estate and so there is an estate tax saving (35% top 2011 rate). Impact of Marital and Charitable Deduction: Because of the gift tax marital and charitable deductions, it is possible to give a spouse (who is a U.S. citizen) or a qualified charity an unlimited amount of money or other property entirely gift or estate tax free. Psychic Income: Finally, a lifetime gift allows the donor to observe the effect of their gift on the charitable organization and to receive psychic income in the form of gratitude or other recognition. 15-16. Federal estate taxes are levied on the transfer of property at death, so one goal of effective estate planning is to minimize the amount of estate taxes paid. The tax is based on the value of the property that the deceased transfers (or is deemed to transfer) to others. The phrase “deemed to transfer” is important because the estate tax applies not only to transfers that a deceased actually makes at death but also to certain transfers made during the person’s lifetime—called lifetime gifts. If the owner-insured gives away his or her life insurance policy within 3 years of his or her death, the proceeds will be included in the insured’s gross estate. The unified tax credit reduces the amount of estate taxes owed. A certain amount of a deceased person's estate, called the exclusion amount, is excluded from estate taxes. The unified tax credit is the amount of estate taxes that would have been due on the excluded amount. Estate taxes are first calculated on the entire estate, and then the unified tax credit amount is subtracted off the total. 15-17. Computation of the federal estate tax due: The six stages involved in the computation of the federal estate tax are (1) determining the gross estate, (2) determining the adjusted gross estate, (3) calculating the taxable estate, (4) computing the estate tax base, (5) determining the total death taxes, and (6) determining the federal estate tax due. 15-18. Dividing: Each time a new tax-paying entity can be created, income taxes will be saved and estate accumulation stimulated. A variety of techniques, such as giving incomeproducing property to children, establishing a corporation, and fully qualifying for the federal estate tax marital deduction, exist for dividing one's estate to reduce taxes. Deferring: Because progressive tax rates penalize taxpayers whose maximum earnings (or estates) reach high levels, persons should attempt to minimize the total tax burden by spreading income over more than one tax year or deferring the tax to a later period. Deferring the tax to a later period gives the taxpayer an opportunity to invest the tax money for a longer period of time, and of course there’s always the possibility that the tax laws may change favorably. In addition, one’s financial situation may change such that yearly income may drop and the accumulated assets are used up during life and hence no longer in the estate. Solutions to Online Bonus Financial Planning Exercises The following are solutions to “Bonus Personal Financial Planning Exercises” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 1. Student lists will vary depending on family circumstances. The general objective should be to maximize the amount of the estate that passes to heirs. Some possible categories of personal objectives are: providing financial security for spouse and children (adequate funds to maintain lifestyle, for college education, etc.), arranging for professional management of assets if necessary, naming guardians for minor children, arranging for transfer of business ownership interests, providing for dependent parents or other relatives, and disposing of assets equitably. 2. Student wills should include the clauses described in the text. The letter of last instructions should cover the location of the will and other important documents, funeral preferences, the names of professional advisors, and any other information that will assist the executor to carry out his or her wishes when administering the estate. 3. Ethical wills are personal statements of values, blessings, life’s lessons, and hopes and dreams for the future. They are informal documents that are usually added to formal wills and read at the same time. They offer a way to share your morals, business ethics, life experiences, family stories and history, and more with future generations. They can take various forms, such as handwritten letters or journals, personal essays written on a computer, or even a digitally recorded discourse to be shared on DVD or audiotape. Students’ responses to whether or not they would record it will vary. 4. Answers to this question may vary, depending on recent changes to estate tax laws. Even if estate taxes are eliminated entirely, individuals will still need to do estate planning for a variety of reasons, some of which are listed below: a. When minor children are involved, guardians need to be named in the event that both parents die. Otherwise, the state will decide the guardian for the children. b. Trusts need to be established to take care of certain special needs children for the remainder of their lives. c. Trusts may also need to be established to care for the surviving spouse, particularly as they become elderly and/or incapacitated. d. Assets need to be divided up in an equitable manner among the heirs. e. Insurance planning needs to be done to provide for the surviving spouse and/or children and/or to take care of debts, final expenses, and transfer costs. Solutions to Critical Thinking Cases The following are solutions to “Critical Thinking Cases” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 15.1 A Long Overdue Will for Latafat 1. Yes, Latafat really needs a will. Without a valid will, the statutes of the state of Colorado would govern the disposition of his sizable estate. This situation would not provide for minimum estate shrinkage, nor would it result in the transfer of assets to those whom Latafat would choose. If Karen is not the mother of his two sons, a battle could ensue over property, and as the sons are still in high school, they are probably not yet “of age,” so their guardian needs to be named. Because Latafat owns property in several states, the states could possibly fight over which is his state of domicile— something which could be avoided with a valid will. 2. His will should contain eight distinct parts: (1) Introductory Clause—stating his place of residence and nullifying old and forgotten wills and codicils (legally binding modifications of an existing will). (2) Direction of Payments—directing his estate with respect to certain payments of expenses. (3) Disposition of Property—disposing of his personal effects, passing money to specified parties, or distributing his residual assets after specific gifts have been made. (4) Appointment Clause—appointing his executors, guardians, and trustees, as well as their successors. (5) Tax Clause—allocating his burden of taxes among his beneficiaries. Otherwise, apportionment statutes of his state will allocate the taxes among beneficiaries. (6) Simultaneous Death Clause—protecting his estate against a common disaster or simultaneous death of his spouse. This clause attempts to avoid double probate of the same assets. (7) Execution and Attestation Clause—providing his signature as a precaution against fraud. Many attorneys suggest initialing each page after the last line and including a signature on the left-hand margin of each page, which of course should be numbered. (8) Witness Clause—containing the signatures of the required number of witnesses, who sign in the presence of each other (with their addresses noted on the will) in order to affirm that the will in question is actually his. 3. Property held in joint tenancy automatically transfers to the surviving joint tenant, hence upon Latafat’s death the mining stock worth $3 million and the Colorado home worth $1.5 million would belong immediately to Karen. There might be some confusion as to whether she should still receive 40% of the balance or whether the joint tenancy property should be taken into account. Note that the joint tenancy represents 29% of his estate $15.5 million estate---or does it? This raises the question of whether only half of the joint tenancy should be counted when figuring out the bequest to Karen because she already owns the other half of it. His estate plan needs to directly address these issues. 4. The living trust would be an appropriate estate planning technique for Latafat. With such a large estate, he should be looking for ways to minimize estate taxes so that more of his assets go to beneficiaries. He may wish to set up several trusts for his wife and sons, so that they will have assistance in managing the large amounts they will inherit. Trusts can also provide management continuity if he should become unable to administer the property. If he establishes irrevocable living trusts, he will reduce estate taxes because he would relinquish control of the property involved. He may wish to transfer some of his assets into this form of trust. Because he wants to allocate a certain amount of money for his sons' education, he can set up trusts that will ensure that the funds can only be used for this purpose. By using trusts, Latafat’s will would probably be shorter, because some assets would already be designated to trusts. There would be no time gap in the management of these assets because a living trust is already in existence at the time of death, whereas probate assets will not be managed until the court appoints a personal representative sometime after death. Living trust assets would avoid probate, which can be expensive (however, the costs of establishing and administering trusts can also be high). Trusts provide a measure of privacy, whereas probating the will is a public process. However, creditors have a much shorter time (typically 4 months) in which to make a claim against the assets going through probate; trust assets can often be subject to such claims for a period of 1-3 years. 5. The boys are both still in school and presumably not yet adults. Having them inherit a significant estate at such young ages will mean appointment of guardians of the estate for them, which in turn means annual court reporting with related attorney fees. Furthermore, guardianships generally must end when the child becomes an adult at age.18. This is still rather young to become a millionaire. The answer probably is for their interests to be held in trust, with benefits given immediately for education, medical, and such, but with actual distribution delayed perhaps until they reach 25 or 30 years of age. Their trustee could be given discretion to make some earlier distributions for such purposes as purchasing a home or starting a business. 6. If Latafat later decides to change or revoke his will, he has a few options. To change the will, he could use a codicil, which is a legal means of modifying an existing will. It is usually used when the will needs only minor modifications and is often a single-page document that reaffirms all the existing provisions in the will except the one to be changed. If substantial changes are to be made, a new will is usually preferable to a codicil. A will may be revoked by (a) making a later will that expressly revokes prior wills, (b) making a codicil that expressly revokes all wills earlier than the one being modified, (c) making a later will that is inconsistent with a former will, and (d) physically mutilating, burning, tearing, or defacing the will with the intention of revoking it. The law automatically revokes or modifies a will under certain circumstances, which vary from state to state but generally revolve around divorce, marriage, birth or adoption, and murder. Living trusts are normally simpler to revise than wills because an amendment to a living trust needs no formalities or witnesses and must be in the trustor’s handwriting anyway. However, remember that in an irrevocable trust, control of the assets has been severed. 7. As coexecutors of Latafat’s estate, Gary Ingram, his close friend and attorney, and Ceylan Sadik, his cousin, will share the duties of estate administration. Upon Latafat’s death, they must take inventory and value his assets, pay his debts or provide for payment of debts that are not yet due, and distribute any remaining assets to the persons entitled to them as specified in Latafat’s will. Their responsibility will, therefore, be to carry out Latafat’s wishes as specified in his will once all legal obligations related to the probate process have been satisfied. Generally, a trustee’s job is long term, e.g., until the youngest boy reaches 30 years of age, and involves long term investing and management of the trust’s assets. Given Gary’s age, he is not a good candidate for trustee, even though he might be appropriate as a co-executor. Ceylan seems to be a good selection for both. He is young enough that it is likely he can serve for many years and his training as a CPA will come in handy in both executor and trustee capacities. A trustee does not have to be an expert in investments merely smart enough to know when he or she needs help and where to find it. 15.2 Estate Taxes on Robert Hancock’s Estate Robert’s estate taxes are computed on Worksheet 15.2 which follows. Answers to the Robert Hancock estate tax and probate questions Gross estate Probate Home $850,000 $850,000 Gross $4,570,000 Cabin $485,000 $485,000 Funeral ($15,000) ($15,000) Stk. bonds $1,890,000 $1,890,000 Admin ($36,000) ($36,000) Pension $645,000 $3,225,000 Debts ($90,000) ($90,000) Life insurance $700,000 Expenses ($25,000) ($25,000) Gross $4,570,000 Adj. Gross estate $4,404,000 ($166,000) Charities Church ($60,000) ($60,000) High school ($25,000) ($25,000) Taxable estate $4,319,000 ($85,000) Adjusted tax gifts $260,000 Adj. Taxable gifts $234,000 ($26,000) Estate tax base $4,553,000 ($85,000) $234,000 ($166,000) ($251,000) 1. The probate estate consists of the gross estate less non-probate assets. The gross estate amount of $4,570,000 is calculated in #2 which follows. Robert’s non-probate assets consist of his life insurance policy ($700,000) and his pension fund ($645,000) which will pass by contract to his son Nathan, his named beneficiary. Therefore, the amount of his probate estate is $3,225,000 [$4,570,000 − ($700,000 + $645,000)]. 2. Robert’s gross estate consists of all his assets at the time of his death. Home $ 850,000 Cabin 485,000 Investments 1,890,000 Pension 645,000 Life Insurance 700,000 Gross Estate $4,570,000 3. Determine the total allowable deductions. Funeral, debts, admin., expenses: $166,000. Charities: $85,000. Total: $251,000 4. In calculating the estate tax base, adjusted taxable gifts made after 1976 must be added back in. Prior to his death in 2012, he made a gift of $260,000 in stock to Nathan and Mary. At that time, $13,000 was the maximum yearly gift exclusion amount per person. Therefore $26,000 was excluded from taxation; the remaining $234,000 was a taxable gift which when added back to the taxable estate of $4,319,000 makes an estate tax base of $4,553,000. 5. In calculating the tentative tax, refer to Exhibit 15.5. For Robert’s estate, the tax on the first $500,000 is $155,800 and the maximum rate of tax over $500,000 is 35%, making his tentative tax $155,800 + ($4,053,000 × .35) or $1,574,350. Exhibit 15.6 shows that the unified tax credit for 2012 is $1,772,800. This unified tax credit is then subtracted from the estate tax base to arrive at the total death taxes of $0 ($1,574,350 − $1,772,800). 6. Case 15.2—Worksheet 15.2 7. While Robert left a sizable estate, no federal estate tax was due. In the event that the relatively low estate taxes do not hold in the future, some things can be done before death to minimize the shrinkage of an estate similar to Robert’s include: • Robert could have given the ownership of the life insurance policy to his son or established a life insurance trust with it in order to remove its value from his estate. We are not told whether the policy was a term or whole life policy with cash value, but the value for gift tax purposes while still alive is usually much less than the value for estate tax purposes after death. • Before his wife’s death, their wills could have established a credit shelter (or family or bypass) trust in order to preserve the available unified credit of the first to die (the exclusion amount when his wife passed away less the portion of the taxable gift attributed to her). These trusts can be set up such that the assets pass to the children but the surviving spouse gets the income off these assets or possibly can use part of these assets while still alive. When one spouse leaves everything to the other spouse, if the estate’s value is over the exclusion amount, then the amount of the unified credit available to the first to die is wasted. A credit shelter trust preserves the exclusion amount available to the first to die. • After his wife’s death, Robert should have realized that the estate taxes would be a problem for his family, and he could have started giving $10,000 to $13,000, a year to his son, daughter-in-law, and four grandchildren (depending on the year of the gift), thereby excluding $60,000–$78,000 every year. He could also have increased charitable gifts during his life. • Robert could have sold his home and moved into something smaller and less expensive. The remainder of the dollars from the sale could have been used for gifts as mentioned above. He also had a cabin at the lake he could have sold or given to his children with only a small amount of gift taxes due. While there can be great sentimental attachment to property, many times people reach a point in life where they no longer wish to continue the upkeep of property. • Robert could have established a charitable trust or gifted property to a charitable foundation such that he could have received the income from the property for life, and then at his death the property would go to the charitable organization. Solution Manual for PFIN Personal Finance Michael D. Joehnk, Randall S. Billingsley, Lawrence J. Gitman 9781305271432

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