Chapter 16


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Chapter 16

  1. 1. Personal Finance: An Integrated Planning Approach Winger & Frasca Chapter 16 Retirement and Pension Planning
  2. 2. Major Topics <ul><li>Review company sponsored retirement plans </li></ul><ul><li>Review other sources of retirement funds </li></ul><ul><li>Establish a personal retirement plan </li></ul>
  3. 3. Table 16.1 No Deferral of Taxes $2,000 Annual Savings -Flat 28% tax rate Year Contribution after taxes Interest inc. after taxes 7.2% Ending Balance
  4. 4. Table 16.1 Deferral of Taxes Tax-deductible IRA Year Contribution after taxes Interest inc. after taxes 10% Ending Balance
  5. 5. Table 16.1 Deferral of Taxes Roth IRA Year Contribution after taxes Interest inc. after taxes 10% Ending Balance
  6. 6. The Power of a Tax Advantage
  7. 7. Company Pension Plans <ul><li>Defined-benefit plans </li></ul><ul><ul><li>Specifies monthly benefit you will receive at retirement </li></ul></ul><ul><li>Defined-contribution plans. </li></ul><ul><ul><li>Specifies amount you receive today. </li></ul></ul><ul><ul><li>Future benefits are uncertain. </li></ul></ul><ul><li>Supplementary savings plans </li></ul><ul><ul><li>Primarily cash or deferred arrangement 401(k) plans </li></ul></ul>
  8. 8. Plan Participation Source: Percent of Full-time employees participating in retirement plans and tax-deferred retirement plans in medium and large establishments in 1997, U.S. Bureau of Labor Statistics 55% Cash or deferred arrangement 401(k) plans 57% Defined Contribution 50% Defined Benefit 79% All plans Percent Type of Plan
  9. 9. Qualified Plan Documents <ul><li>Summary Plan Description </li></ul><ul><ul><li>overview of plan including structure of plan, benefit calculation, benefit dates and rights </li></ul></ul><ul><li>Summary Annual Report </li></ul><ul><ul><li>annual update on financial status </li></ul></ul>
  10. 10. Qualified Plan Documents <ul><li>Personal Benefits Statement </li></ul><ul><ul><li>annual description of total pension benefits currently accrued and vested </li></ul></ul><ul><li>Statement of Deferred Vested Benefits for Terminating Employees </li></ul><ul><ul><li>statement provided on termination </li></ul></ul>
  11. 11. Pension Terminology <ul><li>Credited Year of Service </li></ul><ul><ul><li>Typically requires 1,000 hours </li></ul></ul><ul><ul><li>Number of years of credited service will determine pension benefits </li></ul></ul><ul><li>Accrued benefits </li></ul><ul><ul><li>accumulated benefits based upon credited years </li></ul></ul><ul><li>Vested benefits </li></ul><ul><ul><li>benefits you are entitled to regardless of future service </li></ul></ul>
  12. 12. Vesting Schedules <ul><li>TRA of 2001 provides different vesting schedules for employer contributions that match employee contributions and those that do not </li></ul><ul><ul><li>Non-matching contributions vest 1 year later </li></ul></ul><ul><li>Cliff vesting – </li></ul><ul><ul><li>Full vesting after 5 years of service, with no vesting before then for non-matching contributions </li></ul></ul><ul><ul><li>4 years for matching contributions </li></ul></ul>
  13. 13. Graded Vesting Schedules 6 years 7 years 100% 5 years 6 years 80% 4 years 5 years 60% 3 years 4 years 40% 2 years 3 years 20% Matching Non-matching Percent
  14. 14. Pension Terminology <ul><li>Normal Retirement Age </li></ul><ul><ul><li>age at which you are entitled to full benefits </li></ul></ul><ul><li>Early Retirement Age </li></ul><ul><ul><li>earliest age at which you can retire with reduced benefits </li></ul></ul>
  15. 15. Defined Benefit Pension Formulas <ul><li>Flat benefit method </li></ul><ul><ul><li>benefits equal to a specified dollar amount or percentage of income </li></ul></ul><ul><li>Unit benefit method </li></ul><ul><ul><li>benefits depend upon units of credit service </li></ul></ul>
  16. 16. Defined Benefit Pension Formulas <ul><li>Salary calculation in pension formula </li></ul><ul><ul><li>career average approach </li></ul></ul><ul><ul><li>final average approach </li></ul></ul><ul><li>Cash balance method </li></ul><ul><ul><li>present value of future benefits credited to employee account for each year of service </li></ul></ul>
  17. 17. Survivor’s Benefits in Defined Benefit Plans for Married Workers <ul><li>Automatically provided joint and last survivor annuity at retirement unless both spouses elect otherwise </li></ul><ul><ul><li>Payments continue as long as you or your spouse is alive </li></ul></ul><ul><ul><li>May be reduced benefits for surviving spouse </li></ul></ul><ul><li>Alternative is a single life annuity </li></ul><ul><ul><li>benefits cease at death of pensioner </li></ul></ul>
  18. 18. Checklist - Pension Plan Review <ul><li>Type of plan </li></ul><ul><li>Voluntary or mandatory contributions </li></ul><ul><li>Vesting schedule </li></ul><ul><li>Credited years of service </li></ul><ul><li>Break in service </li></ul><ul><li>Normal retirement age </li></ul><ul><li>Payout options </li></ul>
  19. 19. Other Company Retirement Plans <ul><li>401(k), 403(b) and 457 Salary Reduction Plans </li></ul><ul><li>Profit Sharing Plans </li></ul><ul><li>Employee Stock Ownership Plans (ESOP) </li></ul><ul><li>Simplified Employee Pension Plans (SEP) </li></ul><ul><li>Savings Incentive Match Plans (SIMPLE) </li></ul>
  20. 20. 401(k), 403(b) and 457 Salary Reduction Plans <ul><li>Taxability of earnings can be deferred until the income is withdrawn </li></ul><ul><li>Employer may provide matching contribution </li></ul><ul><li>There may be a choice of savings vehicles </li></ul>
  21. 21. Profit Sharing Plans <ul><li>Contributions contingent upon the profitability of the firm </li></ul><ul><li>May payout before retirement </li></ul><ul><li>Future savings may be highly uncertain </li></ul>
  22. 22. Employee Stock Ownership Plan (ESOP) <ul><li>Contributions are invested primarily in the employer’s stock </li></ul><ul><li>Distributions are also made in stock </li></ul><ul><li>Lack of diversification </li></ul><ul><li>As you near retirement you may elect to put part of your ESOP into diversified investments </li></ul>
  23. 23. Simplified Employee Pension Plan (SEP) <ul><li>Company sponsored pension plan utilizing individual retirement accounts </li></ul><ul><li>Simplified accounting for the employer </li></ul><ul><li>All contributions immediately vested </li></ul><ul><li>Employee may make additional tax deferred contributions </li></ul>
  24. 24. Savings Incentive Match Plans (SIMPLE) <ul><li>For firms that employ 100 or fewer workers </li></ul><ul><li>Simplifies reporting requirements </li></ul><ul><li>Plan may consist of either an IRA or a 401k </li></ul>
  25. 25. Individual Retirement Plans <ul><li>Individual Retirement Accounts </li></ul><ul><ul><li>Traditional IRA </li></ul></ul><ul><ul><li>Roth IRA </li></ul></ul><ul><li>Keogh (HR-10) Plans </li></ul>
  26. 26. Individual Retirement Accounts <ul><li>Trust or custodial account approved by the IRS </li></ul><ul><ul><li>the approval is based on the tax status of the account, not the merits of the investment </li></ul></ul><ul><li>Who is eligible for an IRA? </li></ul><ul><ul><li>every individual receiving income, or alimony </li></ul></ul><ul><ul><li>spouses of workers with market earnings </li></ul></ul>
  27. 27. Individual Retirement Accounts <ul><li>Who much can I contribute to an IRA? </li></ul>Special catch up provisions for those age 50 and older $5,000 2008+ $4,000 2005-2007 $3,000 2002-2004 $2,000 2001 Limit Year
  28. 28. Individual Retirement Accounts <ul><li>Are my IRA contributions deductible? </li></ul><ul><li>If you or your spouse were covered by an employer retirement plan, your allowable IRA deduction may be less than your allowable contributions. </li></ul>
  29. 29. Individual Retirement Accounts <ul><li>Are my IRA contributions deductible? </li></ul><ul><li>For those with a retirement plan, the deduction is phased-out over the following income ranges </li></ul>
  30. 30. Phase-out ranges 80-100 50-60 2007+ 75-85 50-60 2006 70-80 50-60 2005 65-75 45-55 2004 60-70 40-50 2003 54-64 34-44 2002 $53-63 $33-43 2001 Joint Returns (thousands) Single Returns (thousands) Tax year beginning in
  31. 31. Individual Retirement Accounts <ul><li>How are my withdrawals taxed? </li></ul><ul><li>Deductible contributions and all earned interest is taxed upon withdrawal </li></ul><ul><li>Nondeductible contributions are not taxed when withdrawn </li></ul><ul><li>As with all qualified pension plans, there are tax penalties for both early and late withdrawal of funds. </li></ul>
  32. 32. Roth IRA <ul><li>Contributions are not tax deductible </li></ul><ul><li>Same contribution limits as traditional IRA </li></ul><ul><li>More generous limits on phase out for high incomes </li></ul><ul><li>Returns and qualified distributions are tax-free </li></ul><ul><li>Withdrawals are qualified if: </li></ul><ul><ul><li>the account has existed for 5 years, and </li></ul></ul><ul><ul><li>you are over 59 1/2 </li></ul></ul>
  33. 33. Keogh (HR-10) Plans <ul><li>Can be set up by anyone with earnings from self-employment </li></ul><ul><li>Can be held in addition to a company sponsored pension plan </li></ul><ul><li>Generous contribution limits </li></ul>
  34. 34. Retirement Annuities <ul><li>Annuity contract </li></ul><ul><ul><li>provides for some form of periodic payment </li></ul></ul><ul><li>Accumulation period </li></ul><ul><ul><li>term over which the principal in the contract is building </li></ul></ul><ul><li>Liquidation period </li></ul><ul><ul><li>term over which the annuity pays out periodic benefits </li></ul></ul>
  35. 35. Retirement Annuities <ul><li>Fixed annuity </li></ul><ul><ul><li>the principal is guaranteed but the earnings can vary </li></ul></ul><ul><li>Variable annuity </li></ul><ul><ul><li>invested in a portfolio of securities </li></ul></ul><ul><ul><li>value may vary with the market </li></ul></ul>
  36. 36. Retirement Annuities <ul><li>Annuity starting date </li></ul><ul><ul><li>when the annuity begins periodic payments </li></ul></ul><ul><li>Immediate annuity </li></ul><ul><ul><li>payments begin one period from current date </li></ul></ul><ul><li>Deferred annuity </li></ul><ul><ul><li>payments deferred until some later time period </li></ul></ul>
  37. 37. Tradition IRA vs. Roth IRA Relative Advantage of a Traditional IRA Tax rate in accumulation period Tax rate in payout period Assuming a annual $2,000 contribution for 20-years and a lump-sum distribution in the 20 th year. The contribution to the Roth IRA is out of after-tax funds. 0 -$12,600 -$25,201 -$31,501 35% $12,600 0 -$12,600 -$18,901 25% $25,201 $12,600 0 -$6,300 15% $31,501 $18,901 $6,300 0 10% 35% 25% 15% 10%
  38. 38. How Much Will $100,000 Buy Estimates based on 1983 Group Annuity Mortality Table
  39. 39. Retirement Planning Worksheet
  40. 40. Retirement Planning Worksheet
  41. 41. Retirement Planning Worksheet
  42. 42. Retirement Planning Worksheet
  43. 43. The End Personal Finance An Integrated Planning Approach Sixth Edition Bernard J. Winger Ralph R. Frasca Prentice-Hall, Inc.