Ready Set Retire - Farming: Investment Planning - Iowa State ...
Farming:InvestmentPlanningIf there is one lesson to be learned fromthe unstable farm land values andstock markets in recent decades, it isthat having all of a family’s investmentsin one venture is risky. The purposeof this pamphlet is to present issuesin investment considerations beforeretirement and at retirement.Investments BeforeRetirementIn spite of the recommendations ofexperts who suggest that retirementplanning should begin early, manycouples postpone planning for retirementuntil they are in their 40s and 50s. Thechildren are on their own, the initialoutlays for land, equipment, andmachinery have been completed, andit is time to think about puttingmoney aside for retirement.One investment option for farm couplesis a traditional IRA. Up to $3,000may be contributed to an IRA eachyear. If you are not covered by anemployer-sponsored pension plan,your contributions to a traditionalIRA are tax deductible, i.e., the amountyou deposit is not counted as part ofyour taxable income for that year. Ifyou are covered under an employer’spension plan, whether your IRAcontribution is deductible depends onyour income. Earnings grow tax-deferred until withdrawal.Pm-1167i Revised January 2002A Roth IRA is another possibility.Contributions to a Roth IRA (up to$3,000 annually) are not tax-deduct-ible, but distributions at retirementare tax-free. Eligibility to contributeto a Roth is dependent on income(less than $160,000 for married filingjointly). For more information onIRAs, see Retirement InvestmentOptions (PM 1822), cost publication.Keogh plans, established by Congressunder the 1962 Keogh Act, aredesigned to provide retirementmonies for self-employed individualsand have advantages similar to theretirement plans of corporations.Basically, a Keogh plan allows up to$40,000 (in 2002) of compensationto be set aside in various types ofapproved investment funds. Amountscontributed to the plan are taxdeductible (maximum deduction is25 percent of aggregate pay of eligibleemployees), as is income earned bythe investments. Income taxes onboth the contributions and theearnings from the investment arepayable when money is withdrawnfrom the fund. Because withdrawalsare usually after retirement, the taxliability is likely to be lower becausethe individual will be in a lower taxbracket. As with an IRA, an indi-vidual may begin to withdraw moneyfrom a Keogh plan after age 591⁄2;withdrawals must start at age 701⁄2.A Simplified Employee Pension(SEP) allows employers to makecontributions toward their own andtheir employees’ retirement withoutthe administrative complexities of aKeogh plan. A self-employed personis considered both an employer andan employee. With a SEP, the em-ployer contributes to a traditionalIRA (called a SEP-IRA) for eacheligible employee. In 2002, themaximum contribution to a SEP-IRAis 15 percent of compensation (up to$200,000) or $30,000, whichever isless.SIMPLE plans (Savings Incentive MatchPlan for Employees) are the newestretirement investment option for self-employed individuals and smallbusinesses having 100 or feweremployees who earned compensationof $5,000 or more during the year.These plans can be set up as either aSIMPLE IRA or a SIMPLE 404(k)account and involve both employeeand employer contributions. Themaximum employee contribution for2002 is $7,000. The annual employermatch is generally required to be adollar-for-dollar match up to 3 percentof the employee’s contribution. Insteadof using a match formula, the employercan choose to make flat contributionsof 2 percent of compensation forevery eligible employee up to amaximum contribution of $4,000.
For more information on retirementinvestment options for self-employedindividuals and small businesses, seeRetirement Investment Options (PM 1822),cost publication. Retirement Plans forSmall Businesses (publication 560) is anInternal Revenue Service publicationthat provides further details on theretirement plans. It is available free at800-829-3676 or at http://www.irs.ustreas.gov.The retirement plans presented hereare individual retirement plans, ownedby an individual, not by a couple. Ingeneral, the owner of the plan willdesignate the spouse as the beneficiaryupon the owner’s death. If eligible todo so, it is generally advantageous foreach spouse to contribute to a retire-ment plan. It is beneficial for the spousewho works in the farm business butdoes not receive pay to become anemployee of the business, receive asalary, and have a SEP or SIMPLEplan established in his or her name.For example, a husband’s taxableearned income would be reduced bythe amount of his wife’s salary. Inaddition, there would be the deductionof her retirement plan contribution.Cash value life insurance, particularlyuniversal life, can ensure savings forretirement. The cash value of the lifeinsurance can be used as security for aloan for special needs during retirement.Or the cash value can be converted to anannuity to provide retirement income.Probably the most important principlein investing prior to retirement isdiversification. The above plansshould be considered first because of theirpreferential tax treatment. Then considerinvestment in stocks and bonds and realestate. The past 20 years have shownhow risky land investment can be, whenit is the only investment. Purchasingadditional land to “provide for retirement”is probably not as good an investmentas establishing a Keogh plan and anIRA for each member of the couple.A financial plan can be thought of asa pyramid, with the base solid, conser-vative investments. Once that base isbuilt, the pyramid can be topped offwith riskier investments that maygive higher returns. Contributionsand the accumulated interest on IRAsand Keogh plans, plus cash andequity in the dwelling should be themajor components of the pyramidbase at retirement. Next should beinvestment in land and other real estate,along with stocks and bonds. Finally,investments in business assets andcommodities can top off the pyramid.Investments UponRetirementIn addition to preretirement investing,many farm couples are faced withdecisions about investments atretirement. Such decisions are especiallyimportant if the couple has sold all orpart of the farm and has received alump sum as partial or total payment.The investment decisions made shouldbe geared toward using the money toprovide housing and current incomefor both spouses until their deaths. Ifthe sale of the farm business involvedthe sale of the couple’s residence, oneof the obvious investments could bea different dwelling. A couple choosingto rent would, of course, not makethis investment. The estimated monthlyhousing expenses (See Ready, Set,Retire—Farming: Special Considerations,Pm-1167e) would need to be ad-justed accordingly. After the livingarrangements have been secured, atleast a portion of the remaindershould be invested in such a way thatadequate monthly income is ensured.Types of InvestmentAvailableThere are two basic classes of invest-ments. The first involves lending toothers through savings accounts,bonds, mortgages and installmentcontracts, and annuities. The secondis equity ownership, in which all or aportion of something is owned throughoutright purchase (as in the purchaseof real estate), or the purchase ofstock directly or through mutual funds.Savings AccountsThese are probably the most familiarof the investment instruments, and canbe savings deposits like passbook savingsand NOW accounts (in which thereis ready access to the funds) or timedeposits (in which there is a penaltyif the funds are withdrawn prior tothe maturity of the deposit). In general,time deposits earn a higher rate ofreturn than passbook savings accounts.BondsBonds are instruments issued bygovernmental units or by corporationsfor the purpose of raising funds, usuallyfor capital improvements. Bonds canbe issued by governmental units,including the federal government, stategovernments, and local governments.Bonds are available from the issuingbody, through stock brokers, or through amutual fund. A mutual fund is so namedbecause the funds of an investor group,both large and small investors, are pooledto purchase bonds from a variety ofissuers for a diversified portfolio. Somemutual funds specialize in municipalbonds, others in corporate bonds.Mortgages andInstallment ContractsSelling the farm on a land contractwith the sellers receiving interest andprincipal payments amounts tolending money to the farm purchasers.Life Insurance andAnnuitiesPurchasing life insurance or an annuitycan take alternate forms. Essentially,the purchaser deposits a sum of moneyand is returned the principal plusinterest in a single payment at a laterdate or in a series of periodic payments,depending on the terms of theannuity or the life insurance policy.
Common or Preferred StockOwning a share of stock in a corpo-ration essentially means owning apart of the corporation. Stock can bepurchased directly, through a stockbroker, or through a mutual fundthat specializes in stock purchases.Real EstateReal estate can be purchased in anexchange between private individu-als, as in the purchase of rentalproperty, or it can be purchasedthrough investment in a real estatetrust or syndicate. In general, if thelatter course is chosen, there will bemanagement fees. If the formeralternative is selected, the investor willbe the manager, responsible for propertyupkeep, rental, and the like. Invest-ment in farm land is a particular typeof investment in real estate, with manyof the same limitations.BusinessAn investment could be made in abusiness venture, including but notTable 1. Investment alternatives compared by evaluation criteria.Protection ProtectionAnnual Management against againstInvestment Risk return Liquidity required inflation deflation Income taxSavings None, if Low High None None Good Interest taxed asaccounts insured ordinary incomeBonds Low to Low to Variable Very little None Good Interestmoderate. moderate taxed asCan be ordinarysubstantial income,with traded some exemptbonds. or deferredMortgages Variable Low to Low Low to None Variable; Interest taxedand moderate moderate may risk as ordinaryinstallment forfeiture incomecontractsLife None, if Low High None Almost Good Interest incomeinsurance company is none deferred toand financially maturity unlessannuities sound paidCommon and Moderate Moderate Variable Moderate Variable Poor Dividends andpreferred to sub- to high to sub- but gen- capital gainsstock stantial stantial erally good taxed as ordinaryincomeMutual Moderate Moderate High Very little Variable Variable Same as abovefunds to sub- to high but gen-stantial erally goodReal estate Variable Variable Moderate Moderate Generally Moderate Same as aboveto sub- goodstantialReal estate Moderate Variable Very little Gernerally Moderate Same as abovetrust or goodsyndicateLimited Moderate Variable Variable Low to Depends on Depends on Same as abovepartner- to sub- moderate investment investmentships stantialBusiness Moderate Variable Moderate Moderate Variable Variable Same as aboveto sub- to sub-stantial stantialAdapted from NCR 49, Retirement Planning for Farm Families, 1981, Ralph Hepp, Michigan State University, and Michael Boehje, Iowa StateUniversity.
. . . and justice for allThe U.S. Department of Agriculture (USDA) prohibitsdiscrimination in all its programs and activities on thebasis of race, color, national origin, gender, religion,age, disability, political beliefs, sexual orientation, andmarital or family status. (Not all prohibited bases applyto all programs.) Many materials can be made availablein alternative formats for ADA clients. To file acomplaint of discrimination, write USDA, Office of CivilRights, Room 326-W, Whitten Building, 14th andIndependence Avenue, SW, Washington, DC 20250-9410 or call 202-720-5964.Issued in furtherance of Cooperative Extension work,Acts of May 8 and June 30, 1914, in cooperation withthe U.S. Department of Agriculture. Stanley R.Johnson, director, Cooperative Extension Service, IowaState University of Science and Technology, Ames,Iowa.limited to, the farm business. Theinvestor puts up capital and receivesboth the gains and the losses. Investmentcould be though a general partnershipor a limited partnership. Investing inbusiness assets, as in machinery,livestock, and the like is another wayto invest in a business.Investment CriteriaWhen considering either equityinvestments or investments in loans,there are several criteria that shouldbe considered. They include: degreeof risk, annual return, liquidity,marketability, personal managementrequired, protection against inflation,and the tax treatment of the investment.Table 1 compares investment alterna-tives according to these criteria.RiskThe major risk is the loss of the capitalinvested. At retirement, most coupleswant to minimize this risk by selectinglow-risk investments. This does notnecessarily mean the couple is limitedto insured deposits and U.S. governmentsavings bonds. There are excellent low-risk investments available in municipalbonds, mutual funds, and annuitiesoffered by life insurance companies.Annual ReturnA general principle is that the higherthe rate of return, the greater the risk.The goal in investing is to maximizethe annual return while minimizingthe risk. The highest returns in the pastfew years have been in stocks, availabledirectly or through participation inone of a number of mutual funds. Tomeasure the returns accurately, incomefrom both the principal and growthof the principal must be combined.Liquidity andMarketabilityLiquidity refers to the degree to whichthe purchase or selling price approxi-mates the cost or value that is as-signed to the investment. The mar-ketability of an asset refers to theease with which an investment can bebought and sold. The ideal is goodmarketability and good liquidity.Savings accounts generally have thiscombination; bonds have goodmarketability and average liquidity;common stocks have good marketabilityand poor liquidity. Depending on theeconomic climate, real estate often hashigh marketability and low liquidity. Ingeneral, the greater the risk associatedwith the investment, the lower its liquidity.Management RequiredInvesting in a certificate of depositrequires no management, once thedecision has been made to invest. Thecertificateispurchased,and,atmaturity,redeemed. Not so with an investmentin a four-plex that is rented. The realestate investment requires constantattention in terms of maintenance,tenant relationships, and the like. True,such services can be purchased, butthere is a fee that can substantiallyreduce the rate of return.Protection AgainstInflation-DeflationLending to others traditionally hasprovided steady but fixed returns withno opportunity for the growth of thecapital invested. In times of inflation,the returns on this type of investmenthave fallen behind the returns onequity ownership. Equity ownership,on the other hand, has traditionallyprovided greater returns during timesof inflation and greater losses duringtimes of deflation. If inflation anddeflation could be predicted accurately,shifts would be made from lendinginstruments to equity ownershipwhen inflation is on the rise, andback during times of deflation. Sinceeven the best financial analysts arenot able to forecast economic cycleswith that level of accuracy, the key tosound investing is diversification.TaxationThe final consideration is the taxtreatment on returns from investments.In general, returns such as rent orinterest are taxed as ordinary incomein the tax year during which thosereturns are realized. Taxes on theappreciation will be deferred until theinvestment is sold. The capital gainwill be taxed at a lower rate thanordinary income. Careful planningneeds to occur to minimize the impactof capital gains tax liability whenequity in anything is sold.For Further ReadingGrowing Your Nest Egg: Risk andReturn (Pm 1821)Retirement Investment Options (Pm1822) cost publicationFile: Economics 1-5Prepared by Mary Winter, professor,Department of Family Environment; andCarol B. Volker, former extension familyenvironment specialist (family resourcemanagement). Revised by William Edwards,extension agricultural economics specialist.