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

2. 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

3. 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

4. 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

5. 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

6. 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

7. Copyright ©2004 Pearson Education, Inc. All rights reserved.19-7 Social Security Exhibit 19.1: FICA Taxes on Various Income Levels

8. 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.htmlhttp://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.

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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?

16. 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 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.

17. 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

18. Copyright ©2004 Pearson Education, Inc. All rights reserved.19-18 Your Retirement Planning Decisions Exhibit 19.2: Typical Composition of a Retirement Account Portfolio

19. Copyright ©2004 Pearson Education, Inc. All rights reserved.19-19 Your Retirement Planning Decisions Exhibit 19.2: Typical Composition of a Retirement Account Portfolio

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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/ 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.

35. 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

36. 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

37. 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

38. 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:

39. 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

40. 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

41. 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

42. 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)

43. 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

44. 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)

45. 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:

46. 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

47. 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

48. 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)

49. 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)

50. 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

51. 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)

52. 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

53. 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

54. 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)

55. 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

56. 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!

57. 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/ http://www.quicken.com/retirement/planner/ This Web site provides a framework for building a retirement plan based on your financial situation.

58. 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?

59. Copyright ©2004 Pearson Education, Inc. All rights reserved.19-59 Integrating Key Concepts

60. 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