Copyright ©2004 Pearson Education, Inc. All rights reserved. 19-2
Chapter Objectives
• Describe the role of Social Security
• Explain the difference between defined-benefit 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. 19-3
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 how to measure the tax benefits from contributing to a retirement plan
Copyright ©2004 Pearson Education, Inc. All rights reserved. 19-4
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. 19-5
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. 19-6
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. 19-7
Social Security
Exhibit 19.1: FICA Taxes on Various Income Levels
Copyright ©2004 Pearson Education, Inc. All rights reserved. 19-8
Financial Planning Online: Request a Social Security Statement
• Go to: http://www.ssa.gov/top10.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. 19-9
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. 19-10
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. 19-11
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. 19-12
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. 19-13
Employer-Sponsored Retirement Plans
• Defined-contribution plan: an employer-sponsored 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. 19-14
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. 19-15
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. 19-16
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. 19-17
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. 19-18
Your Retirement Planning Decisions
Exhibit 19.2: Typical Composition of a Retirement Account Portfolio
Copyright ©2004 Pearson Education, Inc. All rights reserved. 19-19
Your Retirement Planning Decisions
Exhibit 19.2: Typical Composition of a Retirement Account Portfolio
Copyright ©2004 Pearson Education, Inc. All rights reserved. 19-20
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. 19-21
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. 19-22
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. 19-23
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. 19-24
Retirement Plans Offered by Employers
• SIMPLE (Savings Incentive Match Plan for Employees) Plan: a defined-contribution 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. 19-25
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. 19-26
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. 19-27
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. 19-28
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. 19-29
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. 19-30
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. 19-31
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. 19-32
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. 19-33
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. 19-34
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. 19-35
Annuities
• Annuity: a financial contract that provides annual payments over a specified period
• Contributions taxable but gains are tax-deferred
• 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. 19-36
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. 19-37
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. 19-38
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. 19-39
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. 19-40
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. 19-41
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. 19-42
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. 19-43
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. 19-44
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. 19-45
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. 19-46
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. 19-47
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. 19-48
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. 19-49
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. 19-50
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. 19-51
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. 19-52
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. 19-53
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. 19-54
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. 19-55
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. 19-56
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. 19-57
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. 19-58
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. 19-60
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