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Slides by Pamela L. Hall

Western Washington University

Retirement Planning

Chapter 16

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Introduction

Average life expectancy is over 70 years 100 years ago it was about 55 years so

there wasn’t much need for retirement planning

If you retire when you are 65, you may still have 20+ years remaining and you’ll need money during that time

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Introduction

One fundamental error many people make is not diversifying properly Enron employees, for example

The earlier you start saving for retirement the easier it is

The key is planning

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Threats and Protections

Threats Inflation Heath-care expenses Cost of long-term care Estate taxes Income taxes State and local taxes

Protections Employer pension

plans Retirement savings

plan Social security Wise investing and

spending Medicare Health insurance Estate planning

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A Time Line for Making Important Choices

The time line starts TODAYDuring your working years you need to

periodically review you retirement planBy age 50 you should start thinking more about

what you’d like to do during retirement By age 55 you can begin withdrawing money from

several retirement plans without penalty By age 59½ more options are available By age 65 (the “traditional” retirement age) you

become eligible for many important benefits By age 70½ you must begin withdrawing money from

most retirement accounts

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Factors That Determine Your Savings Needs

Your current ageYour current incomeYour desired retirement incomeYour current retirement savingsOther sources of retirement income (Social

Security, etc.)Your tax rateThe expected rate of inflationThe expected return on your retirement

savings

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The Lessons of Saving for Retirement

Start early and stick with itSave as much as you can afford each

month It’s the savings today that will be earning you

the most interest on interestTake advantage of tax deferred retirement

plansDon’t be too conservative with your

investments While you’re young, you can handle

fluctuations in your retirement funds

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Understanding the Social Security System

Old Age and Survivors Insurance Fund Provides monthly benefits to retired workers and

their survivorsDisability Insurance Trust Fund

Provides benefits to partially or totally disabled workers

Hospital Insurance Trust Fund (Medicare—Part A)

Supplementary Medical Insurance Trust Fund (Medicare—Part B) Provides health-care benefits to elderly Americans

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Social Security

FICA (Federal Insurance Contributions Act) deductions represent the amount you contribute to Social Security Initially tax was 1% on earnings up to $3000 Today rate is 15.3% of earnings up to a set

amount that changes yearly (in 2002 it was $83,000) 12.4% goes to Old Age fund and 2.9% to Hospital Trust

fund Earnings above the limit are still subject to 2.9%

Medicare tax ½ of tax is paid by you and ½ is paid by

employer

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Applying for Social Security Benefits

Once you become eligible for benefits, you must apply Provide evidence that you qualify

Birth certificate is generally sufficient Recent W-2 or tax return

The age at which you can receive benefits is rising Currently it’s about 65 ½ but if you

were born after 1960, it’s 67

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Computing Your Retirement Benefits

Based on what you’ve earned throughout your working life (rather than the last few years of your career)

If you begin withdrawing social security at the ‘normal’ retirement age, your benefit is determined based on the average amount you’ve earned (inflation-adjusted) over the past 35 years Request a Personal Earnings and Benefits

Estimate Statement (PEBES) Make certain it’s accurate (your earnings)

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Other Social Security Issues

Individual vs. Family benefits Retired workers as well as dependent spouse and

young children receive benefits Upper limit exists to total Social Security benefits one

family can receive

Survivor benefits If you die (even before you reach retirement age)

your spouse and children under age 18 will receive survivor benefits

Working after retirement If you work (even part-time) after retirement, you

may lose some of your benefits

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The Future of the Social Security System

Will it be around by the time you retire? By 2025 the social security system will be

paying out more than it is taking in Since the program began in 1930s, it has

been ‘fixed’ 42 times ‘Fixes’ usually mean raising taxes or the wage base Suggested changes

Invest some of current surplus in stocks Force workers to save via mandatory retirement

accounts We don’t know what will happen with Social

Security, so plan for your own retirement

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Employer-Sponsored Retirement Plans

Will probably provide bulk of your retirement income Qualified retirement plan—meets certain

legal requirements and offers tax advantages to both employer and employee Defined benefit plans—you are guaranteed a

certain benefit each year [Ex: pension plan] Defined contribution plan—employer guarantees

a yearly contribution while you’re working but doesn’t guarantee a retirement benefit [Ex: 401(k) and 403(b) plans]

Trend is toward these plans and away from defined benefit plans, but some employers offer both

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Defined Benefit Plan

Many plans are fully funded by employer but others require contribution by employee

Benefits paid based on employee’s income and the number of years employed at company General rule of thumb—multiply number of

years you’ve worked for company by 0.015 times your final salary to estimate your annual pension benefit

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Defined Benefit Plan

Many plans state that if you leave your employer before certain number of years have passed, will lose all or part of retirement benefits (i.e., you are not vested)

Once you are vested, your benefits upon retirement are guaranteed

Many pension plans are not being adequately funded ERISA attempts to protect employees, but

doesn’t cover state and local government employees

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Key Questions to Ask

About defined benefit plans What are the vesting requirements? What benefits have been credited to your account as of

now Will receive periodic report

What is minimum age for a full pension? Early retirement? Are pension rights protected during leaves of absence,

disability, layoffs? Is the plan fully funded? Does the plan have a COLA adjustment? What death benefits are paid to spouse? How are the pension funds invested? How are individual benefits determined?

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Defined Contribution Plans

AKA money purchase plans, profit-sharing plans, employee stock option plans, 401 (k) plans, 403(b) plans

Common characteristics Contributions come from both employee and

employer Typically employer matches employee’s contribution up

to certain amount Employee has more control as to how funds are

invested Most plans offer wide range of investment opportunities

Participation may be partly or wholly voluntary

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Defined Contribution Plans

Can reduce your taxes Your taxable income is reduced by the

amount you contribute Example: You pay $2,000 a year into your 401(k)

and you are in the 28% tax bracket Your taxable income is reduced by $2,000 a year,

saving you $560 a year. So, your $2,000 retirement savings only cost $1,440.

You pay taxes on the amount you withdraw once you retire, but not until then

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Defined Contribution Plans

All plans set a maximum contribution up to limit specified by IRS Current limit is $11,000/year or 15% of

income, whichever is lessVesting requirements differ across

employers Typically your contributions vest

immediately but several years may pass before employer’s contributions vest

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Defined Contribution Plans

Investment Options Many offer numerous mutual funds for you to choose from

Changing jobs If you change jobs you may receive a lump sum comprised of

Your portion of contributions Your employer’s portion (if vested) Your investment returns

You should roll this amount over into a rollover IRA If you don’t, may be subject to a 20% withholding tax + penalties

Borrowing money from your retirement plan It’s possible and then you pay the money back to yourself with

interest over a specified time period But, the interest rate you pay yourself may be less than what

you could have earned and if you leave your job or are laid off, you have only 30 days to repay or you’ll face a tax penalty

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Individual Retirement Plans

Many individuals have their own retirement plan—the best known is the IRA

Regular IRAs Can contribute up to $3,000 ($6,000 total if married—

even if spouse doesn’t work) Ceilings placed on the amount you can deduct (based on

your income) unless you are not covered by a qualified retirement plan, then can deduct full amount (up to the limits specified above)

Even if you can’t deduct IRA contributions, earnings on IRA are still tax deferred

Can contribute to an IRA through 4/15 and still have it count on prior year’s tax return

You control where the money is invested: CDs, bonds, stocks, etc.

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Individual Retirement Accounts

Roth IRAs All earnings are tax deferred Contributions are not tax deductible But, all withdrawals are tax free Higher income limits

Can make a full contribution as long as your AGI < $150,000/year (married)

With a regular IRA can only take a full contribution if you make < $53,000 (married)

Can start using your savings prior to age 59½ for any purpose

Can make tax and penalty-free withdrawals (if account has been opened for 5+ years) to purchase first home

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Individual Retirement Accounts

Rollover IRAs Differs from regular IRA in that

You can deposit your rollover funds in a lump sum, regardless of amount, but don’t mix with an existing IRA account

You generally cannot make additional contributions to a rollover IRA

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Individual Retirement Plans

SEP Plans Simplified employee pension plan

For small businesses with < 25 employees

Basically specialized IRA

Keogh Plans Pension plan for self-employed people

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Payout Options

Annuity—a series of regular, level, monthly payments, usually lasts for rest of your life

Adv: security (regular payments, can’t outlive benefits); spouse may get benefits after your death

Disadv: may not be indexed for inflation; lack of flexibility; taxes due on annuity every year

Periodic payments—installment payments of roughly equal amount over specified time period

Adv: security (regular pmts); larger payments than an annuity; may roll some payments into an IRA

Disadv: taxes due on the amount received each year (may knock you into an higher bracket); no guarantee of lifetime income; lack of flexibility

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Payout Options

Lump sum—a cash payment of all the money in your account

Adv: total control over what is done with money; eligible for forward averaging which can reduce your taxes

Disadv: taxes due immediately; no guarantee you won’t outlive your financial resources; you may spend money too quickly

IRA rollover—lump-sum payment is deposited into special rollover IRA

Adv: investments continue to be tax-deferred; control over where money is invested; flexibility in timing and amounts withdrawn

Disadv: may pay more taxes than if lump sum withdrawal made; MUST begin regular withdrawal at 70½

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Receiving Retirement Benefits

What is best for you may not be what works for someone else

Consult with your benefits office Many offer retirement planning

seminars

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Choosing An AnnuityVery popularMust consider:

Rate—is it fixed or variable? Fixed rate offers a fixed payment throughout life of annuity

Sales commission—are you charged a load fee? Withdrawal penalties—are there any, do they decline

over time? Rates and annual fees—comparison shop Financial strength of issuer—annuities are not federally

insured; most are sold by life insurance companies Will only receive your annuity payment if company remains in

business