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 a Projected Shortfall D. Online Retirement Planning E. Sources of Retirement Income *Concept Check* 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 *Concept Check* 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. Cash-Balance Plans 5. 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 Account (IRAs) 3. Self-Directed Accounts and Their Investment Vehicles *Concept Check* 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 *Concept Check* Summary Financial Planning Exercises Applying Personal Finance Your Ideal Retirement Plan! Critical Thinking Cases 14.1 Comparing Pension Plan Features 14.2 Evaluating Sophia Ramirez’s Retirement Prospects Money Online! 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 Answers to Concept Check Questions 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 trade-off; 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. 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 company-sponsored, 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 company-sponsored 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 at 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 "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. 14-15. 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. 14-16. 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). 14-17. 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. 14-18. A fixed rate annuity would probably be most suitable for someone who wants a minimum amount of risk exposure. 14-19. 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 tax-sheltered retirement account. Financial Planning Exercises [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. Note: The amount of the nest egg decreases as the number of years invested (N) and the interest rate (I/YR) decreases. Because Mike has ten less years to save for retirement than Jacqueline, Jacqueline will have considerably more savings available at retirement. 2. Worksheet 14.1 3. 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. 4. The monthly Social Security retirement benefits for the spouse and his/her partner (both retired) would be $1,994 (refer to Exhibit 14.3) if he/she earns less than $14,640 per year (as of 2012). However, because he/she earns $24,000 at a part-time job and assuming him/her to be under the age of 67, the benefits will be reduced by $1 for every $2 he/she earns above the $14,640 limit. Therefore, instead of receiving annual Social Security benefits in the amount of $23,928 ($1,994 × 12), he/she will receive only $19,248 [$23,928 − ($24,000 − $14,640)/2], a reduction of $4,680. The pension benefits and tax-exempt bond interest are unearned income and therefore do not affect the amount of Social Security benefits he receives. However, assuming the couple files a joint return, they would have to pay taxes of 50% on a combined income between $32,000 and $44,000, of their Social Security benefits. If their combined income is more than $44,000, up to 85% of their Social Security benefits is subject to income tax. 5. With the 401(k) plan, Kristin’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 Kristin 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 Kristin 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. 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). 7. 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.") 8. In order to contribute to an IRA, you must have earned at least as much income during the year as you contribute to your IRA (an exception is the non-working spouse who can now also contribute $5,000). As of 2012, the maximum yearly contribution to an IRA is $5,000 or 100% of your earned income, whichever is less. There are now a variety of IRAs, and it’s possible to contribute to more than one type, but your total yearly contribution, no matter how you split it up, still cannot be more than $5,000 or the current maximum amount allowable. Catch-up provisions allow those age 50 or older to increase their yearly contributions. Traditional IRAs: If neither you nor your spouse (if applicable) is an active participant in an employer-sponsored retirement plan, then you (and your spouse) can claim a full income tax deduction for a contribution to a traditional IRA, regardless of income. If you do actively participate in an employer-sponsored retirement plan and your adjusted gross income (AGI) is less than $58,000 ($92,000 for married couple filing jointly), you can still fully deduct your traditional IRA contribution (limits as of 2012). Nondeductible IRAs: Taxpayers who are ineligible to deduct their traditional IRA contributions can still make nondeductible contributions to a traditional IRA. They will pay income taxes on their earnings contributed to the IRA, but once inside the IRA, the contribution will be allowed to grow on a tax-deferred basis until withdrawn. For both the deductible and nondeductible IRAs, the withdrawal and distribution features are the same. Early withdrawals (taken before the owner turns age 59 ½) are subject to a 10% penalty and income taxes. Exceptions to the 10% penalty are as follow: • Withdrawals are due to the death or disability of the owner. • Withdrawals are set up as a series of “substantially equal periodic payments” taken over the owner’s life expectancy. • Withdrawals are used to pay unreimbursed medical expenses which exceed 7.5% of the owner’s AGI. • Withdrawals are used to pay medical insurance premiums when the owner has received unemployment insurance for more than 12 weeks. • Withdrawals are used to pay for qualified higher education expenses. • Withdrawals are used to cover expenses due to the first time purchase of a home (no more than $10,000 lifetime total). Even though the 10% penalty is waived when withdrawals are made for one of the above reasons, income taxes are still due on the amount withdrawn unless the withdrawal was from a nondeductible contribution. In that case, the portion withdrawn attributed to principal would not be taxable because taxes were paid on that income when it was earned; the portion attributed to earnings would be taxable. Traditional IRAs, whether deductible or nondeductible, are tax-deferred accounts, and the money is allowed to grow tax free until withdrawn. When the owner starts to take distributions in retirement, income taxes are due each year. For a deductible IRA, the entire amount withdrawn each year is taxable. For a nondeductible IRA, as noted above, only the portion attributed to earnings is taxable. (It is best never to commingle the assets of deductible and nondeductible IRAs—just go open another IRA if needed!) Owners are required to start taking distributions by April 1 of the year after the year in which they turn 70 ½. Roth IRA: This nondeductible IRA became available in 1998 and is notably different from the traditional IRAs. You pay taxes on the earnings contributed to the Roth IRA, but when you take distributions in retirement, you pay NO taxes on your withdrawals, provided your account has been established for 5 years. If you make early withdrawals, only the amounts attributed to earnings are subject to the 10% penalty and income taxes, and the first amounts out of your account are considered a return of principal on which you’ve already paid taxes. Only after you’ve withdrawn the entire principal contributed, will you be subject to the penalty and taxes on early withdrawals. Exceptions to the penalty are the same as those above for the traditional IRA. People who continue to work after age 70 ½ can still contribute to a Roth IRA (they cannot contribute to a traditional IRA), and no minimum distributions are required to be taken from a Roth IRA. Whether you participate in an employer-sponsored retirement plan or not, you (and your non-working or low-earning spouse) can still contribute to a Roth IRA if your AGI is less than $110,000 ($173,000 married couple filing jointly).The Roth IRA offers more flexibility in financial planning, both before retirement and during retirement, as well as in estate planning. It will be available to more people, as the income limits are not as restrictive. And even though the contributions are not deductible, the account has the potential to grow even more than a traditional IRA. However, be sure to check current tax laws when making your decision. 9. a. Ralph will accumulate the same amount if he makes a $4,000 yearly contribution to either a traditional or a Roth IRA: 4,000 +/- PMT; 25 N; 10 I; FV = $393,388.24. 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 Ralph 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 $1,120 ($4,000 × .28), so his yearly contribution will have an out-of-pocket cost to him of only $2,880 ($4,000 − $1,120). If Ralph 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 7.2% on an after-tax basis for someone in the 28% tax bracket [.10 × (1− tax rate)]. Comparing a $4,000 contribution made at the end of each year, a taxable account with the above assumption will grow to only $260,379.00 [4,000 +/- PMT; 25 N; 7.2 I; solve for FV], while a tax-sheltered account (whether Roth or traditional IRA) will grow to $393,388.24 (see part a. above), a difference of $133,009.24. 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 $1,120 for someone in the 28% tax bracket. If he were to take his $1,120 yearly tax savings from making a traditional deductible IRA contribution and invest it in a taxable account, after 25 years he would be better off by $72,906.12, [$1,120 +/- PMT; 25 N; 7.2 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 Ralph starts to take distributions in 25 years, the entire amount withdrawn from a traditional IRA is subject to taxes. If he takes his $393,388.24 in a lump sum, 30% will be lost to taxes ($118,016.47), leaving him with $275,371.77. None of the amount withdrawn from a Roth IRA is subject to taxes, so he would have the entire $393,388.24. Even if he had invested his yearly $1,120 tax savings from making a traditional IRA contribution, the amount this would have grown to $72,906.12 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 Ralph. 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. 10. 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. 11. Annuities make it possible to tax shelter more dollars beyond what you can contribute to retirement accounts. Unlike retirement accounts, there is usually no limit to the amount of dollars you can put into annuities, but contributions are not income tax deductible. Annuities contain an insurance component which guarantees that upon your death, your heirs will receive at least the amount you invested, less any withdrawals or charges. Annuities typically have high expenses and offer limited liquidity, not only because of the insurance companies’ loads but also because of the penalties imposed on withdrawals made before age 59 ½. The earnings portion of withdrawals is taxed as ordinary income, whereas some of the return on investments in taxable accounts will be long-term capital gains, which are taxed more favorably. And you may be required to start taking distributions from annuities at a certain age (usually later than required by traditional IRAs). 12. It is extremely important to select a highly rated insurance company with an excellent financial position when purchasing an annuity for several reasons. Fixed annuity assets are commingled with the assets of the insurance company and hence are subject to the claims of the company’s creditors. You certainly don’t want your investment assets used to pay the company’s bills. Additionally, an annuity is a long-term purchase. When you annuitize with a company and select a payout option, say payments for the rest of your life, you want a company which invests wisely so that it will have the funds necessary to meet its long-term obligation to you. The promises made to you are only as good as the financial soundness of your insurance company. Typically, the assets of variable annuities are in separate accounts and not commingled with company assets and therefore not subject to the claims of the company’s creditors. However, during the accumulation phase of your variable annuity, the size to which your investment grows depends on the management of the various funds offered by the annuity. Your principal is not guaranteed (unless you die), so you definitely want to look at the performance track record of the fund managers and steer clear of those who take undue risk. 13. 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. The employer is responsible for the investment of the plan assets and bears the risk of poor investment performance. In contrast, a defined contribution plan specifies how much the employer and/or the employee are to contribute to the plan but says nothing about what the plan benefits will be. That depends on how much the contributions grow to become, which is determined by the investment choices the employee made. The employee bears the risk of poor investment performance. The cash balance plan has some of the features of both the defined benefit and the defined contribution plan. Like a defined contribution plan, the employee has a separate account to which contributions are made. The employer then credits that account with an annual contribution, which is usually a fixed percentage of the employee's pay. The growth of the plan balance over time is more predictable, and like the defined benefit plan, the employer is responsible for the investment of the plan assets and bears the risk of poor investment performance. However, the cash balance plan is more portable for employees who change jobs than is the defined benefit plan. 14. Given that Dan is 65 and at full retirement age, having had average career earnings, his monthly benefit would be $1,229, making his annual benefit $14,748. Fortunately, the Senior Citizens' Freedom to Work Act of 2000 removed earnings restrictions for those aged 65-67, so he will not have to forfeit any of his benefit due to earnings from his job. If Dan were only 62 and started to take his benefits, he would receive only 80% of $1,229 per month (or $983.20), making his annual benefit $11,798.40. However, because his $18,000 a year part-time job is over the $14,640 limit (2012), he will lose $1,680 in annual benefits ($18,000 − $14,640 = $3,360/2 = $1,680) or $140 per month. This would reduce his $983.20 monthly benefit by $140, leaving him $843.20 per month or $10,118.40 in annual benefits. 15. Worksheet 14.1 16. Fixed-rate annuities grow at a minimum fixed rate set by the insurance company, which is usually fairly low. Fixed annuity assets are commingled with the assets of the insurance company and hence are subject to the claims of the company’s creditors. Variable annuities 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, and the return on a variable annuity depends on the investment choices made. Typically, the assets of variable annuities are in separate accounts and not commingled with company assets and therefore not subject to the claims of the company’s creditors. For someone age 60 and close to retirement, a fixed annuity would probably be the better choice. Even though the variable annuity offers greater growth potential, it could also suffer a loss, something that is more difficult for someone close to retirement to bear. However, for someone who has plenty of other assets to live off of in retirement, the variable annuity might be attractive. Solutions to Critical Thinking Cases 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. (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: Future value of $47,400 at 7% rate of return: $47,400 × FVIF (7%, 8 years) = $47,400 × 1.718 = $81,433.20 Thus, from these two sources, Sophia will have: $188,663.40 (or $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 4. [Note: answers obtained with financial calculator are shown in parentheses.] 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 $188,663.40 (or $188,705.30) when she retires. She will throw in another $33,090 ($33,085.42) from the future contributions to her 401(k) plan, and she will end up with about $221,753.40 ($221,790.72) at retirement. That will leave her only about $28,246.60 ($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. Solution Manual for PFIN Personal Finance Lawrence J. Gitman, Michael D. Joehnk, Randall S. Billingsley 9781285082578
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