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RETIRENOTES

4. Some individuals transfer the retirement risk to their children or to society by not preparing for retirement. 18-4. An Overview of Retirement Planning Process ...

Kelvin_Ajay
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RETIRENOTES

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  1. Reasons for the Retirement Risk • 1. Retirement risk arises from uncertainty concerning the time of death • 2. It is influenced by physiological and cultural hazards • people tend to live longer today • people are retiring earlier

  2. Risks Associated with Superannuation • Two parts to the retirement risk • individual will not have accumulated sufficient assets by the time retirement arrives • assets that have been accumulated will not last for the remainder of his or her lifetime

  3. Retirement Risk Alternatives • 1. Some people attempt to avoid the retirement risk by not retiring. • 2. Continuing employment does not totally avoid the risk, since the probability of disability increases with age. • 3. The risk of outliving an accumulation can be transferred to an insurer. • 4. Some individuals transfer the retirement risk to their children or to society by not preparing for retirement.

  4. An Overview of Retirement Planning Process • 1. Estimate future income need • 2. Determine how the funds required to meet the need will be accumulated • 3. Plan the manner in which the accumulation will be consumed

  5. Sources of Retirement Funding • 1. The first leg: Social Security • 2. The second leg: Qualified pensions and profit sharing plans • 3. The third leg: Personal savings

  6. Annuities • 1. Reverse application of the law of large numbers as it is used in life insurance. • 2. Law of averages permits a lifetime guaranteed income to each annuitant. • 3. Persons who live longer than average offset those who live a shorter-than-average period. • 4. Every payment to annuitant is part interest, part principal, and part survivorship benefit.

  7. Annuities • Classification of annuities • 1. Individual versus Group • 2. Fixed versus Variable • 3. Immediate versus Deferred • 4. Single Premium versus Installment • 5. Single Life versus Two or More Lives • 6. Pure Life Annuity versus Annuity Certain

  8. Tax Treatment of Annuities • Investment Nontaxable Payment X in Contract = Return of Expected Return Capital • $6,000 = $60,000 = $60,000 ($500 X 12) X 15 $90,000 • $6,000 X $60,000 = $4,000 $90,000

  9. Specialized Annuities • Single-Premium Deferred Annuity • 1. Increased popularity since TRA-86 eliminated many tax shelters. • 2. Currently taxed same as other annuities:earnings accumulate on tax-deferred basis. • 3. Some insurers sell SPDAs with deposit premium as low as $2,500, but more common minimum is $10,000.

  10. Variable Annuity • 1. Designed as means of coping with inflation. • 2. Premiums invested in common stocks or similar investments. • 3. Based on assumption that the value of a diversified portfolio of common stocks will change in the same direction as price level. • 4. Variable annuity may be variable during accumulation period and fixed during payout period or variable during both accumulation and payout period.

  11. Annuities as Investments for Retirement • 1. Return earned over life of an annuity depends on several features. • 2. Most important determinants of the rate of return are: • interest rate • surrender charge • administrative expenses

  12. Qualified Retirement Plans • Qualified plans are those that conform to the requirements of federal tax laws and for which the law provides favorable tax treatment. • 1. Employee contributions are tax deductible when they are made. • 2. Employee is not taxed on employer’s contribution or investment earnings until benefits are distributed.

  13. ERISA • Employee Retirement Income Security Act of 1974 (ERISA) establishes federal standards for qualified retirement plans: • 1. Prescribes which employees must be included. • 2. Establishes minimum vesting standards. • 3. Sets minimum funding standards. • 4. Requires extensive reporting and disclosure information about pensions and other employee welfare programs.

  14. Qualification Requirements • 1. Designed for exclusive benefit of employees. • 2. In writing and communicated to employees. • 3. Must meet one of several vesting schedules. • 4. Cannot discriminate in favor of officers, stock-holders or highly compensated employees. • 5. Must provide for definite contributions by employer or definite benefits at retirement. • 6. Life insurance included only on an incidental basis. • 7. Top-heavy plans are subject to special vesting and contribution requirements.

  15. Vesting Requirements (specified in plan documents) • 1. No vesting for 5 years, 100% vested after 5 years. • 2. 20% vested after 3 years with 20% per year thereafter so employee is 100% vested at the end of 7 years. • 3. For top-heavy plans: • 100% in three years, or • 20% per year after first year

  16. Types of Qualified Plans (corporations) • 1. Defined Benefit Pension Plans • 2. Defined Contribution Pension Plans • 3. Qualified Profit-sharing Plans • 4. Employee Stock Ownership Plans • 5. Section 401(k) Plans

  17. Factors Influencing Benefit Levels • Benefit received by employees at retirement is based on a formula applicable to all employees. • 1. All plans fall into one of two benefit formula categories • defined contribution • defined benefit. • 2. Plans may be contributory (with employee contributions) or noncontributory (where employer bears the entire cost).

  18. Amount of Benefits or Contributions • Defined Contribution Plans • 1. Work exactly as the name implies: employer’s contribution is set by the employment agreement • 2. Contribution is usually a percentage of compensation, such as 5% or 10% of employee wages

  19. Amount of Benefits or Contribution • Defined Benefit Plans • 1. In defined benefit plan, amount of benefits employee will receive is specified in the benefit formula • 2. In most benefit formulas, retirement benefit is a function of employee’s salary, the benefit accrual rate, and employee’s years of service • 3. Most plans are final average salary plans but some are career average salary plans.

  20. Amount of Benefits or Contributions • FINAL AVERAGE SALARY PLAN • Benefit depends on salary earned in final years of employment and number of years worked • example: 1% of average monthly salary during final three years of employment for each year employed • an employee with 35 years employment would receive 35% of average monthly employment in the final three years

  21. Amount of Benefits or Contributions • CAREER AVERAGE SALARY PLAN • Benefit depends on salary earned in all years of employment and number of years worked • example: 1% of average monthly salary during all years of employment for each year employed, • an employee with 35 years employment would receive 35% of average monthly employment over employment career.

  22. Amount of Benefits and Contributions • Defined Contribution Plans • 1. Maximum allowable contribution to a defined contribution plan varies with the type of plan • 2. For a defined contribution pension plan, the limit is 25% of year’s earnings, subject to a dollar maximum that is adjusted for inflation • 3. Dollar maximum was set at $30,000 in 1986 and will be adjusted for inflation when dollar maximum for defined benefit plans reaches $120,000

  23. Amount of Benefits or Contributions • Defined Benefit Plans • 1. Maximum benefit in a defined benefit plan is 100% of employee’s earnings in three consecutive years of highest earnings. • 2. Dollar maximum for defined benefit was set at $90,000 in 1988 and is adjusted for inflation since that time.

  24. Contribution for Keogh Plans • 1. Keogh plans are subject to essentially the same limitations, deductions and benefits as applicable to corporate pension and profit-sharing plans. • 2. A special definition of earned income is used to make contributions by self-employed persons correspond to those for a common-law employee. • 3. Percentage limitations apply after the contribution to the plan is deducted from income.

  25. Keogh Plan Contribution Illustrated • Partnership establishes a defined contribution plan with 25% of employee compensation. • Partner earns $100,000. • Partner’s contribution is limited to 25% of income after the contribution: • Taxable NontaxableIncome Contribution Total • Employee $40,000 $10,000 $50,000 • Owner 80,000 20,000 100,000

  26. Maximum Contribution 401(k) Plans • 1. Permit pretax contributions (called “elective deferrals”) by employees. • 2. Employees elect to contribute to a profit-sharing plan and instruct employer to make contributions on their behalf. • 3. I.R.C. treats contributions as if they were made by employer rather than by employee. • 4. Limit on employee deferrals to 401(k) plan or SEP is the lesser of 25% of compensation or a dollar maximum (set at $7,000 in 1988 and indexed for inflation since that time).

  27. Nature of the Employer’s Promise • INVESTMENT RISK • Under defined contribution plan, employer promises to make contributions to an account that earns investment income. • Since benefits depend on contributions and investment income, the employee bears the investment risk in defined contribution plans. • Because the employee bears the investment risk, he or she is likely to have some say in how funds are invested.

  28. Nature of the Employer’s Promise • INVESTMENT RISK • In a defined benefit plan, the employer promises to provide a certain level of retirement benefits to the employee. • Employer therefore bears the investment risk in a defined benefit plan.

  29. Advantages to Younger and Older Employees • 1. A higher proportion of ultimate retirement benefits are earned in early years of participation in a defined contribution plan. • 2. Present value of benefits promised to younger workers under a defined benefit plan tends to be small compared with present value of benefits promised when the worker is closer to retirement.

  30. Distribution Requirements • 1. Commencement of benefits: April 1 after year in which individual reaches age 70 1/2 or the date of retirement, if later. • 2. Distribution must be made over • the life of the participant or joint lives of participant and spouse (i.e., an annuity). • the life expectancy of the participant and his or her beneficiary.

  31. Premature Distributions • 10% penalty prior to age 59 1/2 except for • deductible medical expenses • in form of lifetime annuity • at age 55 by worker who meets plan requirements for retirement

  32. Taxation of Distributions • 1. Retirement benefits traditionally paid to participants in form of a lifetime annuity. • 2. Installment distributions taxable only to the extent they exceed employee’s investment in the contract. • 3. Lump-sum distributions may be rolled-over into an annuity and taxed under installment rules. • 4. Lump-sum distributions that are not rolled-over may be subject to five-year averaging.

  33. Individual Retirement Accounts (traditional IRA) • 1. A person who is not covered by an employer-sponsored plan can make tax-deductible contribution to an IRA of $2,000 annually. • 2. Persons covered by an employer plan may be entitled to same deduction, a partial deduction, or no deduction, depending on income. • 3. Persons not eligible for deduction may make a nondeductible contribution. • 4. New rules under TRA-97 allow a full $2,000 deductible contribution by a spouse who is not employed outside the home.

  34. Individual Retirement Accounts (traditional) • Adjusted Gross Income Phase Out Levels • $25,000 to $35,000 for single taxpayers • $40,000 to $50,000 for married filing jointly • 0 to $10,000 for married filing jointly • TRA-97 gradually increases AGI phase-out levels to double the present level by 2007.

  35. IRA Taxation Formula • Total Nondeductible Tax-Free Amount Contributions All _ Withdrawals Distributed X Years to IRAs in Prior Years From IRA Fair Market Value Amount DistributedDuring Year of all IRAs at + From IRA During End of Year the Year

  36. The New Roth IRA • Beginning in January of 1998, contributions permitted to Roth IRA • contributions only on a non-deductible basis. • earnings tax-free when the funds are withdrawn for retirement (i.e., after age 59½). • annual contributions of $2,000 (100% of compensation) per individual. • AGI phase-out $95,000 single $150,000 joint. • no requirement for withdrawals at 70½ and contributions may continue after age 70½. • $2,000 limit for Traditional IRA and a Roth IRA.

  37. Education IRA • Introduced by TRA-97 - despite its designation, has nothing to do with retirement. • designed for saving for higher education. • up to $500 annually per student (to age 18). • phased out for joint filers - $150,000 to $160,000,$95,000 and $110,000 for single taxpayers. • nondeductible, but earnings tax-free. • distributions under age 30 not taxable if used for qualified higher education expenses. • distributions in excess of qualified education expenses taxable with a 10% penalty. • Education IRA contributions are in addition to Roth IRA Plus and traditional IRAs.

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