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Chapter 16
Retirement Planning
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Retirement – It’s Up to YOU!
Start saving today –although retirement seems along way away!
Employer benefits arereduced, or simply notavailable.
The future of governmentbenefits, Social Security, isquestionable.
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The Aspects of Social Security
Mandatory federal insurance programproviding
–retirement, disability, and survivor benefits
Paid for with a federal tax -- FICA
–6.2% of your first $76,200 in 2000 pays for SocialSecurity
–1.45% of your total earnings pay for Medicare
–Equal match by your employer
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Social Security Eligibility
To qualify for full benefits you must earn40 credits
–$780 earned in 2000 equals one credit
–Maximum of four credits earned per year
You must be 65 years of age to receivefull benefits, but will gradually increaseto 67 in 2022.
Reduced benefits may begin at age 62
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Determinants of SocialSecurity Retirement Benefits
Number of years of earnings
Average level of earnings
Inflation
Age you begin receiving benefits
Replaces approximately 42% of your lifetimeaverage annual income, with adjustmentsdown for higher income earners and up forlower income earners
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Taxes and Social SecurityBenefits
Taxes are based on “combinedincome,” or adjusted gross income,nontaxable interest, and 50% of yourbenefits
Percentage of joint benefits tax eligible
–earnings < $32,000 – 0 percent taxed
–earnings of $32,000 to $44,000 – 50%
–earnings > $44,000 – 85%
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Taxes and Social SecurityBenefits (cont’d)
Percentage of individual benefits taxeligible
–earnings < $25,000 – 0 percent taxed
–earnings of $25,000 to $34,000 – 50%
–earnings > $34,000 – 85%
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Earnings Limits on SocialSecurity Benefits
Prior to 2000, earninglimits reduced SocialSecurity benefits formany older workers.
Senior Citizens’Freedom to Work Act of2000 eliminated theretirement earningslimit.
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Disability and SurvivorBenefits
Disability benefits for those physically ormentally impaired
–Impairment expected to result in death
–Impairment prevents “substantial work” for at least1 year
Survivor’s benefits
–small payment to defray funeral costs
–continuing monthly payments to spouse, children,or parents -- with restrictions
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Employer-Funded PensionPlans
Defined benefit plans
Cash balance plans
Advantages:
–Employer bears investment risk for theplan.
–Most are non-contributory
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Contributory andNoncontributory Plans
Contributory -- bothyou and youremployer paytoward yourretirement
Noncontributory --only your employerpays toward yourretirement
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Other Retirement Plan Issues
Funded -- the employer pays into a trustee-managed fund to guarantee future pensions
Unfunded -- pensions are paid out of currentcompany earnings or pay-as-you-go
Vesting period -- required length ofemployment to be eligible to receivecompany paid pension benefits
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Defined Benefit Plans
Predetermined pension payment on thebasis of a formula. Often based onaverage salary, years of service, andage at retirement
Monthly benefit =
Average salary for Y last yrs x yrs of service x Z%
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Defined Benefit Plans--Limitations
Lack of portability – pension does notgo with you if you leave the company
Company changes in the plan with littlenotice
Few plans adjust benefits for inflation
Some are unfunded plans that lacksafety.
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Cash-Balance Plans: A NewTwist on Defined-Benefit Plans
Pension account credited on the basisof a formula:
–Percentage of salary (e.g., 4% - 7%)
–Predetermined rate of interest earnings(e.g., 30-year Treasury-bond rate, S & P500 index rate, or other rate)
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Cash-Balance Plans: Pros andCons
Pros:
–Retirement benefits are easy to track.
–Benefit younger employees who can start to buildbenefits faster
–Portability
Cons:
–No choice on investment decisions and earningsare limited to the stated rate
–Reduced benefits for older workers
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Plan Now, Retire Later -- TheSteps to Success
Step 1: Set goals.
Step 2: Estimate how much you’ll needto meet your goals.
Step 3: Estimate your income availableat retirement.
Step 4: Calculate the annual inflation-adjusted shortfall.
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Plan Now, Retire Later -- TheSteps to Success (cont’d)
Step 5: Calculate the funds needed atretirement to cover this shortfall overyour entire retirement.
Step 6: Determine how much you mustsave annually between now andretirement.
Step 7: Put the plan into play and save.
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Step 1: Set Goals.
How extravagantly willyou want to live?
When will you want toretire?
Who will you have tocare for?
Where will you want tolive?
Will you want to travel?
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Step 2: Estimate Your Needsto Meet Your Goals.
Estimate future costs based on 70% to80% of current living expenses.
Establish how much each of your othergoals will cost.
Calculate how taxes will erode yourspending power.
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Step 3: Estimate Your IncomeAvailable at Retirement.
Estimate your Social Security benefits.
Calculate your employer-providedpension.
Estimate any other windfall income thatcould be used towards retirement, suchas an inheritance from your gozillionaireUncle Morty.
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Step 4: Calculate the AnnualInflation-Adjusted Shortfall.
Compare the difference between yourneeds and your retirement income.
Take inflation into account whencalculating the time value of money.
Use this formula:
FV = PV(FVIF i%, n yr)
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Step 4: Calculate the AnnualInflation-Adjusted Shortfall.
If you fall short, start saving now --remember Axiom 2: The Time Value ofMoney.
If you exceed your projected need --protect yourself against allcontingencies.
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Step 5: Calculate the FundsNeeded for This Shortfall.
Calculate the present value of all yourannual shortfalls by discounting for yourinflation-adjusted rate of return -- this isyour total need at retirement.
Use this formula:
PV = PMT(PVIFA i%, n yr)
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Step 6: Determine How MuchYou Must Save Annually.
Your answer in Step 5 is the total dollaramount you need the day you retire.
Determine your annual savings goal byusing a future value of an annuityequation.
Use the formula
FV = PMT(FVIFA i%, n yr)
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Step 6: Determine How MuchYou Must Save Annually.
Note: Alwaysremember to adjustfor inflation in eachstep or you will fallshort of your goal.
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Step 7: Put the Plan Into Playand Save.
Save, save, save!!
Determine thecombination ofretirement plans andproducts that arebest for you.
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Use Tax-Deferred Plans toSave for Retirement
Contributions may be made on a fully orpartially tax-exempt basis. You cancontribute more.
Earnings are not taxed annually, so thatamount stays in the account to continueearning money – or compound growth.
Taxes are deferred until afterretirement.
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Employer Sponsored RetirementPlans – Defined Contribution
A personal retirement savings accountthat passes responsibility for investmentrisk to the employee.
–Employer or employer and employeecontribute.
–Benefit depends on investment success.
–Employee may choose the investment.
–Future benefits are not guaranteed orinsured.
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Defined Contribution Plans:Various Forms
Defined contribution plans
–Profit-sharing plans
–Money-purchase plans
–Thrift and savings plans
–Employee stock ownership plan (ESOP)
401(k) plans
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Profit-Sharing Plans
Employer contributions can vary yearlydue to profitability.
Contributions can depend on yoursalary level.
Some firms set minimums andmaximums.
Contributions are not guaranteed.
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Money-Purchase Plans
Employer contributions are a setpercentage of your salary.
Contributions are guaranteed.
Preferred over profit-sharing plansbecause of the guaranteedcontributions.
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Thrift and Savings Plans
Employers match aset percentage ofyour contribution toyour retirementplan.
Contributions arenormallyguaranteed.
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Employee Stock OwnershipPlan (ESOP)
Employer contributions are made in theform of company stock.
This form of plan is the riskiest becauseyour retirement is dependent on theperformance of the company.
This type of plan does not allow fordiversification.
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401(k) Plans
Are normally employer-sponsoreddefined-contribution plans.
Are normally set-up as thrift-and-savings plans in which your employernormally matches a set percentage ofyour contribution.
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401(k) Plans (cont’d)
Are very tax advantaged.
–Your contributions are tax-deductible
–Your earnings grow tax-deferred
Offer a wide variety of investmentchoices.
Invest the maximum amount in your401(k) – before any other retirementoptions.
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Self-Employed or SmallBusiness Retirement Plans
Eligibility: self-employed, smallbusiness employee, or part-time free-lance work (even if full-time employeeelsewhere)
Benefit: Fully tax-deductible retirementplan
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Self-Employed or Small BusinessRetirement Plans (cont’d)
Keogh plan
Simplified employeepension plan (SEP-IRA)
Savings incentivematch plan foremployees(SIMPLE) plans
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Keogh Plans
Are vary similar to corporate profit-sharing plans.
Are either defined-contribution, defined-benefit, or a combination of both.
Are self-directed, which means that youchoose the investment.
Contributions are tax-deductible.
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Keogh Plans (cont’d)
Limitations on annual contributions, butliberal (up to $30,000 in 2000)
Withdrawals as early as 59½, but mustbegin by age 70½
10% early withdrawal penalty, except incases of illness, disability, or death
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Simplified Employee PensionPlan (SEP-IRA)
Similar to a defined-contribution Keoghplan, but easier to establish.
Used by small business owners with noor few employees.
Contributions are tax-deductible andearnings are tax-deferred.
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Simplified Employee PensionPlan (SEP-IRA) (cont’d)
Limits contributionsto 15% of salary, or$30,000, whicheveris less.
Flexibility in makingcontributions – canskip years.
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Savings Incentive Match Planfor Employees (SIMPLE)
Are for employers with less than 100employees earning more than $5,000.
Contributions are tax-deductible andearnings are tax-deferred.
Some employer matching funds.
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Individual RetirementAccounts (IRAs)
Traditional IRA, $2,000
–Fully tax deductible
–Partially tax deductible
–Not tax deductible
Roth IRA, $2,000
–Not tax deductible
Education IRA, $500
–Not tax deductible
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Traditional IRA
Contributions grow tax-deferred untilwithdrawal.
Allows nonworking spouses to make acontribution (spousal IRAs).
Self-directed, but cannot invest in lifeinsurance or collectible, except gold orsilver U.S. coins.
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Traditional IRAs (cont’d)
Distributions prior to age 59½ are subject toa 10% tax penalty, with few exceptions
–For first home purchase -- up to $10,000
–Are paying college expenses
–Become disabled
–Need for medical expenses or medical insurancepremiums, with restrictions
After you turn 70½ you must start receivingannual distributions or be penalized 50% ofyour minimum annual distribution.
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Traditional IRAs (cont’d)
Can rollover distributions from aqualified employer plan or other IRA toavoid an early distribution penalty – becareful to avoid taxes.
Cannot use as collateral for a loan.
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To Be A Fully Tax-DeductibleTraditional IRA
If not covered by a plan at work, you maycontribute $2,000 annually, regardless ofincome.
A married couple, with one working spousemay contribute $4,000 or 100% of earnedincome annually, if “modified adjusted grossincome” is below $150,000.
A married couple can contribute $4,000 ifadjusted gross income is below the IRS cutoff.
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For a Partially Tax-DeductibleTraditional IRA: Phaseout Zones
A single person may receive a partial taxdeduction if “modified” adjusted gross incomefalls between $32,000 and $42,000 (2000)
A married couple may receive a partial taxdeduction if “modified” adjusted gross incomefalls between $52,000 and $62,000 (2000)
A married couple, with one workingspouse,may receive a partial tax deduction, if“modified adjusted gross income” is between$150,000 and $160,000 (2000)
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Non-deductible TraditionalIRA
No annual taxdeduction for IRAcontribution
Investment growsfree of income taxesuntil withdrawal
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Roth IRAs
Contributions are not tax deductible.
Earnings grow tax-free.
Withdrawals are tax-free if the Roth IRAis held for 5 years.
Income limits begin at $95,000 perindividual and $150,000 per couple.
No distribution requirement.
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Education IRAs
Contributions are limited to $500annually per child under 18.
Contributions are not tax deductible, butgrow tax-free with no tax due uponwithdrawal.
Savings must be withdrawn by the timethe child reaches 30, but can be rolledinto accounts for younger siblings.
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Education IRAs (cont’d)
Money not used foreducation, may besubject to incometaxes and a 10%penalty uponwithdrawal.
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Traditional versus Roth IRA
Choose the Roth, if you can afford it
At the 31% tax bracket and a 10%return for 40 years:
–You need $2,899 (pretax) to fund a Rothand would end up with $90,519 and NOTAXES.
–You need $2,000 to fund a traditional IRAand would end up with $90,519. Aftertaxes at 31%, you would end up with$62,519.
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Facing Retirement -- ThePayout
Plan ahead before deciding how apayout is to be received.
Make sure you understand the taxconsequences of any move.
Look at all retirement payouts together.
Consider pros and cons of an annuityversus a lump sum payout.
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Types of Retirement Payouts
Single life annuity –payments for life.
Life annuity with “certainperiod” – paymentscontinue as long as youlive; however, if you diethe payments continueuntil the end of theperiod.
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Types of Retirement Payouts(cont’d)
Joint and survivor annuity -- thepayments continue as long as you oryour spouse live; however, in somecases the benefits will be reduced whenyou die.
Lump-sum -- a single payment of allprincipal and accumulated interest.
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Tax Treatment of Distributions
Annuity payments will be taxed asnormal income.
A lump-sum payment
–will normally be taxed as if you receivedthe money over a 10 year span. Thisreduces taxes slightly, but you are stillliable for all the tax immediately.
–could be rolled over into an ira to avoidtaxes and continue tax-deferred growth.
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Putting a Plan Together andMonitoring It
Changes in inflation can have a drastic effecton your retirement planning.
Once you retire, you may live a long time.
Monitor your progress and monitor yourcompany.
Don’t neglect your insurance coverage.
An investment planning computer programmay make things easier.
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Summary
Social Security benefits
–Retirement benefits
–Disability and survivor benefits
–Eligibility
The seven-step retirement planningprocess.
Advantages of tax-deferred retirementplans.
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Summary
Employer-funded retirement plans
–Defined-benefit plans
–Cash balance plans
Employer-sponsored defined contribution plans
–401(k) or 403(b) plans
–Other plans
Self-employment and small business plans
–SEP-IRAs
–SIMPLE plans
–Keogh plans
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Summary (cont’d)
Types of IRAs
–Traditional
–Roth
–Education
Pros and cons of annuity versus lumpsum payouts
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Summary (cont’d)
The payout choices
–single life annuity
–life annuity with “certain period”
–joint and survivor annuity
–lump-sum
Monitoring your process and progress