Retirement and Estate Planning

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1 6P A R T Retirement and Estate Planning Should you invest in a retirement plan? Chapter 19 Retirement Planning Chapter 20 Estate Planning How much should you contribute to your retirement plan? How should you allocate investments within your retirement plan? Should you create a will? Do you need to establish a trust? Should you create a living will or assign the power of attorney? Your Complete Financial Plan Your Wealth T H E C H A P T E R S I N T H I S P A R T explain how you can protect the wealth that you accumulate over time through effective financial planning. Chapter 19 explains how to plan effectively for your retirement so that you can maintain your wealth and live comfortably. Chapter 20 explains how you can pass on as much of your estate as possible to your heirs.

2 Retirement Planning C H A P T E R 19 Social Security, his mortgage still had 25 years of payments remaining, and after his divorce, he had only $225,000 accumulated in his retirement account. Even though he was unhappy in his present job, he needed to remain there as long as possible to build his retirement account. Matt Brenner, a divorcé, really wanted to retire at age 57. After a round of layoffs at his company, he thought he might be next. He was sure that if he worked part time he would be able to scrape by until he began drawing Social Security at age 62. Matt visited his financial planner to discuss the decision. The planner did not have good news. If Matt retired at age 57, he was five years away from drawing Three years later, Matt returned to see his financial planner. This time the news was better. Matt, now aged 60, had refinanced his mortgage and now had only 15 years of payments remaining. In addition, his retirement assets had accumulated to $315,000. Clearly the decision to put retirement on hold had been a sound one. Matt still had two years to go until he could draw early Social Security. At that time, he would be able to take a partial early retirement, although still not at the level of benefits he could have if he worked until age 65. It is never too early to begin planning for retirement. If you begin early in your working years to contribute to the retirement plans available to you, you can avoid the situation that Matt 535

3 536 R E T I R E M E N T P L A N N I N G to you, you can avoid the situation that Matt found himself in: wanting to retire, but simply not financially prepared to do so. The quality and timing of your retirement will depend largely upon your own efforts even if your employer has a retirement plan available. Often the employer-sponsored plan requires contributions from your pay. Social Security, an employer-sponsored retirement plan, and your own retirement assets are all part of the retirement planning puzzle. It will take sound planning and diligent preparation to be financially prepared for retirement. This chapter will describe the process and detail some of the tools available to you. The objectives of this chapter are to: 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 offered by employers, explain the retirement plans available for self-employed individuals, describe types of individual retirement accounts, illustrate how to estimate the savings you will have in your retirement account at the time you retire, and show how to measure the tax benefits from contributing to a retirement account. SOCIAL SECURITY Recall from Chapter 4 that Social Security is a federal program that taxes you during your working years and uses the funds to make payments to you upon retirement (subject to age and other requirements). It is intended to ensure that you receive some income once you retire and therefore is an important part of retirement planning. However, Social Security does not provide sufficient income to support the lifestyles of most individuals. Therefore, additional retirement planning is necessary to ensure that you can live comfortably when you retire. Before discussing other means of retirement planning, we will describe how Social Security functions. QUALIFYING FOR SOCIAL SECURITY To qualify for Social Security benefits, you need to build up a total of 40 credits from contributing to Social Security over time through payroll taxes. You receive one credit for every $900 in income per year, but you can earn no more than four credits per year. In addition to receiving income at retirement, you will

4 SOCIAL SECURITY 537 also receive Social Security benefits if you become disabled, as discussed in Chapter 11, or if you are the survivor when the breadwinner of the household dies. If the person who qualified for Social Security dies (the household s main income earner), the following benefits are provided to the survivors: A one-time income payment to the spouse. Monthly income payments if the spouse is older than age 60 or has a child under the age of 16. Monthly income payments to children under the age of 18. SOCIAL SECURITY TAXES As discussed in Chapter 4, your gross income is subject to a 7.65 percent FICA (Federal Insurance Contributions Act) tax. Your employer pays an additional tax of 7.65 percent of your gross income. Your FICA taxes are used to support Social Security and Medicare, the federal government s health insurance program. The Social Security tax is 6.2 percent of your gross income up to $87,900 in 2004 (this amount is adjusted periodically). The maximum that you pay per year for Social Security taxes is $5, (6.2 percent of $87,900). The Medicare tax of 1.45 percent of gross income is also included in FICA. There is no cap on the income level, however, so you and your employer must pay this tax on your gross income beyond $87,900. The FICA tax rates applied to various levels of gross income are shown in Exhibit Exhibit 19.1 FICA Taxes on Various Income Levels FICA Tax Rate Gross FICA Tax Rate FICA Tax Imposed on FICA Tax Imposed Income Level Imposed on You Imposed on You Your Employer on Your Employer $20, % $1, % $1,530 30, , ,295 40, , ,060 50, , ,825 60, , ,590 70, , ,355 80, , ,120 90, % of the first $6, [computed as 7.65% of the first $6, [computed as $87,900; 1.45% (.0765 $87,900) $87,900; 1.45% (.0765 $87,900) of the remainder (.0145 $2,100)] of the remainder (.0145 $2,100)] 100, % of the first $6, [computed as 7.65% of the first $6, [computed as $87,900; 1.45% (.0765 $87,900) $87,900; 1.45% (.0765 $87,900) of the remainder (.0145 $12,100)] of the remainder (.0145 $12,100)]

5 538 R E T I R E M E N T P L A N N I N G 19.1 Financial Planning Online: Request a Social Security Statement Go to: 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. The taxes received by the Social Security program are distributed to current retirees. Thus, your payments to the Social Security program are not invested for your retirement. When you retire, you will receive Social Security payments contributed by individuals and their employers at that time. RETIREMENT BENEFITS The amount of income that you receive from Social Security when you retire is dependent on the number of years you earned income and your average level of income. Social Security replaces about 42 percent of a worker s average annual income from his or her working years. Due to adjustments, however, this proportion is higher for individuals who had low-income levels and lower for those who had high-income levels. At the age of 65, you can qualify for full retirement benefits. Starting in 2003, the eligibility age will gradually increase until it reaches age 67. You can receive retirement benefits at age 62, but the benefits will be lower than if you wait until you reach full retirement age. As a general rule, though, early retirement will give you about the same total Social Security benefits over your lifetime as full retirement benefits. You can earn other income while receiving Social Security benefits. If your income exceeds a specified limit (which is adjusted over time), however, a portion of your Social Security benefits will be taxed; the amount that is subject to taxes is dependent on how much other income you earn. The Social Security Administration estimates each individual s retirement benefits and sends this information annually to all individuals who will be receiving benefits.

6 EMPLOYER-SPONSORED RETIREMENT PLANS 539 CONCERN ABOUT RETIREMENT BENEFITS IN THE FUTURE There is much debate about whether the Social Security program will be able to support retirees in the future. Today s retirees are now living longer, which means that the program must provide income over a longer period to individuals on average. In addition, there will be more retirees in the future and fewer workers to support them. When the generation of baby boomers begins retiring in the year 2011, much more funding will be needed to provide Social Security payments to all the retirees. Therefore, given the program s uncertain future, many individuals are relying less on Social Security income in their retirement planning. Even if the Social Security program continues, many individuals will want more income after retirement than it provides. In 2002, the estimated average monthly Social Security payment was about $874. Thus, even if the Social Security program continues in its current form, its benefits are unlikely to be sufficient to provide a comfortable lifestyle for most people. For this reason, many individuals accumulate their own retirement assets either through an employersponsored retirement plan or by establishing an individual retirement account. EMPLOYER-SPONSORED RETIREMENT PLANS Employer-sponsored retirement plans are designed to help you save for retirement. Each pay period, you and/or your employer contribute money to a retirement account. The money in most of these accounts can be invested in a manner that you specify (within the range of possibilities offered by your specific plan). The money you contribute to the retirement plan is not taxed until you withdraw it from the account. If you withdraw money from the account before you reach a specific age, you will be subject to a penalty tax. Any money you withdraw from the retirement account after you retire is taxed as ordinary income. Employer-sponsored retirement plans are classified as defined-benefit or defined-contribution plans. defined-benefit plan An employer-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. DEFINED-BENEFIT PLANS Defined-benefit plans guarantee you a specific amount of income when you retire, based on factors such as your salary and years of employment. Your employer makes all the contributions to the plan. The specific formula varies among employers. Guidelines also determine when employees are vested, which means that they have a claim to a portion of the retirement money that has been reserved for them upon retirement. For example, a firm may allow you to be 20 percent vested after two years, which means that 20 percent of the amount reserved for you through employer contributions will be maintained in your retirement account even if you leave the company. The percentage increases with the number of years with the employer, so you may be fully vested (able to retain 100 percent of your retirement account) after six years based on the guidelines of some retirement plans. Once you are fully vested, all money that is reserved for you each year will be maintained in your retirement account. These vesting rules encourage employees to stay at one firm for several years.

7 540 R E T I R E M E N T P L A N N I N G 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. DEFINED-CONTRIBUTION PLANS Defined-contribution plans specify guidelines under which you and/or your employer can contribute to your retirement account. The benefits that you ultimately receive are determined by the performance of the money invested in your account. You can decide how you want the money to be invested. You can also change your investments over time. As a result of their flexibility, defined-contribution plans have become very popular. In the last 10 years, many employers have shifted from defined-benefit to defined-contribution plans. This places more responsibility on the employees to contribute money and to decide how the contributions should be invested until their retirement. Therefore, you need to understand the potential benefits of a defined-contribution plan and how to estimate the potential retirement savings that can be accumulated under this plan. Benefits of a Defined-Contribution Plan. A defined-contribution plan provides you with many benefits. Any money contributed by your employer is like extra income paid to you beyond your salary. In addition, having a retirement account can encourage you to save money each pay period by directing a portion of your income to the account before you receive your paycheck. Investing in a defined-contribution plan also offers tax benefits. The retirement account allows you to defer taxes on income paid by your employer because your contribution to your account is deducted from your pay before taxes are taken out. Also note that the income generated by your investments in a retirement account is not taxed until you withdraw the money after you retire. This tax benefit is very valuable because it provides you with more money that can be invested and accumulate. In addition, by the time you are taxed on the investments (at retirement), you will likely be in a lower tax bracket because you will have less income. Investing Funds in Your Retirement Account. Most defined-contribution plans sponsored by employers allow some flexibility on how your retirement funds can be invested. You can typically select from a variety of stock mutual funds, bond mutual funds, or even money market funds. The amount of funds you accumulate will depend on how your investment in the retirement account performs. YOUR RETIREMENT PLANNING DECISIONS Your key retirement planning decisions involve choosing a retirement plan, determining how much to contribute, and allocating your contributions. Each of these decisions is discussed next. WHICH RETIREMENT PLAN SHOULD YOU PURSUE? The retirement benefits from an employer-sponsored retirement plan vary among employers. Some employer-sponsored plans allow you to invest more money than others. If your employer offers a retirement plan, that should be the first plan that you consider because your employer will likely contribute to it.

8 YOUR RETIREMENT PLANNING DECISIONS 541 HOW MUCH TO CONTRIBUTE Some retirement plans allow you to determine how much money (up to some specified maximum level) to contribute to your retirement account. Although some individuals like this freedom, others are not comfortable making this decision. You do not need to know how much money you will require at retirement to measure your potential savings from contributing to your retirement plan, as the following example shows. EXAMPLE Input Function 40 N 10 I 0 PV 5000 PMT? 2,212,950 FV Input Function 40 N 5 I 0 PV 5000 PMT? 724,782 FV Stephanie Spratt is considering whether she should start saving toward her retirement. Although her retirement is 40 years away, she wants to ensure that she can live comfortably at that time. She decides to contribute $3,600 per year ($300 per month) to her retirement through her employer s defined-contribution plan. Her employer will provide a partial matching contribution of $1,400 per year. Therefore, the total contribution to her retirement account will be $5,000 per year. As a result of contributing to her retirement, Stephanie will have less spending money and will not have access to these savings until she retires in about 40 years. However, her annual contribution helps reduce her taxes now because the money she contributes is not subject to income taxes until she withdraws it at retirement. Stephanie wants to determine how much money she will have in 40 years based on the total contribution of $5,000 per year. She expects to earn a return of 10 percent on her investment. She can use the future value of annuity tables (in Appendix A) to estimate the value of this annuity in 40 years. Her estimate of her savings at the time of her retirement is: Savings in Retirement Account Annual Contribution FVIFA (i 10%, n 40) $5, $2,212,950. Stephanie realizes that she may be overestimating her return, so she reestimates her savings based on a 5 percent return: Savings in Retirement Account Annual Contribution FVIFA (i 5%, n 40) $5, $724,782. Even with this more conservative estimate, Stephanie realizes that she will be able to accumulate more than $700,000 by the time of retirement. The amount that you try to save by the time you retire is partially dependent on the retirement income that you will need to live comfortably. There are various methods of determining the amount that you should save for your retirement. Among the important variables to consider are whether you will be supporting anyone besides yourself at retirement, your personal needs, the

9 542 R E T I R E M E N T P L A N N I N G 19.2 Financial Planning Online: Retirement Expense Calculator Go to: n_retireq/main.asp This Web site provides: an estimate of your expenses at retirement based on your current salary and expenses. expected price level of products at the time of your retirement, and the number of years you will live while retired. Various online calculators based on these factors are available. Given the difficulty of estimating how much income you will need at retirement, a safe approach is to recognize that Social Security will not provide sufficient funds and to invest as much as you can on a consistent basis in your retirement plan. After maintaining enough funds for liquidity purposes, you should invest as much as possible in retirement accounts, especially when the contribution is matched by the employer. HOW TO INVEST YOUR CONTRIBUTIONS When considering investment alternatives within a defined-contribution retirement plan, you do not have to worry about tax effects. All the money you withdraw from your retirement account at the time you retire will be taxed at your ordinary income tax rate, regardless of how it was earned. Most financial advisers suggest a diversified set of investments, such as investing most of the money in one or more stock mutual funds and investing the remainder in one or more bond mutual funds. Your retirement plan investment decision should take into account the number of years until your retirement, as shown in Exhibit If you are far from retirement, you might consider mutual funds that invest in stocks with high potential for growth (such as a capital appreciation fund, a technology fund, and maybe an international stock or bond fund). If you are close to retirement,

10 YOUR RETIREMENT PLANNING DECISIONS 543 Exhibit 19.2 Proportion of Portfolio Typical Composition of a Retirement Account Portfolio 100% Medium-Risk Investments Low-Risk Investments High-Risk Investments Age Common Common Common High-Risk Medium-Risk Low-Risk Investments Investments Investments Stock Mutual Funds Growth stock funds High-dividend stock funds Capital appreciation funds S&P 500 index funds Small-cap funds International stock funds Sector stock funds Bond Mutual Funds Junk bond funds Medium-rated corporate Treasury bond funds International bond funds bond funds Ginnie Mae funds High-rated corporate funds Hybrid Mutual Funds Balanced (stock and bond) funds Money Market Funds Treasury money market funds Money market funds that contain commercial paper and CDs you might consider Ginnie Mae bond funds, Treasury bond funds, and a stock mutual fund that focuses on stocks of very large firms that pay high dividends. Remember, however, that any investment is subject to a possible decline in value. Some investments (such as a money market fund focused on Treasury bills or on bank certificates of deposit) are less risky, but also offer less potential return. Most retirement plans allow a wide variety of investment alternatives to suit various risk tolerances. If you are young and far from retirement, you are in a position to take more risk with your investments. As you approach retirement, however, your

11 544 R E T I R E M E N T P L A N N I N G investments should be more conservative. For example, you may shift some of your investment to Treasury bonds so that your retirement fund is less exposed to risk. RETIREMENT PLANS OFFERED BY EMPLOYERS Next we will take a close look at some of the more popular defined-contribution retirement plans offered by employers. 401(k) plan A defined-contribution plan that allows employees to contribute a maximum of $13,000 ($16,000 if they are age 50 or older) per year on a pretax basis. 401(K) PLAN A 401(k) plan is a defined-contribution plan established by firms for their employees. Under federal guidelines, the maximum amount that employees can contribute is $13,000 ($16,000 if they are age 50 or older) per year as of the year As a result of the Tax Relief Act of 2001, the maximum annual contribution allowed for the 401(k) plan will increase $1,000 per year until it reaches $15,000 in It may also be adjusted beyond that time for inflation. Individuals over age 50 will be able to make additional catch-up contributions of $3,000 in 2004 and that limit is increased by $1,000 per year until the maximum catch-up contribution is $5,000 in year You can usually start contributing after one year of employment. The money you contribute is deducted from your paycheck before taxes are assessed. When you participate in a 401(k) plan, you are automatically vested. Thus, the money you contribute to the plan is yours, regardless of when you leave the firm. Employers offer a set of investment alternatives for the money contributed to a 401(k). For example, you may be able to invest in one or more mutual funds. The mutual funds are not necessarily part of a single family, so you may be able to choose among mutual funds sponsored by many different investment companies. Matching Contributions by Employers. Some 401(k) plans require the entire contribution to come from the employee with no matching contribution from the employer. Other employers match the employee s contribution. This means that if an employee contributes $400 per month, the employer will provide an additional $400 per month to the employee s retirement account. Or the firm may match a percentage of the employee s contribution. For example, if the employee contributes $400, the employer may contribute 50 percent of that amount, or an additional $200, to the employee s retirement account. The amount of matching (if any) provided by the employer has a large impact on the savings that the employee will have at retirement. More than 80 percent of all employers offering 401(k) plans match a portion or all of an employee s contributions. FOCUS ON ETHICS: 401(K) INVESTMENT ALTERNATIVES In some cases, to participate in an employer s retirement plan, employees must invest their 401(k) contributions in their employer s stock. This type of retire-

12 RETIREMENT PLANS OFFERED BY EMPLOYERS 545 ment plan is not only unethical, but it leaves the employee s present-day and future wealth exposed if the firm s financial condition deteriorates. The Enron case has made individuals well aware of this type of risk. Enron s stock declined abruptly, once investors became aware of fraudulent financial reporting. The retirement accounts of employees who had invested in Enron stock abruptly declined in value. Many of these employees not only lost their jobs when Enron went bankrupt, but also lost their retirement savings. When setting up a retirement account through your employer, diversify your investments so that you are not highly exposed to conditions within a single firm or industry. Enron s demise adversely affected many energy stocks, while WorldCom s fraudulent accounting had a negative impact on many telecommunication stocks. Diversifying among mutual funds reduces your risk exposure. Tax on Money Withdrawn from the Account. If you withdraw money from your 401(k) account before age 59 1 / 2, you will be subject to a penalty equal to 10 percent of the amount withdrawn. Your withdrawal will also be taxed as regular income at your marginal income tax rate. However, if you are retired and over age 59 1 / 2 when you withdraw the money, you may not have much other income and therefore will be in a very low marginal income tax bracket. Thus, the 401(k) plan allows you to defer paying taxes on the income you contributed for several years and may also allow you to pay a lower tax rate on the money once you withdraw it. 403-b plan A defined-contribution plan allowing employees of nonprofit organizations to invest up to $13,000 of their income on a taxdeferred basis. Simplified Employee Plan (SEP) A defined-contribution plan commonly offered by firms with 1 to 10 employees or used by selfemployed people. 403-b PLAN Nonprofit organizations such as educational institutions and charitable organizations offer 403-b plans, which are very similar to 401(k) plans in that they allow you to invest a portion of your income on a tax-deferred basis. The maximum amount that you can contribute is dependent on your compensation and years of service, up to a limit of $13,000 in As a result of the Tax Relief Act of 2001, the maximum annual contribution allowed for the 403-b plan will increase gradually until it reaches $15,000 in A 403-b plan allows you to choose investment alternatives. You will be penalized for withdrawals before age 59 1 / 2, and when you withdraw the money at retirement, you will be taxed at your marginal tax rate. SIMPLIFIED EMPLOYEE PLAN (SEP) A Simplified Employee Plan (SEP) is commonly offered by firms with 1 to 10 employees. The employee is not allowed to make contributions. The employer can contribute up to 25 percent of the employee s annual income, up to a maximum annual contribution of $41,000 in SEPs give an employer much flexibility in determining how much money to contribute. The employer may establish your SEP account at an investment company, depository institution, or brokerage firm of your choice. If it is established at an investment company, you will be able to invest the money in a set of mutual funds that the company offers.

13 546 R E T I R E M E N T P L A N N I N G If the account is established at a depository institution, you will be able to invest the money in CDs issued by the institution. If it is established at a brokerage firm, you may be able to invest in some individual stocks or mutual funds that you choose. Withdrawals should occur only after age 59 1/2 to avoid a penalty, and the withdrawals are taxed at your marginal income tax rate at that time. SIMPLE (Savings Incentive Match Plan for Employees) Plan A defined-contribution plan intended for firms with 100 or fewer employees. profit sharing A defined-contribution plan in which the employer makes contributions to employee retirement accounts based on a specified profit formula. employee stock ownership plan (ESOP) A retirement plan in which the employer contributes some of its own stock to the employee s retirement account. rollover IRA An individual retirement account (IRA) into which you can transfer your assets from your company retirement plan tax-free while avoiding early withdrawal penalties. SIMPLE PLAN The SIMPLE (Savings Incentive Match Plan for Employees) plan is intended for firms with 100 or fewer employees. A SIMPLE account can be established at investment companies, depository institutions, or brokerage firms. The employee can contribute up to $9,000 (2004) per year; due to the Tax Relief Act of 2001, this maximum amount has been raised annually by $1,000 and will reach $10,000 in It may also be adjusted beyond that time for inflation. As with the other retirement plans mentioned so far, this contribution is not taxed until the money is withdrawn from the account. Thus, a SIMPLE account is an effective means of deferring tax on income. In addition, the employer can match a portion of the employee s contribution. The SIMPLE plan allows catch-up contributions for employees who are age 50 or older. The catch-up amount is $1,500 in 2004, and is scheduled to rise gradually until it reaches $2,500 in PROFIT SHARING Some firms provide profit sharing, in which the employer makes contributions to employee retirement accounts based on a specified profit formula. The employer can contribute up to 25 percent of an employee s salary each year, up to a maximum annual amount of $41,000. EMPLOYEE STOCK OWNERSHIP PLAN (ESOP) With an employee stock ownership plan (ESOP), the employer contributes some of its own stock to the employee s retirement account. A disadvantage of this plan is that it is focused on one stock; if this stock performs poorly, your retirement account will not be able to support your retirement. Recall from Chapter 18 that a diversified mutual fund is less susceptible to wide swings in value because it contains various stocks that are not likely to experience large downturns simultaneously. An ESOP is generally more risky than retirement plans invested in diversified mutual funds. MANAGING YOUR RETIREMENT ACCOUNT AFTER LEAVING YOUR EMPLOYER When you leave an employer, you may be able to retain your retirement account there if you have at least $5,000 in it. Another option is to transfer your assets tax-free into your new employer s retirement account, assuming that your new employer allows such transfers (most employers do). However, some employers charge high annual fees to manage transferred retirement plans. You can also create a rollover IRA by transferring your assets tax-free from your company retirement plan to an individual retirement account (IRA). You

14 RETIREMENT PLANS FOR SELF-EMPLOYED INDIVIDUALS 547 can initiate a rollover IRA by completing an application provided by various investment companies that sponsor mutual funds or by various brokerage firms. By transferring your retirement account into a rollover IRA, you can avoid cashing in your retirement account and therefore can continue to defer taxes and avoid the early withdrawal penalty. RETIREMENT PLANS FOR SELF-EMPLOYED INDIVIDUALS Two popular retirement plans for self-employed individuals are the Keogh Plan and the Simplified Employee Plan (SEP). Keogh Plan A retirement plan that enables self-employed individuals to contribute part of their pre-tax income to a retirement account. Simplified Employee Plan (SEP) A defined-contribution plan commonly offered by firms with 1 to 10 employees or used by selfemployed people. KEOGH PLAN The Keogh plan enables self-employed individuals to contribute part of their pre-tax income to a retirement account. An individual can contribute up to 25 percent of net income, up to a maximum annual contribution of $41,000. As with other retirement accounts, contributions are not taxed until they are withdrawn at the time of retirement. You can establish a Keogh plan by completing an application form provided by investment companies and some brokerage firms. Withdrawals can begin at age 59 1 / 2, and you are responsible for determining how the plan s funds are invested. SIMPLIFIED EMPLOYEE PLAN (SEP) The Simplified Employee Plan (SEP) is also available for self-employed individuals. If you are self-employed, you can contribute up to 25 percent of your annual net income, up to a maximum annual contribution of $41,000. You can establish your SEP account at an investment company, depository institution, or brokerage firm of your choice. A SEP is easier to set up than a Keogh Plan.

15 548 R E T I R E M E N T P L A N N I N G INDIVIDUAL RETIREMENT ACCOUNTS You should also consider opening an individual retirement account (IRA). There are two main types of IRAs: the traditional IRA and the Roth IRA. traditional individual retirement account (IRA) A retirement plan that enables individuals to invest $3,000 per year ($6,000 per year for married couples). Roth IRA A retirement plan that enables individuals who are under specific income limits to invest $3,000 per year ($6,000 per year for married couples). TRADITIONAL IRA The traditional individual retirement account (IRA) enables you to save for your retirement, separate from any retirement plan provided by your employer. You can invest $3,000 per year ($6,000 per year for a married couple) in an IRA. As a result of the Tax Relief Act of 2001, the maximum annual contribution limit will increase gradually until it reaches $5,000 in The $5,000 level will be adjusted periodically for inflation. Individuals who are age 50 or older are allowed to make additional catch-up contributions of $500 per year until 2005 and $1,000 per year thereafter. If you are covered by an employersponsored plan, and your gross income is above limits specified by the Internal Revenue Service, your IRA contribution is not tax-deductible. However, the income earned on your investments within the IRA is not taxed until you withdraw your money at retirement. You will not be taxed again on the initial investment when you withdraw that money at retirement. (If you are not covered by an employer-sponsored plan, your IRA contribution is tax-deductible unless your income is very high.) When you contribute to an IRA, your investment choices will depend on the retirement plan sponsor. For example, if you set up your IRA at Vanguard, you can select among more than 60 mutual funds for your account. You can withdraw funds from an IRA at age 59 1 / 2 or later. You are taxed on the income earned by your investments at your ordinary income tax rate at the time you withdraw funds. If you withdraw the funds before age 59 1 / 2, you are not only taxed at your ordinary income tax rate, but are typically charged a penalty equal to 10 percent of the withdrawn funds. ROTH IRA The Roth IRA allows individuals who are under specific income limits to invest $3,000 per year ($6,000 per year for married couples). Due to the Tax Relief Act of 2001, the maximum annual contribution limit will be increased gradually until it reaches $5,000 in Individuals who are age 50 or older can make additional catch-up contributions with the same limits as the traditional IRA. You can withdraw funds from the Roth IRA at age 59 1 / 2 or later. You are taxed on money invested in the Roth IRA at the time of the contribution. However, you are not taxed when you withdraw the money, as long as you withdraw the money after age 59 1 / 2 and the Roth IRA has been in existence for at least five years. These tax characteristics differ from the traditional IRA, in which you are not taxed when contributing (if you are under specific income limits), but are taxed when you withdraw the money after retirement. You can invest in both a Roth IRA and a traditional IRA, but you are limited to a total IRA con-

16 INDIVIDUAL RETIREMENT ACCOUNTS 549 tribution. For example, if you are single and invest the maximum amount in a Roth IRA this year, you cannot invest in a traditional IRA. If you invest $1,000 less than the maximum amount in a Roth IRA this year, you can also invest $1,000 in a traditional IRA. You need not maintain a specific allocation between the two types of IRAs each year, but you are subject to the maximum total contribution. Individuals whose income exceeds specified limits are not eligible for the Roth IRA. For married taxpayers filing jointly, eligibility for the Roth IRA phases out from $150,000 to $160,000 of adjusted gross income. For single taxpayers, the Roth IRA phases out from $95,000 to $110,000 of adjusted gross income. COMPARISON OF THE ROTH IRA AND TRADITIONAL IRA To illustrate the difference between the Roth IRA and the traditional IRA, we will consider the effects of investing $3,000 in each type of IRA. Advantage of the Traditional IRA over the Roth IRA. The $3,000 that you contribute to a traditional IRA is sheltered from taxes until you withdraw money from your account. Conversely, you pay taxes on your income before you contribute $3,000 to a Roth IRA so that $3,000 is subject to taxes immediately. Assuming that you are in a 28 percent tax bracket, you would incur a tax of $840 now (computed as $3,000 28%) on the income contributed to a Roth IRA. Had you invested that income in a traditional IRA instead of a Roth IRA, you would not incur taxes on that income at this time. Advantage of the Roth IRA over the Traditional IRA. IRA contributions should grow over time, assuming that you invest each year and that you earn a reasonable return. Assume that you are retired and withdraw $10,000 after several years of investing in your IRA. If you withdraw $10,000 from your Roth IRA, you will not pay any taxes on the amount withdrawn. Conversely, if you withdraw $10,000 from your traditional IRA, you will pay taxes on the amount withdrawn, based on your marginal income tax bracket. If your marginal tax bracket at that time is 25 percent, you will incur a tax of $2,500 (computed as $10,000 25%). Thus, you would incur a tax of $2,500 more than if you had withdrawn the money from a Roth IRA. Investment income accumulates on a tax-free basis in a Roth IRA, whereas money withdrawn from a traditional IRA is taxable. Factors That Affect Your Choice. So which IRA is better? The answer depends on many factors, including what your marginal income tax rate is at the time you contribute money to your IRA and at the time that you withdraw money from your IRA. If you are in a high tax bracket now and expect to be in a very low tax bracket when you withdraw money from the IRA, you may be better off with the traditional IRA. Because you are not taxed on the initial contribution, you will receive your tax benefit when you are working and subject to a high tax rate. If you withdraw money from the IRA after you retire, and you do not have much other income, the money withdrawn from the IRA will be taxed at a low tax rate.

17 550 R E T I R E M E N T P L A N N I N G 19.3 Financial Planning Online: Traditional IRA or Roth IRA? Go to: /cgi-bin/calcs/ira2.cgi/ themotleyfool This Web site provides: an analysis of whether a traditional IRA or a Roth IRA is better suited to you based on your input about your financial situation. A counterargument is that if you save a substantial amount of money in your employer-sponsored account and your IRA, you will be withdrawing a large amount of money from your accounts every year after you retire, so you will likely be in a high tax bracket. In this case, you may be better off paying taxes on the income now with a Roth IRA (as you contribute to your retirement account) rather than later. One other factor to consider is that individuals who are age 70 1 / 2 must begin to withdraw funds from the traditional IRA. The Roth IRA does not require withdrawals for individuals at any age. annuity A financial contract that provides annual payments over a specified period. ANNUITIES When conducting your retirement planning, you should also consider investing in annuities. An annuity is a financial contract that provides annual payments until a specified year or for one s lifetime. The minimum investment in an annuity is usually $5,000. The investment in an annuity is not sheltered from income taxes. Thus, if you invest $5,000 in an annuity, you cannot reduce your taxable income by $5,000. The return on the investment in an annuity is tax-deferred, however, so any gains generated by the annuity are not taxed until the funds are paid to the investor. Although there are benefits from being able to defer the tax on your investment, they are smaller than the benefits from sheltering income

18 ESTIMATING YOUR FUTURE RETIREMENT SAVINGS 551 by using a retirement account. Therefore, annuities are not suitable substitutes for retirement plans. fixed annuity An annuity that provides a specified return on your investment, so you know exactly how much money you will receive at a future point in time (such as retirement). variable annuity An annuity in which the return is based on the performance of the selected investment vehicles. surrender charge A fee that may be imposed on any money withdrawn from an annuity. FIXED VERSUS VARIABLE ANNUITIES Annuities are classified as fixed or variable. Fixed annuities provide a specified return on your investment, so you know exactly how much money you will receive at a future point in time. Variable annuities allow you to choose among various investments (specific stock and bond portfolios), so the return is dependent on the performance of those investments. You may even change the investments (within the list of those allowed) over time. You can withdraw your investment as a lump sum or as a series of payments over time. ANNUITY FEES The main disadvantage of annuities is the high fees charged by the financial institutions (primarily insurance companies) that sell and manage annuities. These fees include management fees that are charged every year (similar to those for a mutual fund) and a surrender charge that may be imposed on any money withdrawn in the first eight years or so. The surrender charge is intended to discourage withdrawals. In addition, there may be insurance fees that are essentially commissions to salespeople for selling the annuities to you. These commissions commonly range from 5.75 to 8.25 percent of your investment. Some financial institutions now offer no-load annuities that do not charge commissions and also charge relatively low management fees. For example, Vanguard s variable annuity plan has total expenses between 0.58 and 0.86 percent of the investment per year, which are lower than what many mutual funds charge. ESTIMATING YOUR FUTURE RETIREMENT SAVINGS To determine how much you will have accumulated by retirement, you can calculate the future value of the amount of money you save. ESTIMATING THE FUTURE VALUE OF ONE INVESTMENT Recall from Chapter 3 that the future value of an investment today can be computed by using the future value interest factor (FVIF) table in Appendix A. You need the following information: The amount of the investment. The annual return that you expect on the investment. The time when the investment will end.

19 552 R E T I R E M E N T P L A N N I N G EXAMPLE Input ? Function N I PV PMT FV Most (but not all) financial calculators, such as the Texas Instruments BAII PLUS, require a negative present value (PV) input. You should consult your manual to determine the requirements of your financial calculator. 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 percent per year on your investment. Based on this information, you expect the value of your investment in 40 years to be: Value in 40 Years Investment FVIF (i 10%, n 40) $5, $226,295. It may surprise you that $5,000 can grow into more than a quarter of a million dollars if it is invested over a 40-year period. This should motivate you to consider saving for your retirement as soon as possible. Relationship between Amount Saved Now and Retirement Savings. Consider how the amount you save now can affect your future savings. As Exhibit 19.3 shows, if you invested $10,000 instead of $5,000 today, your savings would grow to $452,590 in 40 years. The more you save today, the more money you will have at the time of your retirement. Relationship between Years of Saving and Your Retirement Savings. The amount of money you accumulate by the time you retire is also dependent on the number of years your savings are invested. As Exhibit 19.4 shows, the longer your savings are invested, the more they will be worth (assuming a positive rate of return) at retirement. If you invest $5,000 for 25 years instead of 40 years, it will be worth only $54,175. Exhibit 19.3 Relationship between Savings Today and Amount of Money at Retirement (in 40 years, assuming a 10% annual return) Savings at Retirement $500,000 $400,000 $300,000 $200,000 Savings Today $100,000 Savings at Retirement $0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $7,000 $8,000 $9,000 $10,000 Savings Today

20 ESTIMATING YOUR FUTURE RETIREMENT SAVINGS 553 Exhibit 19.4 Relationship between the Investment Period and Your Savings at Retirement (assuming a $5,000 investment and a 10% annual return) Savings at Retirement $250,000 $200,000 $150,000 $100,000 $50,000 $ Number of Years Exhibit 19.5 Relationship between the Annual Return on Your Investment and Your Savings at Retirement (in 40 years, assuming a $5,000 initial investment) Savings at Retirement $1,000,000 $800,000 $600,000 $400,000 $200,000 $0 0% 2% 4% 6% 8% 10% 12% 14% Annual Return Relationship between Your Annual Return and Your Retirement Savings. The amount of money you will accumulate by the time you retire is also dependent on your annual return, as shown in Exhibit Notice the sensitivity of your savings at retirement to the annual return. Two extra percentage points on the annual return can increase the savings from a single $5,000 investment by hundreds of thousands of dollars. With a 14 percent return instead of 10 percent, your $5,000 would be worth $944,400 in 40 years when you retire.

21 554 R E T I R E M E N T P L A N N I N G ESTIMATING THE FUTURE VALUE OF A SET OF ANNUAL INVESTMENTS If you plan to save a specified amount of money every year for retirement, you can easily determine the value of your savings by the time you retire. Recall that a set of annual payments is an annuity. The future value of an annuity can be computed by using the future value interest factor of an annuity (FVIFA) table in Appendix A. You need the following information: The amount of the annual payment (investment). The annual return that you expect on the investments. The time when the investments will end. EXAMPLE Input Function 40 N 10 I 0 PV 5000 PMT? FV You consider investing $5,000 at the end of each of the next 40 years to accumulate retirement savings. You anticipate that you can earn a return of 10 percent per year on your investments. Based on this information, you expect the value of your investments in 40 years to be: Value in 40 Years Annual Investment FVIFA (i 10%, n 40) $5, $2,212,950. This is not a misprint. You will have more than $2 million in 40 years if you invest $5,000 each year for the next 40 years and earn a 10 percent annual return. The compounding of interest is very powerful and allows you to accumulate a large amount of funds over time with relatively small investments. Set aside income for your retirement as soon as possible so that you can benefit from the power of compounding. Relationship between Size of Annuity and Retirement Savings. Consider how the amount of your savings at retirement is affected by the amount that you save each year. As Exhibit 19.6 shows, for every extra $1,000 that you can save by the end of each year, you will accumulate an additional $442,590 at retirement. Relationship between Years of Saving and Retirement Savings. The amount of money you will accumulate when saving money on a yearly basis is also dependent on the number of years your investment remains in your retirement account. As Exhibit 19.7 shows, the longer your annual savings are invested, the more they will be worth at retirement. If you plan to retire at age 65, notice that if you start saving $5,000 per year at age 25 (and therefore save for 40 years until retirement), you will save $857,850 more than if you wait until age 30 to start saving (and therefore save for 35 years until retirement). Relationship between Your Annual Return and Your Savings at Retirement. The amount you will have at retirement is also dependent on the return you

22 ESTIMATING YOUR FUTURE RETIREMENT SAVINGS 555 Exhibit 19.6 Savings at Retirement Relationship between Amount Saved per Year and Amount of Savings at Retirement (in 40 years, assuming a 10% annual return) $5,000,000 $4,500,000 $4,000,000 $3,500,000 $3,000,000 $2,500,000 $2,000,000 $1,500,000 $1,000,000 $500,000 $0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $7,000 $8,000 $9,000 $10,000 Amount Saved Per Year 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) Savings at Retirement $2,500,000 $2,000,000 $1,500,000 $1,000,000 $500,000 $ Number of Consecutive Years You Invest $5,000 at the End of Each Year earn on your annual savings, as shown in Exhibit Notice how sensitive your savings are to the annual return. Almost $1 million more is accumulated from an annual return of 10 percent than from an annual return of 8 percent. An annual return of 12 percent produces about $1.6 million more in accumulated savings than an annual return of 10 percent.

23 556 R E T I R E M E N T P L A N N I N G Exhibit 19.8 Relationship between the Annual Return on Your Annual Savings and Your Savings at Retirement (in 40 years, assuming a $5,000 annual investment) Savings at Retirement $7,500,000 $7,000,000 $6,500,000 $6,000,000 $5,500,000 $5,000,000 $4,500,000 $4,000,000 $3,500,000 $3,000,000 $2,500,000 $2,000,000 $1,500,000 $1,000,000 $500,000 $0 0% 2% 4% 6% 8% 10% 12% 14% Annual Returm MEASURING THE TAX BENEFITS FROM A RETIREMENT ACCOUNT If you can avoid or defer taxes when investing in your retirement, you will likely be able to save a much larger amount of money. Since some retirement contributions from your income are not taxed until they are withdrawn from the retirement account, you can reduce the present level of income taxes. The potential tax benefits of investing in a retirement account are illustrated in the following example. EXAMPLE Input Function 40 N 10 I 0 PV 5000 PMT? FV You wish to invest $5,000 per year in a retirement account for the next 40 years when you plan to retire. You expect to earn a return of 10 percent per year. Using the future value of an annuity (FVIFA) table in Appendix A, your savings at retirement would be: Savings at Retirement Annual Investment FVIFA (i 10%, n 40) $5, $2,212,950. As you withdraw the money from your account after you retire, you will be taxed at your ordinary income tax rate, even though the investment appreciated over time due to capital gains. If you withdraw all of your money in one year, and are taxed at a 25 percent rate, your tax will be:

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