Planning for Retirement in Style Assignment

Assignment 1. Planning for retirement in style How do you begin to plan for retirement? They say it’s easy to retire—but retire in style, that’s the difficult part! To plan for retirement you will need to learn about budgets, taxes, investments and the basics of retirement planning. To realize your retirement dreams and to have all financial resources in place, you must begin planning for retirement by making a commitment to begin saving today. True or False: The first step in retirement planning is to establish retirement goals. True Choices, choices, choices ... Consider the following scenario: You started your first job. Each month, you have an extra $200 left over after paying bills. Your friend advises that you should put the $200 toward the Aspen Ski Works offer. You’ll have it paid for in 12 months! Should you spend $200 on a ski package? No. I need to save some of the $200. 2. Retirement planning steps Planning for Retirement To retire in style takes careful, early planning with an understanding of budgets, taxes, and investments. Identify the first three steps of retirement planning. 1. Define retirement goals. 2. Determine the size of the nest egg that you’ll need. 3. Formulate an investment program. People often start by thinking, “I want to retire with a million dollars.” The following tasks will help you make a commitment, understand the financial community, and understand the future. Identify the components of an investment program. 1. Establish a systematic savings plan. 2. Identify the investment vehicles to meet your retirement goals. 3. Understand tax planning so as to legitimately shield as much income as possible from taxes. 3. Compound interest and its effects Understanding the Impact of Compounding There are many reasons why people don’t save: “I don’t have any extra money.” “I promise to start next year.” “I have $100 . . . what will that do?” “I’d rather pay extra on my bills and get those taken care of first.” Many people who did establish a retirement plan have found that, years into their plan, they made three mistakes: • They started too late. • They put away too little. • They invested too conservatively. And these pitfalls are magnified when you consider compound interest. Consider the compound interest effect in the following two scenarios. (Note: In your calculations, use either the formula or the financial calculator. Round your answers to the nearest cent.) Musashi, age 30, is starting his savings plan this year by putting away $1,000.00 at the end of every year until he reaches age 65. He will deposit this money at his local savings and loan at an interest rate of 6%. The future value annuity interest factor is 111.4348. Based on the information provided, by the time Musashi turns 65, he will have $111,434.80 . Rina, age 35, is starting her savings plan this year by putting away $1,000.00 at the end of every year until she reaches age 65. She will deposit this money at her local savings and loan at an interest rate of 6%. The future value annuity interest factor is 79.0582. Based on the information provided, by the time Rina turns 65, she will have $79,058.20 . Musashi started his investment program five years earlier and set aside $5,000.00 more than Rina. By the time Musashi turns 65, he will have accumulated $32,376.59 more than Rina. Explanation: To calculate the amount each person will have when they reach age 65, take the amount they are saving times the compounding factor. So, for Musashi, he will have $1,000.00×111.4348=$111,434.80, while Rina will accumulate $1,000.00×79.0582=$79,058.20. By starting five years earlier and reaping the benefits of compound interest, Musashi has accumulated a nest egg of $111,434.78, which is $111,434.78−$79,058.19=$32,376.59 more than Rina! So, setting aside an additional $5,000.00 ($1,000.00 per year for five more years), has a dramatic effect due to the interest compounding. So, starting early can help you to retire in style. 4. Looking forward - Future value Compounding Interest You know that paying yourself by depositing money in a savings account is a prudent start to your retirement plan. You determined that, based on your other obligations, you can save $7,500.00 per year via an annual, single year-end deposit. You are 30 years old now, so your money will grow for the next 35 years until you turn 65. You will open a savings account at the CitiBank branch near your home. Its savings accounts are paying 6% interest. The following table shows the future value factors for various periods and interest rates: Future Value of an Annuity Factor Year 2% 3% 10 10.950 11.460 12 13.412 15 17.293 5% 6% 8% 9% 10% 12.578 13.180 14.487 15.190 15.937 14.190 15.917 16.870 18.977 20.140 21.384 18.600 21.578 23.270 27.152 29.360 31.772 Year 2% 3% 20 24.297 26.870 25 32.030 30 40.567 5% 6% 8% 9% 10% 33.066 36.780 45.762 51.160 57.274 36.460 47.726 54.860 73.105 84.700 98.346 47.570 66.438 79.060 113.28 136.300 164.491 215.700 271.018 337.870 442.580 2 35 49.994 60.460 90.318 111.430 172.31 4 40 60.401 75.400 120.797 154.760 259.05 2 Complete the following table by entering relevant values. Then use the table of future value factors to calculate the value of this nest egg. Annual savings $7,500 Years over which it will grow 35 % Interest rate 6.0 Interest factor 111.430 What will be the value of this money in 35 years? (Note: Round to two decimal places.) $835,725.00 You began saving at age 30. If you had started five years earlier, so that your funds would grow for 40 years, what would your nest egg be worth, assuming the same interest rate and annual savings amount? (Note: Round to two decimal places.) $1,160,700.00 Explanation: When a single value is saved over a number of years, it is referred to as an annuity. So, interest is earned in year 2 for the first amount deposited (at the end of the previous year). Then in the third year, interest is earned on the principal plus interest and the additional principal added in at the end of the second year. This accumulation continues over the defined periods: Future Value of an Annuity = Amount Invested Annually×Future Value of an Annuity Factor The future value of annuity (FVA) factor combines the interest rate and the number of periods. The factor can be found at the intersection of the 6% column and the 35-year row in the future value factor table. Insert the factor and a simple calculation determines what your nest egg will be worth when you reach age 65! Compound Interest Facto r = $7,500.00×111.430 = $835,725.00 If you had started your savings plan five years earlier, you would need to recalculate the value of your nest egg. Return to the future value factor table, and find the intersection of 6% (interest rate) and 40 years (or 154.760): Compound Interest Facto r = $7,500.00×154.760 = 0 $1,160,700.00 Suppose that a new bank in town offers 8% interest. How much would your yearly deposits be worth if you open a savings account there, assuming that your funds are invested for 35 years and all other factors remain the same? Complete the following table by entering relevant values. Then use either the table of future value factors, the future value formula, or your financial calculator to calculate the value of this nest egg. (Hint: Remember that the FVA factor is based on the new interest rate now.) Annual savings $7,500 Years over which it will grow 35 % Interest rate 8.0 Interest factor 172.314 What will be the value of this money in 35 years? (Note: Round to two decimal places.) $1,292,355.00 Again, if you had started your savings program five years earlier, what would your nest egg be worth, assuming that your funds were invested at this higher interest rate, the annual savings amount remains the same, and the funds are invested for 40 $1,942,890.00 years? (Note: Round to two decimal places.) Explanation: Researching various investment vehicles and adjusting for possible interest rate differences can increase your nest egg in the process. This revised calculation requires that, instead of following the 6% column, you consider the 8% column for the same number of years. Insert the factor and see how a rate increase adds to your nest egg when you reach age 65! Compound Interest Factor = $7,500.00×172.314 = $1,292,355.00 If you had started your savings plan five years earlier, such that your funds earned interest for 40 years, look for the annuity factor at the intersection of 8% (interest rate) and 40 years(or 259.052). The calculation is as follows: Compound Interest Factor = $7,500.00×259.052 = $1,942,890.00 7. Monthly Social Security benefits Monthly Benefits The Social Security Administration has a computerized service that determines your benefits because Social Security benefits are based on a fairly complicated formula. In fact, the government is required to provide all covered workers with a Social Security Statement. Identify the range of benefits you can expect. • If you retire at age 62, benefits of 70 to 80 % of your full retirement benefits • If you retire at age 65 to 67, receipt of your full retirement benefits • If you delay retirement until age 70, you can receive an increase . . in your benefits. Range of Benefits Hubert, a 66 years old worker, is deciding between retirement either this year or the next year. His average monthly benefit is determined to be $1,089.50. Assume that the benefit is the same for this year and the next year. Compute Hubert’s annual benefit reduction amounts in each of the following scenarios. • If Hubert retires this year and secures a part-time job earning $18,000, his annual benefit reduction amount is $1,140.00. • If Hubert retires this year, secures the same part-time job, and in addition projects interest and dividend earnings of $7,000 per year, what his annual benefit reduction amount is $1,140.00. • If Hubert retires next year and secures the same part-time job, the annual benefit reduction amount is $0.00 . Explanation: If Social Security recipients are under age 67 and still gainfully employed, they are subject to an earnings test. The rule states that if you are a Social Security recipient aged 62 through 66, your annual benefit is reduced by $1 for every $2 earned above the earnings test amount (the limit is $15,720 per year). To calculate the reduction, find the difference between the earnings ($18,000) and the earnings test amount ($15,720), or $2,280. Divide this by 2 to yield the reduction amount, or $1,140. Unearned income (interest, dividends, rents, or stock market transactions) can be received in an unlimited amount without a benefit reduction. Also, if this individual retires at their full retirement age (age 67), the earnings test no longer applies, and there would be no reduction in Social Security benefits. It is important to remember that when a covered worker receives a monthly benefit amount, it is the amount for the first year of retirement. The monthly amount is annually adjusted based on the cost of living determined by the Social Security Administration. Taxes on Benefits Social Security is paid in with after-tax dollars but may be subject to tax if annual income exceeds a base amount. A single taxpayer’s base is $25,000. Married taxpayers filing jointly have a base of $32,000. Married taxpayers filing separately have a base of zero. Suppose Manuel is retiring this year at age 67. The following table shows his data. Part-time salary $31,500 Annual savings account interest Annual dividends $2,500 Annual interest on Denver municipal bonds Based on the income calculated, Manuel will have 85 $275 $1,350 % of his Social Security benefits taxed. Explanation: To determine the rate at which Social Security benefits may be taxed, Manuel’s adjusted gross income (AGI) needs to be determined. His part-time job earns $31,500 annually, and he also earns $275 on a savings account and $2,500 in dividends on his investments. These added together constitute AGI (Adjusted Gross Income). Remember, while interest earned on municipal bonds is normally a nontaxable item, for the purposes of determining at what rate Social Security benefits are taxed, the interest earned on municipal bonds is added to Manuel’s AGI. Therefore, his AGI—for Social Security tax purposes only—is $35,625. • For single taxpayers, income that exceeds $25,000 but is less than $34,000, 50% of their Social Security benefits will be taxed. • For single taxpayers, income that exceeds $34,000, 85% of their Social Security benefits will be taxed. Thus, based on the income calculated, Manuel will have 85% of his Social Security benefits taxed. (Note: A stipulated portion of the Social Security benefits received will also be added when determining the tax rate of benefits. In this example, Manuel had already reached the 50% tax rate without regard to this additional stipulated amount.) 8. Vocabulary - Pension plans and retirement programs What does it mean? The expansion of the Social Security system resulted in an expansion of employer-sponsored pension and retirement plans. In 1948, the National Labor Relations Board ruled that pensions and other types of insurance programs were legitimate subjects for collective bargaining. In response, many employers established new pension plans or liberalized the provisions of existing ones to meet or anticipate union demands. Match the pension plan and retirement program terms on the right with the descriptions of the terms on the left. (Hint: These are not necessarily complete definitions, but there is only one possible answer for each term.) Description Under this plan, the employer not only makes the contributions (based on a percentage of an employee’s salary), controls the investment, and guarantees a given payout at retirement, it also creates a separate “account” that details the employee’s accumulated balance. This type of plan has the employer paying the total contribution costs. Term Cash-balance plan Noncontributory pension plan This type of plan encourages employees to work harder, because they benefit when the firm prospers. Profit-sharing plans This federal law shores up the financial integrity of private traditional (defined benefit) plans. Pension Protection Act With this type of plan, the worker is awarded whatever level of monthly benefits those contributions will purchase. 9. Employer-sponsored programs Employer-Sponsored Retirement Programs In addition to pension plans, employers of all sizes offer supplemental plans. These plans are often voluntary and help employees to not only increase the amount of funds being held for retirement but also enjoy attractive tax benefits. Defined contribution plan A profit-sharing plan allows employees to participate in the earnings of their employer. This type of plan may be IRS qualified, making it eligible for the same tax treatment as other types of pension plans. Some companies may offer a voluntary profit-sharing program that invests heavily in their own stocks . A Roth 401(k) is a supplement retirement plan, which, unlike a traditional 401(k) plan, requires that all contributions are made in after-tax dollars . With a Roth 401(k), monies withdrawn from the plan are tax free , assuming that you are age 59 1/2 and held the account for five years or more. A thrift and savings plan has the employer contribute an amount equal to a proportion of the employee’s contribution to the plan. If the plan is IRS qualified, employer contributions and earnings aren’t included in taxable income until withdrawal. An employee’s contribution is considered part of taxable income. Thus, it is subject to income tax. The salary reduction plan, (a 401(k) plan), gives employees the option to divert part of their salary to a company-sponsored, tax-sheltered savings account. In this way, the earnings diverted accumulate tax free . Because these contributions are made pretax, the amount necessary to fund a contribution is reduced by the contribution times the individual’s tax rate . 10. Benefits of traditional and Roth 401(k) plans Traditional 401(k) versus Roth 401(k) Juanita has decided to contribute to a savings program. She can open a traditional 401(k) or a Roth 401(k) and has determined that she can afford a $14,400 contribution. Juanita’s salary is $106,500 per year, and she is in the 32% tax bracket. If Juanita decides to go with a traditional 401(k), her contribution amount will be $14,400.00 And the amount offset via a reduced tax bill will be $4,608.00 . . Explanation: A traditional 401(k) contribution is made with pretax dollars. This allows Juanita to contribute to retirement and at the same time receive a reduction in taxable income (with a reduction in taxes withheld). Juanita determined that she could contribute $14,400 to a traditional 401(k) plan. Based on her tax rate, Juanita will reduce her taxable income and have her taxes withheld reduced by $14,400×0.32=$4,608.00$14,400×0.32=$4,608.00. If, instead, Juanita decides to go with a Roth 401(k), her contribution amount will be $14,400.00 And the amount offset via a reduced tax bill will be $0.00 . . Explanation: In the case of the Roth contribution, it is made with after-tax dollars. So, the contribution amount is the same, but Juanita will not have a reduction in taxable income (and correspondingly a reduction in taxes withheld). Assuming all the same facts, suppose that Juanita decides to open both 401(k) plans, splitting what she can afford to contribute equally between both plans. Under this scenario, Juanita’s contribution amount will be $14,400.00 And the amount offset via a reduced tax bill will be $2,304.00 . . Explanation: In the case of opening both types of 401(k) plans, Juanita will have a reduction in taxable income for the amount contributed to her traditional plan (one-half of $14,400). This contribution will also reduce taxes withheld (Juanita’s contribution×0.32Juanita’s contribution×0.32). The other half of the contribution, to the Roth plan, goes in after tax, so no reduction in taxable income nor taxes withheld occurs. When Juanita retires, which plan’s monies will she be able to exclude from taxable income? Roth 401(k) Explanation: When Juanita retires, she will be able to exclude monies withdrawn from her Roth 401(k) from taxable income. Remember that Juanita must be at least 59 1/2 years old and have had a Roth account for at least five years. 11. Evaluating employer plans What retirement plan options are available? It is always your responsibility to learn about the basic and supplemental (voluntary) plans an employer may offer. There are noncontributory and contributory pension plans, which stipulate vesting requirements. Within these types, there is either a defined contribution plan or a defined benefit plan. Many employers also offer supplemental or voluntary programs such as profit-sharing, thrift and savings, and 401(k) plans. Consider a dialogue between Nick and Rosa, both new employees at a big Fortune 500 company. Both had taken a personal finance class in college several years ago. Today, they are reviewing their notes from the recent new-employee benefits meeting and helping each other complete the notes they’ve taken. NICK: I heard the HR manager say that the company uses the cliff vesting schedule. I’m not sure what that means. ROSA: I remember this from personal finance class. Cliff vesting requires full vesting over three years. NICK: What’s the other option? ROSA: The graded schedule. Graded schedule assumes that vesting is gradual over six years. NICK: Did you understand everything about the pension plans? Could you help me there? ROSA: Sure! A pension plan is a contributory shared by employer and employee plan, which means that the contribution cost is . In addition, it is a defined contribution means that the plan states how much we all plan, which have to contribute. NICK: I heard the HR manager say that they offer two supplemental plans, but I only wrote down the profit-sharing plan. Under this type of plan, your account depends on the company’s performance. This is because when profits are low, the company makes smaller contributions to the plan, and when profits are high, it pays more minimum and maximum . However, employers set amounts to be paid as contributions. What is the other plan? ROSA: The other plan she mentioned is the traditional 401(k) plan . NICK: Because our employer is a big Fortune 500 company, our plan is voluntary. It takes everyone’s contributions and heavily invests it in company stock. ROSA: Well, I think I have my notes complete. I may need to clarify a few things that will apply just to me, vesting, profit-sharing percentages, and retirement age. YAKOV: I heard the HR manager say that they offer two supplemental plans, but I only wrote down the traditional 401(k) plan. It’s the type of plan where we can contribute pretax set maximum , up to an IRS- . What is the other plan? ANA: The other plan she mentioned is the profit-sharing plan . YAKOV: Because our employer is a big Fortune 500 company, our plan is voluntary. It takes everyone’s contributions and heavily invests it in company stock. ANA: Well, I think I have my notes complete. I may need to clarify a few things that will apply just to me, vesting, profit-sharing percentages, and retirement age. NICK: Agreed. Thanks for helping me complete my notes! Explanation: Nick and Rosa’s discussion addresses the following points: • Vested rights define the criteria that must be met before an employee can obtain a nonforfeitable right to a pension. Cliff vesting requires full vesting after no more than three years of service. You obtain no privileges until them. Once vested, you are entitled to everything that is paid in so far (your contributions plus your employer’s). Graded schedule vesting takes place gradually over the first six years of employment. At a minimum, after two years you’d have a nonforfeiture right to at least 20% of the benefits, with an additional 20% each year thereafter until you’re 100% vested after six years. • A contributory pension plan has the employer and employee sharing the cost on contributions. A noncontributory plan has the employer paying the total cost of the contribution. • A defined contribution plan specifies the amount of contribution that both the employer and employee must make. At retirement, the employee is awarded whatever level of monthly benefits those contributions will purchase. A defined benefit plan has a formula for computing benefits (not the contribution), which is stipulated in the plan provisions. These benefits are paid out regardless of how well (or poorly) the retirement funds perform. • A profit-sharing plan allows employees to participate in the earning of their employer. Some large companies offer voluntary profit-sharing plans which invest heavily in their own stock. Employees can accumulate a large amount of company stock. If the company is doing well, there is employee incentive to do well. If the company is doing poorly, an employee’s value in the stock can decline, which would be a disincentive to participate. 12. Vocabulary - Self-directed retirement programs What does it mean? The retirement planning conversations usually involve the employer–employee relationship. For individuals who are self-employed, self-directed retirement programs also allow them to plan for their retirement. Match the self-directed retirement program terms on the right with the descriptions of the terms on the left. (Hint: These are not necessarily complete definitions, but there is only one possible answer for each term.) Description Term If you change jobs, arrange for your IRA funds to transfer from one firm to another. Rollover Similar to 401(k) plans, payments from this account may be taken as deductions from taxable income. Keogh plans Couples filing jointly with adjusted gross incomes of up to $193,000 ($131,000 for single filers) can open this type of account, without regard to participation in an employer retirement program. Roth IRA With this type of account, earnings accrue tax free and are not subject to tax until they are withdrawn (after the individual reaches age 59 1/2). Two basic types of retirement programs—Keogh and SEP (for selfemployed individuals)—and IRAs allow individuals to set up their own tax-sheltered retirement plans. 13. Vocabulary – Annuities What are annuities? An annuity is just the opposite of life insurance. Life insurance is the systematic accumulation of an estate that is used for protection against financial loss resulting from premature death. In contrast, annuities are a means of securing a steady cash flow during retirement. The period in which the premiums are paid toward the purchase of an annuity is called the accumulation period. The period when the annuity payments are made is called the distribution period. The principal is the premium paid by the individual buying the annuity (called the annuitant ). Interest is earned between the time annuities are paid for and distributed , accruing tax free but paid for with after-tax dollars. If any portion of the principal and interest has not been returned, it is referred to as the survivorship benefit. Nondeductible IRA Self-directed retirement plans Description The insurance company safeguards the principal and agrees to a minimum interest rate over the life of the contract. Term Fixed-rate annuity Starting with regular payments (monthly, quarterly, annually) and as low as $100, this annuity is purchased over an extended period of time. Installment premium annuity contract This annuity usually requires a minimum investment ($2,500 to $10,000) and is often purchased just before retirement as a way of creating a future stream of income. Single premium annuity contract This type of contract allows cash benefits to be stretched for several years. The purchaser receives a specified amount of income for life, without regard to the distribution period and with the contract terminating upon death. This annuity’s monthly income varies as a function of the insurer’s actual investment experience. This annuity allows the purchaser to receive monthly benefits immediately. Deferred annuity Pure life Variable annuity Immediate annuity Without regard for life contingency, this annuity specifies monthly income for a stated number of years. Annuity certain A lump-sum payment purchases this annuity. Single premium annuity contract For this annuity, the insurance company agrees to pay a guaranteed interest rate on your money. Fixed-rate annuity