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Chapter 16

Chapter 16. Retirement Planning. Retirement – It’s Up to YOU!. Start saving today – although retirement seems a long way away! Employer benefits are reduced, or simply not available. The future of government benefits, Social Security, is questionable. The Aspects of Social Security.

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Chapter 16

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  1. Chapter 16 Retirement Planning

  2. Retirement – It’s Up to YOU! • Start saving today – although retirement seems a long way away! • Employer benefits are reduced, or simply not available. • The future of government benefits, Social Security, is questionable.

  3. The Aspects of Social Security • Mandatory federal insurance program providing • retirement, disability, and survivor benefits • Paid for with a federal tax -- FICA • 6.2% of your first $76,200 in 2000 pays for Social Security • 1.45% of your total earnings pay for Medicare • Equal match by your employer

  4. Social Security Eligibility • To qualify for full benefits you must earn 40 credits • $780 earned in 2000 equals one credit • Maximum of four credits earned per year • You must be 65 years of age to receive full benefits, but will gradually increase to 67 in 2022. • Reduced benefits may begin at age 62

  5. Determinants of Social Security Retirement Benefits • Number of years of earnings • Average level of earnings • Inflation • Age you begin receiving benefits • Replaces approximately 42% of your lifetime average annual income, with adjustments down for higher income earners and up for lower income earners

  6. Taxes and Social Security Benefits • Taxes are based on “combined income,” or adjusted gross income, nontaxable interest, and 50% of your benefits • Percentage of joint benefits tax eligible • earnings < $32,000 – 0 percent taxed • earnings of $32,000 to $44,000 – 50% • earnings > $44,000 – 85%

  7. Taxes and Social Security Benefits (cont’d) • Percentage of individual benefits tax eligible • earnings < $25,000 – 0 percent taxed • earnings of $25,000 to $34,000 – 50% • earnings > $34,000 – 85%

  8. Earnings Limits on Social Security Benefits • Prior to 2000, earning limits reduced Social Security benefits for many older workers. • Senior Citizens’ Freedom to Work Act of 2000 eliminated the retirement earnings limit.

  9. Disability and Survivor Benefits • Disability benefits for those physically or mentally impaired • Impairment expected to result in death • Impairment prevents “substantial work” for at least 1 year • Survivor’s benefits • small payment to defray funeral costs • continuing monthly payments to spouse, children, or parents -- with restrictions

  10. Employer-Funded Pension Plans • Defined benefit plans • Cash balance plans • Advantages: • Employer bears investment risk for the plan. • Most are non-contributory

  11. Contributory and Noncontributory Plans • Contributory -- both you and your employer pay toward your retirement • Noncontributory -- only your employer pays toward your retirement

  12. Other Retirement Plan Issues • Funded -- the employer pays into a trustee-managed fund to guarantee future pensions • Unfunded -- pensions are paid out of current company earnings or pay-as-you-go • Vesting period -- required length of employment to be eligible to receive company paid pension benefits

  13. Defined Benefit Plans • Predetermined pension payment on the basis of a formula. Often based on average salary, years of service, and age at retirement Monthly benefit = Average salary for Y last yrs x yrs of service x Z%

  14. Defined Benefit Plans--Limitations • Lack of portability – pension does not go with you if you leave the company • Company changes in the plan with little notice • Few plans adjust benefits for inflation • Some are unfunded plans that lack safety.

  15. Cash-Balance Plans: A New Twist on Defined-Benefit Plans • Pension account credited on the basis of a formula: • Percentage of salary (e.g., 4% - 7%) • Predetermined rate of interest earnings (e.g., 30-year Treasury-bond rate, S & P 500 index rate, or other rate)

  16. Cash-Balance Plans: Pros and Cons • Pros: • Retirement benefits are easy to track. • Benefit younger employees who can start to build benefits faster • Portability • Cons: • No choice on investment decisions and earnings are limited to the stated rate • Reduced benefits for older workers

  17. Plan Now, Retire Later -- The Steps to Success • Step 1: Set goals. • Step 2: Estimate how much you’ll need to meet your goals. • Step 3: Estimate your income available at retirement. • Step 4: Calculate the annual inflation-adjusted shortfall.

  18. Plan Now, Retire Later -- The Steps to Success (cont’d) • Step 5: Calculate the funds needed at retirement to cover this shortfall over your entire retirement. • Step 6: Determine how much you must save annually between now and retirement. • Step 7: Put the plan into play and save.

  19. Step 1: Set Goals. • How extravagantly will you want to live? • When will you want to retire? • Who will you have to care for? • Where will you want to live? • Will you want to travel?

  20. Step 2: Estimate Your Needs to Meet Your Goals. • Estimate future costs based on 70% to 80% of current living expenses. • Establish how much each of your other goals will cost. • Calculate how taxes will erode your spending power.

  21. Step 3: Estimate Your Income Available at Retirement. • Estimate your Social Security benefits. • Calculate your employer-provided pension. • Estimate any other windfall income that could be used towards retirement, such as an inheritance from your gozillionaire Uncle Morty.

  22. Step 4: Calculate the Annual Inflation-Adjusted Shortfall. • Compare the difference between your needs and your retirement income. • Take inflation into account when calculating the time value of money. • Use this formula: FV = PV(FVIF i%, n yr)

  23. Step 4: Calculate the Annual Inflation-Adjusted Shortfall. • If you fall short, start saving now -- remember Axiom 2: The Time Value of Money. • If you exceed your projected need -- protect yourself against all contingencies.

  24. Step 5: Calculate the Funds Needed for This Shortfall. • Calculate the present value of all your annual shortfalls by discounting for your inflation-adjusted rate of return -- this is your total need at retirement. • Use this formula: PV = PMT(PVIFA i%, n yr)

  25. Step 6: Determine How Much You Must Save Annually. • Your answer in Step 5 is the total dollar amount you need the day you retire. • Determine your annual savings goal by using a future value of an annuity equation. • Use the formula FV = PMT(FVIFA i%, n yr)

  26. Step 6: Determine How Much You Must Save Annually. • Note: Always remember to adjust for inflation in each step or you will fall short of your goal.

  27. Step 7: Put the Plan Into Play and Save. • Save, save, save!! • Determine the combination of retirement plans and products that are best for you.

  28. Use Tax-Deferred Plans to Save for Retirement • Contributions may be made on a fully or partially tax-exempt basis. You can contribute more. • Earnings are not taxed annually, so that amount stays in the account to continue earning money – or compound growth. • Taxes are deferred until after retirement.

  29. Employer Sponsored Retirement Plans – Defined Contribution • A personal retirement savings account that passes responsibility for investment risk to the employee. • Employer or employer and employee contribute. • Benefit depends on investment success. • Employee may choose the investment. • Future benefits are not guaranteed or insured.

  30. 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

  31. Profit-Sharing Plans • Employer contributions can vary yearly due to profitability. • Contributions can depend on your salary level. • Some firms set minimums and maximums. • Contributions are not guaranteed.

  32. Money-Purchase Plans • Employer contributions are a set percentage of your salary. • Contributions are guaranteed. • Preferred over profit-sharing plans because of the guaranteed contributions.

  33. Thrift and Savings Plans • Employers match a set percentage of your contribution to your retirement plan. • Contributions are normally guaranteed.

  34. Employee Stock Ownership Plan (ESOP) • Employer contributions are made in the form of company stock. • This form of plan is the riskiest because your retirement is dependent on the performance of the company. • This type of plan does not allow for diversification.

  35. 401(k) Plans • Are normally employer-sponsored defined-contribution plans. • Are normally set-up as thrift-and-savings plans in which your employer normally matches a set percentage of your contribution.

  36. 401(k) Plans (cont’d) • Are very tax advantaged. • Your contributions are tax-deductible • Your earnings grow tax-deferred • Offer a wide variety of investment choices. • Invest the maximum amount in your 401(k) – before any other retirement options.

  37. Self-Employed or Small Business Retirement Plans • Eligibility: self-employed, small business employee, or part-time free-lance work (even if full-time employee elsewhere) • Benefit: Fully tax-deductible retirement plan

  38. Self-Employed or Small Business Retirement Plans (cont’d) • Keogh plan • Simplified employee pension plan (SEP-IRA) • Savings incentive match plan for employees (SIMPLE) plans

  39. 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 you choose the investment. • Contributions are tax-deductible.

  40. Keogh Plans (cont’d) • Limitations on annual contributions, but liberal (up to $30,000 in 2000) • Withdrawals as early as 59½, but must begin by age 70½ • 10% early withdrawal penalty, except in cases of illness, disability, or death

  41. Simplified Employee Pension Plan (SEP-IRA) • Similar to a defined-contribution Keogh plan, but easier to establish. • Used by small business owners with no or few employees. • Contributions are tax-deductible and earnings are tax-deferred.

  42. Simplified Employee Pension Plan (SEP-IRA) (cont’d) • Limits contributions to 15% of salary, or $30,000, whichever is less. • Flexibility in making contributions – can skip years.

  43. Savings Incentive Match Plan for Employees (SIMPLE) • Are for employers with less than 100 employees earning more than $5,000. • Contributions are tax-deductible and earnings are tax-deferred. • Some employer matching funds.

  44. Individual Retirement Accounts (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

  45. Traditional IRA • Contributions grow tax-deferred until withdrawal. • Allows nonworking spouses to make a contribution (spousal IRAs). • Self-directed, but cannot invest in life insurance or collectible, except gold or silver U.S. coins.

  46. Traditional IRAs (cont’d) • Distributions prior to age 59½ are subject to a 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 insurance premiums, with restrictions • After you turn 70½ you must start receiving annual distributions or be penalized 50% of your minimum annual distribution.

  47. Traditional IRAs (cont’d) • Can rollover distributions from a qualified employer plan or other IRA to avoid an early distribution penalty – be careful to avoid taxes. • Cannot use as collateral for a loan.

  48. To Be A Fully Tax-Deductible Traditional IRA • If not covered by a plan at work, you may contribute $2,000 annually, regardless of income. • A married couple, with one working spouse may contribute $4,000 or 100% of earned income annually, if “modified adjusted gross income” is below $150,000. • A married couple can contribute $4,000 if adjusted gross income is below the IRS cutoff.

  49. For a Partially Tax-Deductible Traditional IRA: Phaseout Zones • A single person may receive a partial tax deduction if “modified” adjusted gross income falls between $32,000 and $42,000 (2000) • A married couple may receive a partial tax deduction if “modified” adjusted gross income falls between $52,000 and $62,000 (2000) • A married couple, with one working spouse,may receive a partial tax deduction, if “modified adjusted gross income” is between $150,000 and $160,000 (2000)

  50. Non-deductible Traditional IRA • No annual tax deduction for IRA contribution • Investment grows free of income taxes until withdrawal

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