CHAPTER 18. Personal Finance. The Importance of Starting Early. Misconceptions About Retirement Planning. Why Think About Retirement Planning Now?

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1 CHAPTER 18 The Importance of Starting Early Retirement Planning Personal Finance 7e Kapoor Dlabay Hughes 18-1 To take advantage of the time value of money. If from age 25 to 65 you invest $300 a month (9%) at age 65 you ll have 1.4 million in your retirement fund. Wait ten years until age 35 to start and you ll have about $550,000 at age 65. Wait twenty years until age 45 and you ll have only $201,000 at age See Exhibit Misconceptions About Retirement Planning Why Think About Retirement Planning Now? My expenses will drop when I retire. My retirement will only last 15 years. I can depend on Social Security and my company pension to pay for my basic living expenses. My pension benefits will increase to keep pace with inflation People are spending more years (16-25) in retirement. You don t want to be bored, lonely and broke. A private pension and Social Security are most often insufficient to cover the cost of living. Inflation may diminish the purchasing power of your retirement savings Misconceptions About Retirement Planning My employers health insurance plan and Medicare will cover my medical expenses. There s plenty of time for me to start saving for retirement. Saving just a little bit won t help. Review Your Assets for Retirement Housing. If owned, probably your biggest single asset. If large equity, a reverse annuity mortgage could provide additional retirement income. You could sell your home, buy a less expensive one, and invest the difference

2 Review Your Assets for Retirement Life insurance cash value can be converted into an annuity. Review other investments, such as stocks and bonds. Retirement assets are affected by divorce. Pension benefits are considered a marital asset to be divided, depending on the length of the marriage. There are tax implications of the divorce settlement Use Websites to Help You Estimate Retirement Expenses American Savings Education Council website at and click on Ballpark Estimate Worksheet. Roth IRA website For online planning software see sites: Go to financial calculator websites and then click on Retirement. or Estimating Your Retirement Living Expenses Spending patterns and where and how you live will probably change. Some expenses may go down or stop, such as 401(k) retirement fund contributions. Work expenses - less for gas, lunches out. Clothing expenses - fewer and more casual. Housing expenses - house payment may stop if your house is paid off by taxes and insurance going up. Federal income taxes will probably be lower How an Average Older (65+) Household Spends its Money Housing 32.5% Transportation U.S. Bureau of Labor Statistics 16.3% Medical 11.3% 6.2% 15.4% 5.7% 4.9% 7.7% Food Entertainment Insurance and other Clothing Contributions Estimating Retirement Living Expenses Other expenses may go up. Life and health insurance unless your employer continues to pay them. Medical expenses increase with age. Expenses for leisure activities may go up. Gifts and contributions may increase. Inflation will raise the amount you need to cover your expenses over the course of your probable years in retirement Planning Your Retirement Housing Think about where you want to live. Consider the cost of living and taxes. Type of housing and changing needs. Staying in their home that they own is what most people (92%) prefer. A universal designed home is built to allow for potential physical limitations. If not built using universal design, home may need to be retrofitted. Continuing care retirement community provide increasing levels of care

3 Avoid Retirement Housing Traps If you plan to move when you retire Write the local Chamber of commerce to learn about taxes and the economic profile. Check on state income and sales taxes, and taxes on pension income. Call a local CPA to find our what taxes are rising. Subscribe to a local Sunday paper. Estimate what your utility, health care, auto insurance, food, and clothing costs would be in the area. Rent for a while instead of buying immediately Future of Social Security The Social Security administration says the program is financially sound, but many people are concerned about the future of Social Security. Longer life expectancies means retirees collect benefits longer. People are retiring earlier and entering the system sooner and staying longer. The baby boomers will begin retiring soon and the ratio of workers to retirees is doing down. In 1945 there were 45 workers per retiree, In 2050 is it estimated there will be two workers per retiree. Social Security Most widely used source of retirement income, covering 97% of U.S. workers. Meant to be part of your retirement income, but not the sole source. Check the Earnings & Benefit statement you receive each year for accuracy. Full retirement benefits at age 65 to age 67, depending on the year you were born, but reduced benefits at age 62. See Individual accounts for each employee. Employer Pension Plans - Defined Contribution Money-purchase pension plans - A percent of your earnings are set aside, along with any employer contributions. Stock bonus plans - Employer s contribution is used to buy stock in your company for you. Profit-sharing plans - Employer s contribution depends on the company s profits Social Security Up to 85% of your benefit may be subject to federal income tax for any year in which your AGI plus your nontaxable interest income and one-half of your Social Security benefits exceed a base amount. Cost of living adjustment (COLA) each year. Spouse's benefit is one-half of the worker s benefit. If you are a spouse, sometimes your own benefit will be higher than what you could collect as a spouse. Employer Pension Plans - Defined Contribution Salary reduction or 401(k), 403(b) or 457 plans. Employer makes non-taxable contributions and reduces your salary by the same amount. Employee contributions are tax-deferred. Some employers match a portion of the funds you contribute

4 Employer Pension Plans - Defined Benefit Employer will pay you a certain amount per month when you retire based on your pre-retirement salary and number of years of service. Employer makes the investment decisions for your and their contribution, but your benefit amount stays the same regardless of how the investments perform Individual Retirement Accounts Roth IRAs. Contributions are not tax deductible, but earnings accumulate with distributions tax free after age 591/2. You can contribute up to $3,000 ($3,500 if age 50 or older) per year if you are single and have an AGI of $95,000 or less or an AGI of $150,000 if you are filing jointly. After five years, up to $10,000 can be used as a down payment on a first-time home buyer expenses penalty-free and tax-free Pension Plan Portability and Vesting Portability allows you to carry earned benefits from one employer s pension plan to another s when you change jobs. Vesting is your right to at least a portion of the benefits you have accrued under an employer pension plan, even if you leave before you retire. When you leave a job you can cash in your pension (tax consequences), have the employer keep the funds so you will get a future pension from them, rollover the funds into an IRA, or transfer the funds to invest in a pension with your new employer if your pension is portable. Individual Retirement Accounts A Rollover IRA is a traditional IRA that accepts rollovers of all, or a portion, of your taxable distribution from a retirement plan or other IRA. You decide where your money is invested. Many people put IRA money in a savings account or CD rather than thinking about their options to invest for growth. Stocks, company stock, bonds, and mutual funds are options for long term growth. A Keogh is a pension plan developed for self-employed people, and their employees Individual Retirement Accounts (IRA) The most popular personal retirement plan. Regular (traditional) IRA. Lets you contribute up to $3,000 per year (see text chart as these amount are gradually rising). Depending on your tax filing status and income, your contribution may be tax-deductible. The interest accumulates tax free until you start taking it out. You pay taxes on the money as you withdraw it once you are retired but must begin to withdraw funds by age 70 1/ The Education IRA (renamed Coverdell Education Savings Account) You can give up to $2,000 a year to each child. The accounts grow tax-free, and can be invested any way you choose. The money can be used for elementary and secondary school costs, including books, tuition and tutoring

5 Annuities An annuity provides guaranteed income for life. If you have fully funded all other retirement plan options, including your 401(k), 403b(7), Keogh, and profit-sharing plans but still want more money for retirement you may want to buy an annuity. You can buy an annuity with the proceeds of an IRA or company pension, or as supplemental retirement income. You can buy one with a single payment or with periodic payments Anticipated Sources of Retirement Income Other Spouse's pension 9% 401(k) 7% 7% Social Security Administration, 1997 Social Security 27% 18% 12% 7% 5% IRA Company pension Savings Part-time work 8% Home equity Annuities You can also buy an annuity by converting the cash value of your life insurance policy into an annuity. Interest accumulates tax free until payments begin. Immediate annuities are set up to begin payments right away. With deferred annuities, income payments begin at some future date. Contributions, and the interest they earn, are tax-deferred until you begin drawing the money out Living on Your Retirement Income Estimate possible sources of retirement income. Together, your pension and Social Security will cover about 60% of retirement income needs. Determine how much you will need in retirement accounts such as IRAs, savings, and investments to supply the other 40%. Develop a plan to accumulate this amount in assets, or plan for post-retirement employment. Monitor your investments. Take advantage of all tax savings retirees receive Develop a spending plan for retirement. Annuities Options in annuities allow you to decide which is best for your situation. A straight-life annuity provides more income than any other type, but payments stop when you die. The life-with-period-certain option guarantees the number of payments. A joint-and -survivor annuity pays until the last survivor you designate dies. Do you want a guaranteed fixed return or a variable annuity with a minimum guaranteed and the rest depending on how your investment choices for you annuity dollar are performing? Living on Your Retirement Income If you have the skills and ability, do some things yourself that you used to hire others to do. Retirees get a variety of tax savings. Fewer senior discounts as boomers retire. Invest some of your retirement income for growth, to allow for inflation and increased health care costs. Consider 60% stocks and 40% bonds. Dip into savings with caution, since you do not know how long you will live

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