1. BM410: Investments Personal Investing 3: Taxes, Inflation, and Investment Strategy

2. 2 Objectives A. Review the Investment Hourglass B. Understand the factors in developing a retirement plan C. Understand Social Security

3. 3 A. Review the Investment Hourglass Remember the investment hourglass It is a way of helping remember that investing is a means to help us achieve our goals—it is not an end in itself And since our goals should be based on our values, our investments should reflect those values

4. 4 Before you Invest: The Hourglass Top 4. Know your personal goals, budget, and have an investment plan If you can answer these affirmatively, you are ready to invest ! 3. Be out of credit card and consumer debt 2. Have adequate life and health insurance 1. Have your priorities in order and are “square” with the Lord

5. 5 Taxable Assets Retirement Assets 1. Basics: Emergency Fund and Food Storage 2. Core: Broad Market Exposure: Core Mutual Funds 3. Diversify: Broaden and Deepen your Asset Classes 4. Opportunistic: Individual Stocks and Sector Funds The Hourglass Bottom (continued)

6. 6 B.Factors in Developing a Retirement Plan What are the critical factors in developing a retirement plan? 1. Inflation 2. Tax rate 3. Rate of return 4. Time until retirement 5. Allocation to savings 6. Life expectancy

7. 7 1. Inflation What is the impact of inflation Inflation reduces the retirement benefit. It can substantially reduce the purchasing power of future cash inflows How do you handle inflation? To overcome inflation requires greater allocation to savings or higher rates of return on investment. What is the formula for calculating real returns? Real Return = (1 + r (n) )/(1+r (infl.) )-1

8. 8 2. Taxes What is the impact of taxes? Taxes further reduces the retirement benefits available Different investment vehicles are taxed differently Utilize the vehicles that maximize after-tax return How do you handle taxes? Use larger allocations to savings or higher returns on investments Invest tax-efficiently

9. 9 3.Rate of Return What is the impact of the rate of return? The higher the rate of return, the: Faster you will achieve your goals, or Less you will need to save each month to achieve your goals Use wisdom in your forecasts This rate should be consistent with your asset allocation and the return requirement from your Investment Plan

10. 10 4. Time Until Retirement Why is time until retirement important? This is the amount of time that your money can be working for you Start earlier rather than later, or you will have to save significantly more to reach your goals.

11. 11 5.Allocation to Savings (i.e. savings percent) Why is your allocation to savings important? You cannot save what you do not have Set your goals now, and follow through This allocation should increase as you get older But it should never be below a specific percentage (I recommend your minimum to be 10%)

12. 12 6. Life Expectancy Why is life expectancy important? It determines how long you will need funds in retirement You do not want your money to be gone before you are Plan for a long life, and if it is shorter, there are more funds for your kid’s inheritance

13. 13 Putting it All Together: A Retirement Planning Worksheet How do we bring it all together? We have developed a Retirement Planning Spreadsheet to help with this activity (see RP-1 Retirement Planning Worksheet) We have also developed another spreadsheet to help you see where you are on your road to achieve your financial goals (see RP-2 Retirement Planning Ratio Forecasts)

14. 14 Applications #1 You are 25 and will graduate with a degree in Business this year. You expect to retire in 30 years, and believe you can ear 8% on your investments until retirement. You expect inflation to average 2% until retirement. You expect to be in retirement for 25 years, and will earn 7% during retirement and inflation will stay at 2%. You estimate your tax rate in retirement at 30%. You estimate that you will need $75,000 in after-tax dollars to retire comfortably, and that social security will provide $25,000 per year. How much must you save each year to achieve your goals?

15. 15 Applications #2 You are 45 years old, married, with three kids. You have $175,000 in savings, and your remaining balance on your home mortgage and other debt is $250,000. Your annual salary is $70,000 per year. Is there any way of determining if you are on-track for retirement or not? How are you doing?

16. 16 Source: WSJ, 23Mar05, p. D1.

17. 17

18. Measuring Up Savings- Debt-to- Age to-Income Income 30 0.1 1.70 35 0.9 1.50 40 1.8 1.25 45 3.0 1.00 50 4.5 0.75 55 6.5 0.50 60 8.9 0.20 65 12.0 0.00 This chart is from Doman Farrell, LLC as quoted in: Jonathan Clements, “Ugly Math: How Soaring Housing Costs are Jeopardizing Retirement Savings,” Wall Street Journal, 23Mar05, p. D1.

19. 19 The Relationship between Savings and Debt What does this framework tell us? It gives a reality check in today’s overheated spending frenzy It shows the relationship between savings and debt and how we need to manage both It encourages us to reduce debt at the same time you increase savings

20. 20 Assumptions of the Model Assumptions 1. Investors will earn 5% more than inflation What do you think? 2. Investors will save about 12% of pre-tax income every year from age 30 to 65 What do you think? 3. Investors will withdraw 5% of portfolio value each year What do you think?

21. 21 Overall View Assumptions 1. Earn 5% over inflation? You may have a hard time achieving that return 2. Save 12% of pre-tax income That is a challenge for most people (but not students of this class) 3. Withdraw 5% of portfolio value each year This is probably OK Overall, these guidelines are likely to be too soft. They should probably be made more stringent!!!

22. 22 Application #2 Answers Calculations Current SalarySavingsDebt Age 45 $70,000$175,000$250,000 RatiosCurrent Recommended Savings ratio 2.5($175/70)> 3.0 Debt ratio 3.6($250/70)< 1.0 Overall recommendations They have too little savings and too much debt. They either need to begin saving more, or selling assets to reduce their debt!

23. 23 Teaching Tool in Process One of the ways we are working on this problem, is through Teaching Tool 25 – Retirement Planning Forecasts Ratio. While it is in preliminary form, it may be useful given different financial situations and goals.

24. 24 Application #3 You are a menace to society, single and make $65,000 per year. Your company has a 401(k) plan that matches 50 percent of your contributions up to 3 percent of your salary. You determine that you can save 15% of your salary, and will put 10% or $6,500 away year for retirement, with the other 5% for other goals. Which investment vehicles you should use and why? How much will you ultimately save, including company match and tax savings? Assume your are in the 25% federal and 7% state marginal tax rates.

25. 25 Review the Priority of Money (for investing and retirement) What is the priority of money? The priority of money is a process of understanding which types of investment vehicles will help you achieve your goals the fastest Why should we learn it? Investment vehicles have different benefits, i.e., due to matching (free money), tax avoidance, tax deferral, or just tax-efficient and wise investing. The wise use of correct investment vehicles will help you reach your goals faster

26. 26 Priority of Money (continued) What is the difference between investment vehicles and financial or investment assets? The investment vehicle is the tax-law defined framework that has specific tax advantages, i.e., 401k, 403b, Individual Retirement Account (IRA), SEP IRA, etc. The financial assets are the securities that are invested in by the vehicles, i.e., stocks, bonds, mutual funds, REITs, MMMFs, CDs, etc.

27. 27 Priority of Money (continued) Current Investment Vehicles: Plan Tax-def. Tax-elim. Max Amount For Employees of: 401-k Y $14,000 Businesses w/plans 403-b Y 14,000 Non-profit, tax-exempt 457 Y 14,000 State/municipalities SEP IRA Y 42,000 Small businesses SIMPLE IRA Y 10,000 Small businesses IRA Y 4,000 Individuals Roth IRA Y 4,000 Individuals Education IRA Y 2,000 Individual Education 529 Plans Y 315,000 p.c. Individual Education

28. 28 Priority of Money (continued) What is the priority of money? 1. Free money Money that is made available by your company, generally on a matching basis, to encourage greater participation in company sponsored retirement plans, i.e., 401k, Keogh and other matching plans What are the risks? You must stay at the company a certain number of years to become fully vested, i.e., to be able to take full ownership of these funds

29. 29 Priority of Money (continued) 2. Tax-advantaged money 2.a. Tax Eliminated money This money allows the elimination of all future taxes This money can be used at retirement (or education) without penalty or taxes (i.e., Roth IRA), and the Education IRA, 529 Funds, and Series EE/I bonds for education) What are the risks? You must be 59½ to take distributions Money from 529 Funds and government bonds must be used for qualified educational expenses to be tax-free

30. 30 Priority of Money (continued) 2.b. Tax-deferred money This money defers taxes until retirement This is money that has specific tax advantages, particularly the ability to be invested before-tax, with principle and earnings taxed only at retirement (IRA, SEP IRA, 401k, 403b, etc.) What are the risks? You must be 59½ to take distributions Distributions before retirement require a 10% penalty and the funds are taxed at ordinary income tax rates This money changes capital gains to ordinary income

31. 31 Priority of Money (continued) 3. Tax-efficient and wise investments This is money that is invested tax-efficiently and wisely, consistent with the investment principles discussed earlier What are the risks? Earnings are taxed consistent with the assets invested in You need to take into account the tax and transaction cost implications of whatever you invest in

32. 32 Priority of Money (continued) Remember, investment earnings from assets not in retirement vehicles are not all created equal. 1. Know the impact of taxes on your returns This includes the tax rates on all distributions, capital gains, dividends, and interest. After-tax return = Before-Tax * (1 – Marginal Tax Rate). The marginal rate includes federal and state

33. 33 Priority of Money (continued) 2. Look to Capital Gains Replace ordinary income with capital gains Capital gains are taxed at 15%, whereas earnings from interest and short-term capital gains (from assets held less than 12 months) are taxed at ordinary income rates How is this done? Get earnings as long-term capital gains. Invest with a buy and hold strategy, don’t trade in taxable accounts, and hold assets as long as possible. Minimize transactions costs and defer earnings to the future. Pay as little in taxes now as possible

34. 34 Priority of Money (continued) 3. Defer earnings to the future With some types of earnings, you are not taxed until you take the money out at retirement. Defer as much as you can to the future. How is this done? Utilize as much as possible retirement vehicles where the objectives are consistent with your goals and Personal Financial Plan.

35. 35 Priority of Money (continued) 4. Minimize turnover and distributions Minimize turnover. Turnover leads to higher transactions costs and taxes Minimize distributions from mutual funds. Mutual funds are required by law to distribute most of their realized capital gains and interest annually to the shareholders in the fund, which are taxed at the shareholder level (even though they did not sell shares) How is this done? Utilize a buy and hold strategy Invest in mutual funds that limit trading and minimize distributions

36. 36 Priority of Money (continued) 5. Look to Stock Dividends Taxes on stock dividends are taxed at 15%, while taxes on interest earnings on bond dividends are taxed at the higher ordinary income rates of up to 35% federal and 10% state. How is this done? Include stocks or stock mutual funds in your diversified portfolio. Compare the after-tax return on stocks with the after-tax return on bonds

37. 37 Priority of Money (continued) 6. Invest Tax Free If your tax rate is high, you can look to financial assets which are tax-advantaged. U.S. government securities are free of state tax Municipal bonds are free of federal tax If municipal bonds are from your state of residence, they may be state tax-free as well. How is this done? Compare the after-tax return on municipal bonds to the after-tax return of corporate bonds Invest in the assets that give you the highest after-tax return for your specific asset class

38. 38 Priority of Money (continued) What is the impact of taxes on these two bond funds: Mutual FundsFund A Fund B Beginning Net Asset Value$10.00 $10.00 Short-term distributions.10.90 Ending NAV 10.90 10.10 YTD Nominal returns 10% (.10+.90)/10 10% (.90+.10)/10 Turnover 10%(guess) 90% (guess) Fed tax rate on ST distributions 35% 35% Taxes paid (without selling).035 (.10 * 35%).315 (.90 * 35%) After-tax return 9.65% (.90+.065)/10 6.85% (.10+.585)/10 Loss from return due to taxes.35% 3.15% Although both have the same nominal return, fund B had a 29% lower return due to taxes, even though both had the same before-tax return

39. 39 Priority of Money (continued) How do you prioritize vehicle choices? Some investment vehicles are higher on the priority list than others, but they also have lower contribution amounts (i.e., $4,000 for the Roth in 2005). What should you do? Use the highest priority money first, and then next highest, etc. until you have utilized all your available funds

40. 40 Application #3 Answer First, look to free money If you will save 3 percent of your salary, or $1,950 per year, your company will match that with 50 percent of that amount, or $975. Note that this is tax-deferred money, or money that has not been taxed yet. The maximum contribution for 2005 in a 401(k) account is $14,000 Since your first priority of money is free money, you should invest $1,950 here first. Note that there is also a tax saving here, as investments reduce your adjusted gross income

41. 41 Application #3 Answer Second, look to tax-advantaged money. A Roth IRA would likely be your second choice. A Roth IRA not only offers total elimination of future taxes, it also has an additional benefit: should you need funds in the future, you can withdraw the principle without penalty as it has been taxed You can invest up to $4,000 in 2005 in a Roth or Traditional IRA You invested $1,950 in your 401(k) plan and $4,000 in a Roth IRA What about the remaining $550?

42. 42 Application #3 Answer Third, look to tax-deferred money. Invest the remaining $550 in your 401(k), even though there is no additional match. Note that your goal was to invest $6,500 for retirement. In reality, you: Invested $6,500 of your own money Got a free $975 match from the company And saved taxes on the $2,500 ($1,950 for the match and $550 extra) in your 401k. Multiplied times your Marginal Tax Rate of 32%, you saved $800 in taxes. Total Savings: $6,500 + $975 + $800 = $8,275

43. 43 Implications for Portfolios Where should you put different types of financial assets? Retirement Accounts: 401k, IRA’s, 529 Funds, etc. Financial assets in which you trade actively Taxable bonds, and high turnover funds You do not pay taxes until you take out funds Taxable Accounts: investment portfolios Stocks and mutual funds with a buy and hold strategy Tax-free bonds and tax-efficient index funds You pay taxes on these funds each year

44. 44 Questions Any questions on the priority of money and how that should impact your portfolio?

45. 45 C. Understand Social Security What is social security? It is a government sponsored retirement plan It was set up to keep individuals from retiring in poverty It was never intended to be an individuals entire retirement program—but a help to that program It is planned to cover 42% of retirement It was started in an environment were there were 17 contributors to every recipient It is moving to an environment where there are 2 contributors to every recipient

46. 46 Social Security (continued) How much does an employee pay in Social Security and Medicare Taxes? FICA tax rates Social security tax6.20% Medicare tax1.45% The employer pays 7.65% Maximum wage subject to SS tax is $90,000 in 2005 No maximum wage for Medicare tax

47. 47 Social Security (continued) What is the employer’s share of Social Security and Medicare Taxes? Your employer matches dollar for dollar

48. 48 Social Security (continued) How is Social Security Funded? Social Security is a pass-through account FICA taxes being paid by today’s workers are providing the money for benefit payments to today’s retirees There is no investment or savings component The assumption is that when you retire, there will be enough others paying into the system to pay for your benefits Interesting assumption!

49. 49 Social Security (continued) Changes in Social Security Tax Rate  Social Security Tax Rates  1937 1.0%  1954 2.0%  1960 3.0%  1971 4.7%  1984 5.8%  1990 6.2%

50. 50 Social Security (continued) How much Self-Employment tax must a self- employed person pay in 2005? A self-employed person pays both parts 12.4% on first $90,000 of net earnings (SS tax) 2.9% on all taxable earnings (Medicare tax) Self-employed may deduct half of their SS taxes as an adjustment to taxable income

51. 51 Social Security (continued) If you have a job and a small business on the side, what do you pay? No more than $90,000 of combined wages are subject to FICA tax in 2005 Additional wages are subject to Medicare tax though

52. 52 Social Security (continued) How does one qualify for benefits? To qualify for full benefits Quarters-of -coverage requirement The number of calendar quarters that you earned required minimum amount For 2003 the quarter-of-coverage minimum is $890 in earnings Need 40 quarters to qualify for full benefits (10 years) Earning beyond 40 quarters will not increase benefits

53. 53 Social Security (continued) How much will one get? Benefit amounts vary depending on: Number of years of earnings, average level of earnings, an adjustment for inflation, and age at retirement Nonworking spouses get benefits equal to 50% of their working spouses benefit If both spouses worked, each is eligible for benefits based on own earnings or based on 50% of spouse’s benefit, whichever is greater The formula goal is to replace 42% of your average earnings

54. 54 Social Security (continued) How do I get a copy of my benefits? To get a copy of your Social Security Statement benefits, go to www.ssa.gov/mystatement.www.ssa.gov/mystatement Click on “Your Benefits” near the top, and then click on “Request a Social Security Statement” at the bottom of the page. Fill out your name, middle initial, last name, social security number, birthday, and other information that is requested. Click on “continue” to submit a request for your Statement. You will receive your Statement in 3-4 weeks.

55. 55 Social Security (continued) How about getting an estimate? As a preliminary estimate of benefits, go to www.ssa.gov/mystatement. www.ssa.gov/mystatement Click on “Need to Request a Social Security Statement” in the top, and then click on “How can I calculate my own benefit estimates” in the middle of the page. Then click on “Benefits Planner” and “calculate your retirement benefits based on different retirement scenarios.” You can either fill out the quick calculator “Quick Calculator” or the more detailed “Online Calculator.” Click on the calculator desired, and then fill in the information.

56. 56 Social Security (continued) How does starting age affect benefits? You can start receiving benefits anytime after age 62, but benefits will be less than starting at your full retirement age of 67 (for those born after 1959). What is my full retirement age? Birth YearFull Retirement Age 193765 1943-195466 196067

57. 57 Social Security (continued) What if I want to retire at 62 and I was born in 1960? Payments would be reduced by 5/9 percent for each month prior to age 67 for the first 36 months and 5/12 percent for each month prior to that To retire at age 62 would be: 5/9 percent x 36 months = 20% 5/12 percent x 24 months = 10% Total reduction in payments = 30% You may delay benefits after age 67 up to age 70 and receive credits amounting to 8 percent per year for those born after 1943

58. 58 Social Security (continued) What is the annual Social Security statement and when does one get it? Must be 25 or older Statement arrives 3 months prior to birth date Statement shows: Quarter coverage credit How much you have paid Estimated benefit data

59. 59 Social Security (continued) Where is Social Security now? The Social Security program is currently taking in more than it is paying out It had income of $632bn in 2003 ($627bn in 2002). and paid out $470bn in 2003 ($454bn in 2002) in benefits to 47mn (46mn in 2002) people Reserves are in government bonds (SS Trust Fund) Today there are 3.4 workers per recipient

60. 60 From http://strengtheningsocialsecurity.gov/need_for_action.shtml, 21Mar05http://strengtheningsocialsecurity.gov/need_for_action.shtml From http://strengtheningsocialsecurity.gov/need_for_action.shtml, 21Mar05http://strengtheningsocialsecurity.gov/need_for_action.shtml

61. 61 From http://strengtheningsocialsecurity.gov/need_for_action.shtml, 21Mar05http://strengtheningsocialsecurity.gov/need_for_action.shtml From http://strengtheningsocialsecurity.gov/need_for_action.shtml, 21Mar05http://strengtheningsocialsecurity.gov/need_for_action.shtml

62. 62 Social Security (continued) Until 2014 Benefits can be paid solely from tax revenues until 2014 Until 2025 From 2015-2025 SS will have to use the interest on the bonds Beyond 2037 From 2026-2037 the SS will have to redeem bonds At current projections social security funds will be exhausted in 2042 By year 2075 there will be 1.9 workers per recipient

63. 63 Social Security (continued) What about a worst-case scenario in 2042? Even if SS assets are exhausted in 2042, Social Security calculates that from the regular inflow of tax revenue alone it could pay about 73 percent of benefits My recommendation? Don’t plan for much, but if it still is available, be thankful

64. 64 Social Security (continued) President Bush’s Plan Establish Personal Accounts (PA) which would be totally voluntary. This is similar to the existing Federal Employee Thrift Savings Plan PA’s would be invested in a conservative mix of stock and bond funds Those who earned an average of $35,000 over their career would have $250,000 at retirement Savings would supplement the Social Security benefits, or be passed to children

65. 65 Review of Objectives A. Do you understand the Investment Hourglass B. Do you understand the factors in developing a retirement plan C. Do you understand Social Security

66. 66 For more information Go to www.socialsecurity.gov for more informationwww.socialsecurity.gov