Chapter 19 Retirement Planning Copyright 2004 Pearson Education

Chapter 19 Retirement Planning Copyright © 2004 Pearson Education, Inc. All rights reserved.

Chapter Objectives • Describe the role of Social Security • Explain the difference between definedbenefit and defined-contribution retirement plans • Present the key decisions you must make regarding retirement plans • Introduce the retirement plans available for self-employed individuals Copyright © 2004 Pearson Education, Inc. All rights reserved. 2

Chapter Objectives • Describe types of individual retirement accounts • Illustrate how to estimate the savings you will have in your retirement account at the time you retire • Show to measure the tax benefits from contributing to a retirement plan Copyright © 2004 Pearson Education, Inc. All rights reserved. 3

Social Security • Social Security is a federal program that taxes you during your working years and uses the funds to make payments to you upon retirement • It does not provide adequate income to solely support most people Copyright © 2004 Pearson Education, Inc. All rights reserved. 4

Social Security • Qualifying for Social Security – You need to accumulate 40 credits from contributing to Social Security • One credit for each $780 in income per year, maximum 4 per year – Social Security also available for disabled Copyright © 2004 Pearson Education, Inc. All rights reserved. 5

Social Security – Survivor’s benefits are also provided • A one-time income payment to the spouse • Monthly income payments if spouse is older than 60 or has a child under the age of 16 • Monthly income payments to children under age 18 • Social Security Taxes – Collected from both employees and employers • 6. 2% for Social Security • 1. 45% for Medicare Copyright © 2004 Pearson Education, Inc. All rights reserved. 6

Social Security Exhibit 19. 1: FICA Taxes on Various Income Levels Copyright © 2004 Pearson Education, Inc. All rights reserved. 7

Financial Planning Online: Request a Social Security Statement • Go to: http: //www. ssa. gov/top 10. html • This Web site provides a form that you can use to request that a statement of your lifetime earnings and an estimate of your benefits be mailed to you. Copyright © 2004 Pearson Education, Inc. All rights reserved. 8

Social Security • Retirement benefits – Depends on your income and the number of years you earned income – Provides about 42% of your annual income – Eligible for full retirement benefits at age 65 – You can earn limited income while receiving Social Security Copyright © 2004 Pearson Education, Inc. All rights reserved. 9

Social Security • Concern about retirement benefits in the future – Retirees are living longer which costs the program more in benefits – The number of retirees continues to grow – Many people are relying less on Social Security and establishing their own retirement programs Copyright © 2004 Pearson Education, Inc. All rights reserved. 10

Employer-Sponsored Retirement Plans • Designed to help you save for retirement • Employees and/or employers contribute • A penalty is imposed for early withdrawal • Your contributions are tax-deferred Copyright © 2004 Pearson Education, Inc. All rights reserved. 11

Employer-Sponsored Retirement Plans • Defined-benefit plan: an employee-sponsored retirement plan that guarantees you a specific amount of income when you retire based on your salary and years of employment – Vested: having a claim to a portion of the money in an employer-sponsored retirement account that has been reserved for you upon your retirement even if you leave the company Copyright © 2004 Pearson Education, Inc. All rights reserved. 12

Employer-Sponsored Retirement Plans • Defined-contribution plan: an employersponsored retirement plan that specifies guidelines under which you and/or your employer can contribute to your retirement account and that allows you to invest the funds as you wish Copyright © 2004 Pearson Education, Inc. All rights reserved. 13

Employer-Sponsored Retirement Plans – Benefits of a defined-contribution plan • Money contributed by employer is like extra income • Encourages employees to save • Offers tax deferred income – Investing funds in your retirement account • Employer can usually choose from a number of different funds Copyright © 2004 Pearson Education, Inc. All rights reserved. 14

Your Retirement Planning Decisions • Which retirement plan should you pursue? – An employer-sponsored plan is usually the best choice if your employer contributes • How much to contribute? – As much as you can as early as you can! – How much to save? • How many people will you be supporting? • What do you expect prices to be? • What is your estimated life expectancy? Copyright © 2004 Pearson Education, Inc. All rights reserved. 15

Financial Planning Online: Retirement Expense Calculator • Go to: http: //moneycentral. msn. com/investor/ calcs/n_retireq/main. asp • This Web site provides an estimate of your expenses at retirement based on your current salary and expenses. Copyright © 2004 Pearson Education, Inc. All rights reserved. 16

Your Retirement Planning Decisions • How to invest your contributions? – Use a diversified set of investments – Consider the number of years to retirement – Consider your level of risk tolerance Copyright © 2004 Pearson Education, Inc. All rights reserved. 17

Your Retirement Planning Decisions Exhibit 19. 2: Typical Composition of a Retirement Account Portfolio Copyright © 2004 Pearson Education, Inc. All rights reserved. 18

Your Retirement Planning Decisions Exhibit 19. 2: Typical Composition of a Retirement Account Portfolio Copyright © 2004 Pearson Education, Inc. All rights reserved. 19

Retirement Plans Offered by Employers • 401(k) plan: a defined-contribution plan that allows employees to contribute a maximum of $10, 500 per year or 15 percent of their salary on a pre-tax basis – Amount of contribution gradually increasing to $15, 000 under Tax Relief Act of 2001 – Matching contributions by some employers – Tax on money withdrawn from the account • Tax and penalty for withdrawals before age 59½ Copyright © 2004 Pearson Education, Inc. All rights reserved. 20

Retirement Plans Offered by Employers • Focus on Ethics: 401(k) investment alternatives – Plans requiring employees to invest their 401(k) contributions in their employer’s stock is unethical – These contributions should be diversified Copyright © 2004 Pearson Education, Inc. All rights reserved. 21

Retirement Plans Offered by Employers • 403 -b plan: a defined-contribution plan allowing employees of non-profit organizations to invest up to $10, 000 of their income on a tax-deferred basis – Gradually increasing to $15, 000 under Tax Relief Act of 2001 Copyright © 2004 Pearson Education, Inc. All rights reserved. 22

Retirement Plans Offered by Employers • Simplified Employee Plan (SEP): a defined-contribution plan commonly offered by firms with 1 to 10 employees or used by self-employed people – Employee cannot contribute to this plan – Tax and penalty for withdrawals before age 59 Copyright © 2004 Pearson Education, Inc. All rights reserved. 23

Retirement Plans Offered by Employers • SIMPLE (Savings Incentive Match Plan for Employees) Plan: a definedcontribution plan intended for firms with 100 or fewer employees – Employee can contribute up to $6, 000 annually and the employer can match Copyright © 2004 Pearson Education, Inc. All rights reserved. 24

Retirement Plans Offered by Employers • Profit sharing: a defined-contribution plan in which the employer makes contributions to employee retirement accounts based on a specified formula – Up to 15% of employee’s salary, maximum $24, 000 per year Copyright © 2004 Pearson Education, Inc. All rights reserved. 25

Retirement Plans Offered by Employers • Employee Stock Ownership Plan (ESOP): a retirement plan in which the employer contributes some of its own stock to the employee’s retirement account – More risky because it is not diversified Copyright © 2004 Pearson Education, Inc. All rights reserved. 26

Retirement Plans Offered by Employers • Managing your retirement account after leaving your employer – Rollover IRA: an individual retirement account into which you can transfer your assets from your company retirement plan tax-free while avoiding penalties Copyright © 2004 Pearson Education, Inc. All rights reserved. 27

Retirement Plans for Self. Employed Individuals • Keogh Plan: a retirement plan that enables self-employed individuals to contribute part of their pre-tax income to a retirement account – Up to 25% to a maximum of $30, 000 annually – Individual determines how funds are invested Copyright © 2004 Pearson Education, Inc. All rights reserved. 28

Retirement Plans for Self. Employed Individuals • Simplified Employee Plan (SEP) – Also available for self-employed who can contribute up to 15% of annual income to a maximum of $24, 000 annually Copyright © 2004 Pearson Education, Inc. All rights reserved. 29

Individual Retirement Accounts • Traditional IRA: a retirement plan that enables individuals to invest $2, 000 per year – Gradually increasing to $5000 under Tax Relief Act of 2001 – Contributions may or may not be tax-deductible – Interest earned is tax-deferred – Tax and penalty on withdrawals before age 59 Copyright © 2004 Pearson Education, Inc. All rights reserved. 30

Individual Retirement Accounts • Roth IRA: a retirement plan that enables individuals who are under specific income limits to invest $2, 000 per year – Gradually increasing to $5000 under Tax Relief Act of 2001 – Income taxed at time of contribution, but not when withdrawn Copyright © 2004 Pearson Education, Inc. All rights reserved. 31

Individual Retirement Accounts • Comparison of the Roth IRA and Traditional IRA – Advantage of traditional IRA over Roth IRA • Contributions are sheltered from taxes until withdrawn – Advantage of Roth IRA over traditional IRA • Investment income accumulates tax-free in a Roth IRA Copyright © 2004 Pearson Education, Inc. All rights reserved. 32

Individual Retirement Accounts – Factors that affect your choice • Marginal tax rates at time of contribution and withdrawal Copyright © 2004 Pearson Education, Inc. All rights reserved. 33

Financial Planning Online: Traditional IRA or Roth IRA? • Go to: http: //www. financenter. com/products/ sellingtools/calculators/ira/ • Click on: “Should I convert my IRA into a Roth IRA? ” • This Web site provides an analysis of whether a Traditional or a Roth IRA is better suited to you. Copyright © 2004 Pearson Education, Inc. All rights reserved. 34

Annuities • Annuity: a financial contract that provides annual payments over a specified period • Contributions taxable but gains are taxdeferred • Fixed versus variable annuities – Fixed annuity: an annuity that provides a specified return on your investment, so you know exactly how much you will receive at a future time Copyright © 2004 Pearson Education, Inc. All rights reserved. 35

Annuities – Variable annuity: an annuity in which the return is based on the performance of the selected investment vehicles • Annuity fees – High fees is a disadvantage of annuities – Surrender charge: a fee that may be imposed on any money withdrawn from an annuity Copyright © 2004 Pearson Education, Inc. All rights reserved. 36

Annuities – Also commissions to salespeople – Look for no-load annuities that do not charge commissions and have low management fees Copyright © 2004 Pearson Education, Inc. All rights reserved. 37

Estimating Your Future Retirement Savings • Estimating the future value of one investment • Example: – You consider investing $5, 000 this year, and this investment will remain in your account until 40 years from now when you retire. You believe that you can earn a return of 10% per year on your investment. Using FVIF, you expect the value of your investment in 40 years to be: Copyright © 2004 Pearson Education, Inc. All rights reserved. 38

Estimating Your Future Retirement Savings Value in 40 years = Investment FVIF(I=10, n=40) = $5, 000 45. 259 = $226, 295 Copyright © 2004 Pearson Education, Inc. All rights reserved. 39

Estimating Your Future Retirement Savings • Estimating the future value of one investment – Relationship between amount saved now and retirement savings • If you invested $10, 000 instead of $5, 000, your savings would grow to $452, 590 in 40 years Copyright © 2004 Pearson Education, Inc. All rights reserved. 40

Estimating Your Future Retirement Savings – Relationship between years of saving and your retirement savings • If you invested $5, 000 for 25 years instead of 40 years, your savings would be only $54, 175 Copyright © 2004 Pearson Education, Inc. All rights reserved. 41

Estimating Your Future Retirement Savings Exhibit 19. 3: Relationship between Savings Today and Amount of Money at Retirement (in 40 years, assuming a 10% annual return) Copyright © 2004 Pearson Education, Inc. All rights reserved. 42

Estimating Your Future Retirement Savings – Relationship between your annual return and your retirement savings • If you earned a return of 14% instead of 10%, your $5, 000 would be worth $944, 400 in 40 years Copyright © 2004 Pearson Education, Inc. All rights reserved. 43

Estimating Your Future Retirement Savings Exhibit 19. 4: Relationship between the Investment Period and Your Savings at Retirement (assuming a $5, 000 investment and a 10% annual return) Copyright © 2004 Pearson Education, Inc. All rights reserved. 44

Estimating Your Future Retirement Savings • Estimating the future value of a set of annual investments • Example: – You consider investing $5, 000 at the end of each of the next 40 years to accumulate retirement savings. You believe that you can earn a return of 10% per year on your investment. Using FVIFA, you expect the value of your investment in 40 years to be: Copyright © 2004 Pearson Education, Inc. All rights reserved. 45

Estimating Your Future Retirement Savings • Value in 40 years = Investment FVIFA = $5, 000 442. 59 = $2, 212, 950 Copyright © 2004 Pearson Education, Inc. All rights reserved. 46

Estimating Your Future Retirement Savings – Relationship between size of annuity and retirement savings • For every extra $1, 000 you can save by the end of each year, you will accumulate an additional $442, 590 – Relationship between years of saving and retirement savings • If you start saving $5, 000 per year at age 25 instead of age 30 (saving until age 65), you will save an additional $857, 850 Copyright © 2004 Pearson Education, Inc. All rights reserved. 47

Estimating Your Future Retirement Savings Exhibit 19. 6: Relationship between the Amount Saved per Year and Amount of Savings at Retirement (in 40 years, assuming a 10% annual return) Copyright © 2004 Pearson Education, Inc. All rights reserved. 48

Estimating Your Future Retirement Savings Exhibit 19. 7: Relationship between the Number of Years You Invest Annual Savings and Your Savings at Retirement (assuming a $5, 000 investment and a 10% annual return) Copyright © 2004 Pearson Education, Inc. All rights reserved. 49

Estimating Your Future Retirement Savings – Relationship between your annual return and your savings at retirement • If you earn a return of 12% instead of 10% your savings will accumulate at additional $1. 6 million Copyright © 2004 Pearson Education, Inc. All rights reserved. 50

Estimating Your Future Retirement Savings Exhibit 19. 8: Relationship between the Annual Return on Your Annual Savings and Your Savings at Retirement (in 40 years, assuming a $5, 000 initial investment) Copyright © 2004 Pearson Education, Inc. All rights reserved. 51

Measuring the Tax Benefits From a Retirement Account • Example: – You wish to invest $5, 000 per year in a retirement account for the next 40 years. You expect to earn a return of 10% per year. Using FVIFA, your savings at retirement would be: $5, 000 442. 59 = $2, 212, 950 Copyright © 2004 Pearson Education, Inc. All rights reserved. 52

Measuring the Tax Benefits From a Retirement Account – If you withdrew all of your money in one year, with a 25% tax rate, your tax would be: $2, 212, 950 . 25 = $553, 238 – Your income after taxes would be: $2, 212, 950 - $553, 238 = $1, 659, 712 Copyright © 2004 Pearson Education, Inc. All rights reserved. 53

Measuring the Tax Benefits From a Retirement Account – Consider if you invest the $5, 000 elsewhere, you have an additional $5, 000 taxable income each year. Assuming a marginal tax rate of 30%, you have only $3, 500 each year to invest. Assume a 10% return on those savings over the next 40 years. Using FVIFA, your savings would be: (cont’d on next slide) Copyright © 2004 Pearson Education, Inc. All rights reserved. 54

Measuring the Tax Benefits From a Retirement Account $3, 500 442. 59 = $1, 549, 065 – You would have a capital gain of: $1, 549, 065 - ($3, 500 40) = $1, 409, 065 Copyright © 2004 Pearson Education, Inc. All rights reserved. 55

Measuring the Tax Benefits From a Retirement Account – Assuming a capital gains tax of 20%, your capital gains tax would be: $1, 409, 065 . 20 = $281, 813 – Therefore, after 40 years you have: $1, 409, 065 - $281, 813 = $1, 127, 252 – With your IRA, your account would be worth over $500, 000 more! Copyright © 2004 Pearson Education, Inc. All rights reserved. 56

Financial Planning Online: How to Build Your Retirement Plan • Go to: http: //www. quicken. com/retirement/planner/ • This Web site provides a framework for building a retirement plan based on your financial situation. Copyright © 2004 Pearson Education, Inc. All rights reserved. 57

How Retirement Planning Fits within Your Financial Plan • Key decisions about retirement planning for your financial plan are: – Should you invest in a retirement plan? – How much should you invest in a retirement plan? – How should you allocate investments within your retirement plan? Copyright © 2004 Pearson Education, Inc. All rights reserved. 58

Integrating Key Concepts Copyright © 2004 Pearson Education, Inc. All rights reserved. 59

Integrating Key Concepts • • • Part 1: Financial Planning Tools Part 2: Liquidity Management Part 3: Financing Part 4: Protecting Your Assets and Income Part 5: Investing Part 6: Retirement and Estate Planning – In Chapter 19 we learned about retirement planning – In Chapter 20 we will learn about estate planning Copyright © 2004 Pearson Education, Inc. All rights reserved. 60