Chapter 16

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 6th Ed., Prentice Hall Inc.

Personal Finance:Personal Finance:An Integrated Planning ApproachAn Integrated Planning Approach

Winger & FrascaWinger & Frasca

Chapter 16Chapter 16Retirement and Pension PlanningRetirement and Pension Planning

http://www.prenhall.com/winger/


Major TopicsMajor Topics

Review company sponsored retirement plans

Review other sources of retirement funds Establish a personal retirement plan


Table 16.1 Table 16.1 NoNo Deferral of Taxes Deferral of Taxes$2,000 Annual Savings -Flat 28% tax rate$2,000 Annual Savings -Flat 28% tax rate

1 $1,440 $104 $1,5442 1,440 215 3,1993 1,440 334 4,972... ... ... ...18 1,440 3,593 53,50319 1,440 3,956 58,89920 1,440 4,344 64,683

Taxes due at maturity -0-Ending year’s balance after taxes $64,683

Year Contribution after taxes

Interest inc. after taxes 7.2%

Ending Balance


Table 16.1 Deferral of TaxesTable 16.1 Deferral of Taxes Tax-deductible IRA Tax-deductible IRA

1 $2,000 $200 $2,2002 2,000 420 4,6203 2,000 662 7,282... ... ... ...18 2,000 9,120 100,31819 2,000 10,232 112,55020 2,000 11,455 126,005

Taxes due at maturity -35,281Ending year’s balance after taxes $90,724


Interest inc. after taxes 10%

Ending Balance


Table 16.1 Deferral of TaxesTable 16.1 Deferral of Taxes Roth IRA Roth IRA

1 $1,440 $144 $1,5842 1,440 302 3,3263 1,440 477 5,243... ... ... ...18 1,440 6,566 72,22919 1,440 7,367 81,03620 1,440 8,248 90,724

Taxes due at maturity 0Ending year’s balance after taxes $90,724


Interest inc. after taxes 10%

Ending Balance


The Power of a Tax AdvantageThe Power of a Tax Advantage

Ending BalancesTax advantaged savings $90,723.60No deferral of taxes 64,683.27

Net Savings $26,040.33


Company Pension PlansCompany Pension Plans

Defined-benefit plans– Specifies monthly benefit you will receive at retirement

Defined-contribution plans.– Specifies amount you receive today.– Future benefits are uncertain.

Supplementary savings plans– Primarily cash or deferred arrangement 401(k)

plans


Plan ParticipationPlan Participation

Type of Plan Percent

All plans 79%

Defined Benefit 50%

Defined Contribution 57%

Cash or deferred arrangement 401(k) plans

55%

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


Qualified Plan DocumentsQualified Plan Documents

Summary Plan Description– overview of plan including structure of plan,

benefit calculation, benefit dates and rights Summary Annual Report

– annual update on financial status


Qualified Plan DocumentsQualified Plan Documents

Personal Benefits Statement– annual description of total pension benefits

currently accrued and vested Statement of Deferred Vested Benefits for

Terminating Employees– statement provided on termination


Pension TerminologyPension Terminology

Credited Year of Service– Typically requires 1,000 hours– Number of years of credited service will determine

pension benefits Accrued benefits

– accumulated benefits based upon credited years Vested benefits

– benefits you are entitled to regardless of future service


Vesting SchedulesVesting Schedules

TRA of 2001 provides different vesting schedules for employer contributions that match employee contributions and those that do not– Non-matching contributions vest 1 year later

Cliff vesting – – Full vesting after 5 years of service, with no vesting before then for non-

matching contributions – 4 years for matching contributions


Graded Vesting SchedulesGraded Vesting Schedules

Percent Non-matching

Matching

20% 3 years 2 years

40% 4 years 3 years

60% 5 years 4 years

80% 6 years 5 years

100% 7 years 6 years


Pension TerminologyPension Terminology

Normal Retirement Age– age at which you are entitled to full benefits

Early Retirement Age– earliest age at which you can retire with

reduced benefits


Defined Benefit Pension FormulasDefined Benefit Pension Formulas

Flat benefit method– benefits equal to a specified dollar amount or

percentage of income Unit benefit method

– benefits depend upon units of credit service


Defined Benefit Pension FormulasDefined Benefit Pension Formulas

Salary calculation in pension formula– career average approach– final average approach

Cash balance method– present value of future benefits credited to

employee account for each year of service


Survivor’s Benefits in Defined Survivor’s Benefits in Defined Benefit Plans for Married WorkersBenefit Plans for Married Workers

Automatically provided joint and last survivor annuity at retirement unless both spouses elect otherwise– Payments continue as long as you or your

spouse is alive– May be reduced benefits for surviving spouse

Alternative is a single life annuity – benefits cease at death of pensioner


Checklist - Pension Plan ReviewChecklist - Pension Plan Review

Type of plan Voluntary or mandatory contributions Vesting schedule Credited years of service Break in service Normal retirement age Payout options


Other Company Retirement Other Company Retirement PlansPlans

401(k), 403(b) and 457 Salary Reduction Plans

Profit Sharing Plans Employee Stock Ownership Plans (ESOP) Simplified Employee Pension Plans (SEP) Savings Incentive Match Plans (SIMPLE)


401(k), 403(b) and 457401(k), 403(b) and 457 Salary Reduction Plans Salary Reduction Plans

Taxability of earnings can be deferred until the income is withdrawn

Employer may provide matching contribution

There may be a choice of savings vehicles


Profit Sharing PlansProfit Sharing Plans

Contributions contingent upon the profitability of the firm

May payout before retirement Future savings may be highly uncertain


Employee Stock Ownership PlanEmployee Stock Ownership Plan (ESOP)(ESOP)

Contributions are invested primarily in the employer’s stock

Distributions are also made in stock Lack of diversification As you near retirement you may elect to put

part of your ESOP into diversified investments


Simplified Employee Pension Plan Simplified Employee Pension Plan (SEP)(SEP)

Company sponsored pension plan utilizing individual retirement accounts

Simplified accounting for the employer All contributions immediately vested Employee may make additional tax deferred

contributions


Savings Incentive Match Plans Savings Incentive Match Plans (SIMPLE)(SIMPLE)

For firms that employ 100 or fewer workers Simplifies reporting requirements Plan may consist of either an IRA or a 401k


Individual Retirement PlansIndividual Retirement Plans

Individual Retirement Accounts– Traditional IRA– Roth IRA

Keogh (HR-10) Plans


Individual Retirement AccountsIndividual Retirement Accounts

Trust or custodial account approved by the IRS– the approval is based on the tax status of the

account, not the merits of the investment Who is eligible for an IRA?

– every individual receiving income, or alimony – spouses of workers with market earnings



Who much can I contribute to an IRA?Year Limit

2001 $2,000

2002-2004 $3,000

2005-2007 $4,000

2008+ $5,000

Special catch up provisions for those age 50 and older



Are my IRA contributions deductible? If you or your spouse were covered by an

employer retirement plan, your allowable IRA deduction may be less than your allowable contributions.



Are my IRA contributions deductible? For those with a retirement plan, the

deduction is phased-out over the following income ranges


Phase-out rangesPhase-out ranges

Tax year beginning in

Single Returns

(thousands)

Joint Returns

(thousands)

2001 $33-43 $53-63

2002 34-44 54-64

2003 40-50 60-70

2004 45-55 65-75

2005 50-60 70-80

2006 50-60 75-85

2007+ 50-60 80-100



How are my withdrawals taxed? Deductible contributions and all earned

interest is taxed upon withdrawal Nondeductible contributions are not taxed

when withdrawn As with all qualified pension plans, there are

tax penalties for both early and late withdrawal of funds.


Roth IRARoth IRA

Contributions are not tax deductible Same contribution limits as traditional IRA More generous limits on phase out for high

incomes Returns and qualified distributions are tax-free Withdrawals are qualified if:

– the account has existed for 5 years, and

– you are over 59 1/2


Keogh (HR-10) PlansKeogh (HR-10) Plans

Can be set up by anyone with earnings from self-employment

Can be held in addition to a company sponsored pension plan

Generous contribution limits


Retirement AnnuitiesRetirement Annuities

Annuity contract– provides for some form of periodic payment

Accumulation period– term over which the principal in the contract is

building Liquidation period

– term over which the annuity pays out periodic benefits



Fixed annuity– the principal is guaranteed but the earnings can

vary Variable annuity

– invested in a portfolio of securities– value may vary with the market



Annuity starting date – when the annuity begins periodic payments

Immediate annuity– payments begin one period from current date

Deferred annuity– payments deferred until some later time period


Tradition IRA vs. Roth IRATradition IRA vs. Roth IRA

10% 15% 25% 35%

10% 0 $6,300 $18,901 $31,501

15% -$6,300 0 $12,600 $25,201

25% -$18,901 -$12,600 0 $12,600

35% -$31,501 -$25,201 -$12,600 0

Relative Advantage of a Traditional IRATax 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 20th year. The contribution to the Roth IRA is out of after-tax funds.


How Much Will $100,000 BuyHow Much Will $100,000 Buy

Males - Starting Age

Interest Rate 60 65 70

8% 866 964 1,103

7% 803 902 1,041

6% 741 840 979

Females -Starting Age

Interest Rate 60 65 70

8% 783 847 943

7% 719 784 882

6% 656 723 821

Estimates based on 1983 Group Annuity Mortality Table


Retirement Planning WorksheetRetirement Planning Worksheet

1.Current salary $60,000 2. Percentage replacement x 0.60 3. Retirement income target $36,000 4. Minus vested defined benefits -0 5. Minus Social Security -17,503 6. Required supplement $18,497


Retirement Planning Worksheet Retirement Planning Worksheet

6. Required supplemental income $18,497 7. Years to retirement 30 Inflation rate 3% Future value of $1 x 2.4273 Future value of supp. income $44,897 8. Years of retirement 24 Net discount rate 4% Present value of $1 annuity due x 15.8568 Lump sum needed at retirement $711,926


8. Lump-sum needed at retirement $711,926 9. Years to retirement 30 After-tax return on 7% investments Present funds $50,000 Future value of $1 x 7.6123 Future target resources 380,613 10. Needed savings $331,313



10. Needed savings $331,313 Future value of $1 annuity 94.4608 11. Needed current ann. savings $3,507



The EndThe End

Personal FinancePersonal FinanceAn Integrated Planning An Integrated Planning

ApproachApproachSixth EditionSixth Edition

Bernard J. WingerBernard J. WingerRalph R. FrascaRalph R. Frasca

Prentice-Hall, Inc.Prentice-Hall, Inc.

Chapter 16

Business

profit sharing

individual

qualified

normal retirement

ira contributions

pension terminology

retirement

matching contributions