Social Security

1
Chapter 19

• Retirement Planning

2
Chapter Objectives

• 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 available for
  self-employed individuals

3
Chapter Objectives

• Describe types of individual retirement accounts
• Illustrate how to estimate the savings you will
  have in your retirement account at the time you
  retire
• Show how to measure the tax benefits from
  contributing to a retirement plan

4
Social Security

• Social Security is a federal program that taxes
  you during your working years and uses the funds
  to make payments to you upon retirement
• It does not provide adequate income to solely
  support most people

5
Social Security

• Qualifying for Social Security
• You need to accumulate 40 credits from
  contributing to Social Security
• One credit for each 780 in income per year,
  maximum 4 per year
• Social Security also available for disabled

6
Social Security

• Survivors benefits are also provided
• A one-time income payment to the spouse
• Monthly income payments if spouse is older than
  60 or has a child under the age of 16
• Monthly income payments to children under age 18
• Social Security Taxes
• Collected from both employees and employers
• 6.2 for Social Security
• 1.45 for Medicare

7
Social Security
Exhibit 19.1 FICA Taxes on Various Income Levels
8
Financial Planning Online Request a Social
Security Statement

• Go to http//www.ssa.gov/top10.html
• 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.

9
Social Security

• Retirement benefits
• Depends on your income and the number of years
  you earned income
• Provides about 42 of your annual income
• Eligible for full retirement benefits at age 65
• You can earn limited income while receiving
  Social Security

10
Social Security

• Concern about retirement benefits in the future
• Retirees are living longer which costs the
  program more in benefits
• The number of retirees continues to grow
• Many people are relying less on Social Security
  and establishing their own retirement programs

11
Employer-Sponsored Retirement Plans

• Designed to help you save for retirement
• Employees and/or employers contribute
• A penalty is imposed for early withdrawal
• Your contributions are tax-deferred

12
Employer-Sponsored Retirement Plans

• Defined-benefit plan an employee-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

13
Employer-Sponsored Retirement Plans

• 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

14
Employer-Sponsored Retirement Plans

• Benefits of a defined-contribution plan
• Money contributed by employer is like extra
  income
• Encourages employees to save
• Offers tax deferred income
• Investing funds in your retirement account
• Employer can usually choose from a number of
  different funds

15
Your Retirement Planning Decisions

• Which retirement plan should you pursue?
• An employer-sponsored plan is usually the best
  choice if your employer contributes
• How much to contribute?
• As much as you can as early as you can!
• How much to save?
• How many people will you be supporting?
• What do you expect prices to be?
• What is your estimated life expectancy?

16
Financial Planning Online Retirement Expense
Calculator

• Go to http//moneycentral.msn.com/investor/calc
  s/n_retireq/main.asp
• This Web site provides an estimate of your
  expenses at retirement based on your current
  salary and expenses.

17
Your Retirement Planning Decisions

• How to invest your contributions?
• Use a diversified set of investments
• Consider the number of years to retirement
• Consider your level of risk tolerance

18
Your Retirement Planning Decisions
Exhibit 19.2 Typical Composition of a Retirement
Account Portfolio
19
Your Retirement Planning Decisions
Exhibit 19.2 Typical Composition of a Retirement
Account Portfolio
20
Retirement Plans Offered by Employers

• 401(k) plan a defined-contribution plan that
  allows employees to contribute a maximum of
  10,500 per year or 15 percent of their salary on
  a pre-tax basis
• Amount of contribution gradually increasing to
  15,000 under Tax Relief Act of 2001
• Matching contributions by some employers
• Tax on money withdrawn from the account
• Tax and penalty for withdrawals before age 59½

21
Retirement Plans Offered by Employers

• Focus on Ethics 401(k) investment alternatives
• Plans requiring employees to invest their 401(k)
  contributions in their employers stock is
  unethical
• These contributions should be diversified

22
Retirement Plans Offered by Employers

• 403-b plan a defined-contribution plan allowing
  employees of non-profit organizations to invest
  up to 10,000 of their income on a tax-deferred
  basis
• Gradually increasing to 15,000 under Tax Relief
  Act of 2001

23
Retirement Plans Offered by Employers

• Simplified Employee Plan (SEP) a
  defined-contribution plan commonly offered by
  firms with 1 to 10 employees or used by
  self-employed people
• Employee cannot contribute to this plan
• Tax and penalty for withdrawals before age 59

24
Retirement Plans Offered by Employers

• SIMPLE (Savings Incentive Match Plan for
  Employees) Plan a defined-contribution plan
  intended for firms with 100 or fewer employees
• Employee can contribute up to 6,000 annually and
  the employer can match

25
Retirement Plans Offered by Employers

• Profit sharing a defined-contribution plan in
  which the employer makes contributions to
  employee retirement accounts based on a specified
  formula
• Up to 15 of employees salary, maximum 24,000
  per year

26
Retirement Plans Offered by Employers

• Employee Stock Ownership Plan (ESOP) a
  retirement plan in which the employer contributes
  some of its own stock to the employees
  retirement account
• More risky because it is not diversified

27
Retirement Plans Offered by Employers

• Managing your retirement account after leaving
  your employer
• Rollover IRA an individual retirement account
  into which you can transfer your assets from your
  company retirement plan tax-free while avoiding
  penalties

28
Retirement Plans for Self-Employed Individuals

• Keogh Plan a retirement plan that enables
  self-employed individuals to contribute part of
  their pre-tax income to a retirement account
• Up to 25 to a maximum of 30,000 annually
• Individual determines how funds are invested

29
Retirement Plans for Self-Employed Individuals

• Simplified Employee Plan (SEP)
• Also available for self-employed who can
  contribute up to 15 of annual income to a
  maximum of 24,000 annually

30
Individual Retirement Accounts

• Traditional IRA a retirement plan that enables
  individuals to invest 2,000 per year
• Gradually increasing to 5000 under Tax Relief
  Act of 2001
• Contributions may or may not be tax-deductible
• Interest earned is tax-deferred
• Tax and penalty on withdrawals before age 59

31
Individual Retirement Accounts

• Roth IRA a retirement plan that enables
  individuals who are under specific income limits
  to invest 2,000 per year
• Gradually increasing to 5000 under Tax Relief
  Act of 2001
• Income taxed at time of contribution, but not
  when withdrawn

32
Individual Retirement Accounts

• Comparison of the Roth IRA and Traditional IRA
• Advantage of traditional IRA over Roth IRA
• Contributions are sheltered from taxes until
  withdrawn
• Advantage of Roth IRA over traditional IRA
• Investment income accumulates tax-free in a Roth
  IRA

33
Individual Retirement Accounts

• Factors that affect your choice
• Marginal tax rates at time of contribution and
  withdrawal

34
Financial Planning Online Traditional IRA or
Roth IRA?

• Go to http//www.financenter.com/products/selli
  ngtools/calculators/ira/
• Click on Should I convert my IRA into a Roth
  IRA?
• This Web site provides an analysis of whether a
  Traditional or a Roth IRA is better suited to you.

35
Annuities

• Annuity a financial contract that provides
  annual payments over a specified period
• Contributions taxable but gains are tax-deferred
• Fixed versus variable annuities
• Fixed annuity an annuity that provides a
  specified return on your investment, so you know
  exactly how much you will receive at a future time

36
Annuities

• Variable annuity an annuity in which the return
  is based on the performance of the selected
  investment vehicles
• Annuity fees
• High fees is a disadvantage of annuities
• Surrender charge a fee that may be imposed on
  any money withdrawn from an annuity

37
Annuities

• Also commissions to salespeople
• Look for no-load annuities that do not charge
  commissions and have low management fees

38
Estimating Your Future Retirement Savings

• Estimating the future value of one investment
• Example
• 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 per year on your
  investment. Using FVIF, you expect the value of
  your investment in 40 years to be

39
Estimating Your Future Retirement Savings

• Value in 40 years Investment ?
  FVIF(I10, n40)
• 5,000 ? 45.259
• 226,295

40
Estimating Your Future Retirement Savings

• Estimating the future value of one investment
• Relationship between amount saved now and
  retirement savings
• If you invested 10,000 instead of 5,000, your
  savings would grow to 452,590 in 40 years

41
Estimating Your Future Retirement Savings

• Relationship between years of saving and your
  retirement savings
• If you invested 5,000 for 25 years instead of 40
  years, your savings would be only 54,175

42
Estimating Your Future Retirement Savings
Exhibit 19.3 Relationship between Savings Today
and Amount of Money at Retirement (in 40 years,
assuming a 10 annual return)
43
Estimating Your Future Retirement Savings

• Relationship between your annual return and your
  retirement savings
• If you earned a return of 14 instead of 10,
  your 5,000 would be worth 944,400 in 40 years

44
Estimating Your Future Retirement Savings
Exhibit 19.4 Relationship between the Investment
Period and Your Savings at Retirement (assuming
a 5,000 investment and a 10 annual return)
45
Estimating Your Future Retirement Savings

• Estimating the future value of a set of annual
  investments
• Example
• You consider investing 5,000 at the end of each
  of the next 40 years to accumulate retirement
  savings. You believe that you can earn a return
  of 10 per year on your investment. Using FVIFA,
  you expect the value of your investment in 40
  years to be

46
Estimating Your Future Retirement Savings

• Value in 40 years Investment ? FVIFA
• 5,000 ? 442.59
• 2,212,950

47
Estimating Your Future Retirement Savings

• Relationship between size of annuity and
  retirement savings
• For every extra 1,000 you can save by the end of
  each year, you will accumulate an additional
  442,590
• Relationship between years of saving and
  retirement savings
• If you start saving 5,000 per year at age 25
  instead of age 30 (saving until age 65), you will
  save an additional 857,850

48
Estimating Your Future Retirement Savings
Exhibit 19.6 Relationship between the Amount
Saved per Year and Amount of Savings at
Retirement(in 40 years, assuming a 10 annual
return)
49
Estimating Your Future Retirement Savings
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)
50
Estimating Your Future Retirement Savings

• Relationship between your annual return and your
  savings at retirement
• If you earn a return of 12 instead of 10 your
  savings will accumulate at additional 1.6 million

51
Estimating Your Future Retirement Savings
Exhibit 19.8 Relationship between the Annual
Return on Your Annual Savings and Your Savings at
Retirement (in 40 years, assuming a 5,000
initial investment)
52
Measuring the Tax Benefits From a Retirement
Account

• Example
• You wish to invest 5,000 per year in a
  retirement account for the next 40 years. You
  expect to earn a return of 10 per year. Using
  FVIFA, your savings at retirement would be
• 5,000 ? 442.59 2,212,950

53
Measuring the Tax Benefits From a Retirement
Account

• If you withdrew all of your money in one year,
  with a 25 tax rate, your tax would be
• 2,212,950 ? .25 553,238
• Your income after taxes would be
• 2,212,950 - 553,238 1,659,712

54
Measuring the Tax Benefits From a Retirement
Account

• Consider if you invest the 5,000 elsewhere, you
  have an additional 5,000 taxable income each
  year. Assuming a marginal tax rate of 30, you
  have only 3,500 each year to invest. Assume a
  10 return on those savings over the next 40
  years. Using FVIFA, your savings would
  be(contd on next slide)

55
Measuring the Tax Benefits From a Retirement
Account

• 3,500 ? 442.59 1,549,065
• You would have a capital gain of
• 1,549,065 - (3,500 ? 40)
  1,409,065

56
Measuring the Tax Benefits From a Retirement
Account

• Assuming a capital gains tax of 20, your
  capital gains tax would be
• 1,409,065 ? .20 281,813
• Therefore, after 40 years you have
• 1,409,065 - 281,813 1,127,252
• With your IRA, your account would be worth over
  500,000 more!

57
Financial Planning Online How to Build Your
Retirement Plan

• Go to http//www.quicken.com/retirement/planner/
  
• This Web site provides a framework for building a
  retirement plan based on your financial situation.

58
How Retirement Planning Fits within Your
Financial Plan

• Key decisions about retirement planning for your
  financial plan are
• Should you invest in a retirement plan?
• How much should you invest in a retirement plan?
• How should you allocate investments within your
  retirement plan?

59
Integrating Key Concepts
60
Integrating Key Concepts

• Part 1 Financial Planning Tools
• Part 2 Liquidity Management
• Part 3 Financing
• Part 4 Protecting Your Assets and Income
• Part 5 Investing
• Part 6 Retirement and Estate Planning
• In Chapter 19 we learned about retirement
  planning
• In Chapter 20 we will learn about estate planning