Retirement savings and Income Planning Chapter 8

Paul estimates he will need a $75,000 annual income in today's dollars when he retires 10 years from now. He assumes a 3% annual rate of inflation, a 5% after-tax rate of return on his investments, and a 20-year retirement period. What lump-sum amount should Paul have accumulated over the next 10 years to support his retirement income need?

$1,689,612 The client's first-year retirement income need is $100,794. PV = -$75,000 i = 3 n = 10 FV = $100,794 The total capital required to support this need for 20 years is $1,689,612. In BEGIN mode (the client will make annual withdrawals at the beginning of each year) PMT = $100,794 n = 20 i = 1.9417 [(1.05 ÷ 1.03) - 1] × 100 PVAD = -$1,689,612

Jeanette uses the serial payment approach to calculate the amount she must save each year to accumulate her desired retirement income fund. She assumes an annual inflation rate of 4%, and an annual investment rate of return of 7%. If she determines that she must save $10,000 in the first year, how much must she save in the second year to meet her goal?

$10,400 Under the serial payment approach, the first-year savings amount is computed and then increased each year by the inflation rate. In this example, the amount in the second year is $10,000 × 1.04, or $10,400.

Richard participates in a defined benefit pension plan at his place of employment. His projected monthly benefit under the plan is $1,000. If the plan provides life insurance for Richard, the death benefit payable under the policy is limited to

$100,000. Defined benefit pension plans use the 100 times test for determining whether they comply with the incidental benefit rules. Under this test, the death benefit cannot exceed 100 times the participant's projected monthly benefit.

Carol has an additional retirement need of $30,000 annually in today's dollars. She will retire in 15 years and projects a retirement period of 20 years. Carol believes she can achieve a 6% after-tax rate of return and is assuming a 4% annual rate of inflation. Using the level payment approach, how much will Carol need to save in a single annual payment at the end of each year to fund her retirement need?

$38,973.65 What will it take to have $30,000 of today's purchasing power in 15 years? $30,000, +/-, PV 4, I 15, N 0, PMT FV Answer: $54,028.3052 How much needs to be in the account at retirement to fund 20 years of serial payments at the first of each year? +/-, +/-, PMT (Hitting the +/- button twice before PMT allows the entire FV of 54,028.3052 to be entered as the PMT quickly and to nine decimal places, The second +/- makes the value positive again) Shift, MAR (To get into the Begin Mode) 0, FV [(1.06 ÷ 1.04) -1] × 100 = 1.9231, I 20, N PV Answer: -$907,149.5440 How much needs to be saved at the end of each year to have $907,149.5440? +/-, $907,149.5440, FV (Hitting the +/- here allows the calculator to take the answer and turns the number positive) 15, N 6, I 0, PV Shift MAR (To be in the End Mode.) PMT Answer: $38,973.65

Lisa has accumulated assets of $350,000 that she wishes to dedicate to her retirement. Inflation is anticipated to average 2% over the next 20 years. She plans on retiring in 15 years. What would be the value of her fund at retirement if Lisa can average a 5% after-tax rate of return on her accumulated assets?

$727,625 This is a future value calculation. PV = -$350,000 i = 5 (after-tax rate of return) n = 15 (years to retirement) FV = $727,625

Which type of assumed annual rate of return is frequently used in retirement planning calculations?

A flat annual return based on past performance Most planners use a flat annual rate of return based on past performance. The Black-Scholes model is a stock option valuation model. The Consumer Price Index (CPI) measures inflation.

If the client's business objectives are to reduce income tax, reward executive employees, retain and recruit employees, and reduce employee turnover, which plan selection approach is the client using?

A pension plan or a profit-sharing plan

Which of the following can be used as a funding vehicle for tax-sheltered annuities (TSAs)? Stocks Bonds Annuities Regulated investment company shares held within a custodial account

Annuities Regulated investment company shares held within a custodial account

A businessowner-client approaches a financial planner for advice on selecting a retirement plan for the business. What factors should guide the financial planner's recommendations? The owner's retirement savings need The owner's current age The amount of risk the client is comfortable assuming The financial stability of the business

I, II, III and IV

The employee bears the investment risk in all of the following types of retirement plans except

cash balance pension plans. Employees bear the investment risk in defined contribution plans, and employers bear the investment risk in defined benefit plans. Cash balance pension plans are defined benefit plans; all the other answer choices are defined contribution plans

A planner may use a before-tax rate of return in making projections regarding the preretirement investment returns for all of the following assets except

mutual fund held outside a qualified retirement plan. Using a before-tax rate of return to project investment performance is appropriate for tax-advantaged assets, such as qualified plans and IRAs, because the earnings on these assets are not taxed each year as they accumulate.

Paul estimates he will need $75,000 of annual income in today's dollars when he retires 10 years from now. He assumes a 3% annual rate of inflation, a 5% after-tax rate of return on his investments, and a 20-year retirement period. Using the serial payment approach, how much will Paul need to save in a single annual payment at the end of the first year to fund his retirement need?

$118,578.00 What will it take in ten years to have $75,000 of today's purchasing power? 75,000, +/-, PV 3, I 10, N FV Answer: $100,793.7285 What does Paul need to have in his account when he retires to produce a serial payment of $100,793.7285 at the beginning of the year for 20 years? +/-, +/-, PMT (This enters $100,793.7285 into the PMT as a positive value. The first +/- allows the calculator to accept the number. The second +/- makes it a positive number.) Shift, MAR (To get into the Begin mode.) 20, N 0, FV [(1.05 ÷ 1.03) - 1] × 100 = 1.9417, I PV Answer: $1,689,607.5595 What is $1,689,607.5595 in 10 years with inflation taken out of it? This step is critical because it prepares for the serial payment from today to retirement by removing the inflation from the dollar goal in 10 years. Serial payments account for inflation by adjusting the interest rate. Without expressing the FV in today's dollars, inflation will be double counted for the investment period. +/- $1,689,607.5595, FV (Only one +/- is needed here because the first +/- allows the calculator to accept the value and the PV was negative so after one +/- the new value will for FV will be positive.) 10, N 0, PMT 3, I PV Answer: -$1,257,226.7036 What is the first serial payment required at the end of the first year to have $1,257,226.7036 in 10 years? +/-, FV (This enters the result from aboe and changes the sing to positive $1,257,226.7036 Shift, MAR (To get in the End mode.) [(1.05 ÷ 1.03) - 1] × 100 = 1.9417, I 0, PV 10, N PMT Answer: $115,124.2738 This answer is in today's dollars, but the first payment will be made in a year, so... $115,124.27 X 1.03 = $118,578

Brad Elberly has been the sole owner and operator of Woodmasters Inc. for the past 15 years. Brad is age 45, and his salary from the business is $130,000. Brad and his wife, Laura, want to retire when Brad is age 65. Relevant information regarding the business is summarized below: Financial performance fluctuated over the first 10 years. Cash flow and profits have stabilized during the past five years and are expected to show modest but consistent growth in the future. Excess cash flow of approximately $150,000 is expected to be available this year. Future years should be about the same. Brad has expressed some concern about the company's outdated equipment and is considering renovating the plant and replacing the outdated equipment over the next five years. The total cost should be about $300,000. Total compensation for all employees (including Brad) is $245,000. The four full-time rank-and-file employees range from age 19 to age 38 and have been with Woodmasters for periods ranging from four months to six years. Age and service information is shown below: Employee Age CompletedYears of Service Compensation Brad 45 15 years $130,000 Beth 38 6 years $40,000 Todd 27 6 months $25,000 Carol 30 2 years $28,000 Jim 19 4 months $22,000 Assuming that Brad and Laura need to start saving approximately 17% of Brad's salary to build their retirement fund, which one of the following statements describes the most appropriate qualified plan(s) for Woodmasters, assuming Brad wants to minimize the plan cost?

A safe harbor 401(k) plan would be appropriate. Selecting a plan means selecting the best plan for the owner (i.e., the owner gets the desired or needed amount at the minimum cost for the other employees). Any retirement plan installed by the company would have to be affordable, considering the need for large cash outlays to update company equipment. The safe harbor 401(k) plan is the best choice since it not only fits within the contribution requirements with flexibility, but also meets the objective of minimizing cost. By increasing his compensation and using the increase as his deferral, Brad will get a disproportionate share of the contribution, and because of his much higher compensation, the nonelective contribution will be skewed in his favor. Thus, he can meet his personal contribution requirement while paying significantly less for the other participants. A 401(k) safe harbor plan will allow Brad to defer $19,500 in 2020. The required matching contribution is dollar-for-dollar of the first 3% of deferral and $.50 on the dollar for the next 2%. Brad needs only 17% of his current compensation, so we would choose the safe harbor 401(k), and not a defined benefit plan, since we can achieve the desired savings with a contribution that is less than 25%. (This calculation is not required, but knowledge of the safe harbor plan is.)

What may be the client's personal retirement plan objective if he selects a qualified defined benefit pension plan as the retirement plan for his company? An approaching retirement need A desire to maximize tax benefits to the business Selectively choose participants in the plan Maximize retirement contributions for older workers

An approaching retirement need A desire to maximize tax benefits to the business Maximize retirement contributions for older workers

Which of the following constitutes unrelated business taxable income (UBTI) to a qualified plan trust?

Dividends from common stock purchased on margin Unrelated business taxable income (UBTI) is gross income generated by a qualified plan trust that is not related to the function that is the basis for the trust's income tax exemption. In addition, the trust is generally prohibited from incurring debt. Therefore, dividends declared on common stock purchased on margin are treated as UBTI

Which of the following events should trigger a recalculation of the retirement needs analysis? Marriage Employment change Change in FICA rate Significant income change

Marriage Employment change Significant income change The retirement needs analysis should be recalculated any time there is a change in the client's life such as marriage, divorce, births, deaths, employment and income, or health. Temporary changes in tax laws will not impact the retirement needs over the long term.

Sharon plans to retire next year and begin taking distributions from her traditional IRA. Her investment objectives are low risk, safety of principal, and liquidity. She is content with minimal rates of return. Which of the following investments is most suitable for her IRA?

Money market instruments Money market instruments provide the low risk, safety, and liquidity Sharon is seeking for her IRA. Corporate bonds and stocks do not provide safety of principal.

Which of the following investments would be the least suitable for a qualified retirement plan?

Municipal bond fund

Which of the following statements accurately describes a reason for the suitability of an asset class in a qualified retirement plan portfolio?

Mutual funds provide diversification and offer a competitive rate of return. In determining the suitability of an asset class in a retirement plan portfolio, mutual funds provide diversification and provide a comparable historical rate of return to that of equities (of course, depending on the investment objective and composition of the particular fund).

Which of the following should a businessowner accomplish before considering the adoption of a retirement plan?

Purchase personal and business liability insurance. Establish cash reserves sufficient to cover potential emergencies. Ensure the business has sufficient cash flow to support ongoing funding of the plan.

Life insurance may be a suitable investment for all of the following retirement plans except

SEP Plans

All of the following retirement plans permit employees to make elective deferrals except

SEP plans.

XYZ Inc. has 80 employees in the current year and is expected to employ the same number next year. They are considering the adoption of a retirement plan next year. The objectives are to use elective deferrals by employees with an appropriate match and immediate vesting. Which of the following plans would be appropriate? Traditional defined benefit pension plan Section 403(b) plan SIMPLE 401(k) SIMPLE IRA

SIMPLE 401(k) SIMPLE IRA

Which of the following retirement plans can be adopted only by private, tax-exempt organizations and state or local governments?

Section 457 plan

Joe, age 52, has just started a consulting company. He currently employs six people, who range in age from 22 to 31 years old. Joe estimates the average employment period for his employees will be approximately three years and would like to implement a retirement plan that will favor older participants while including an appropriate vesting schedule. In addition, Joe would like the employees to bear the risk of investment performance within the plan. Which of the following plans is most appropriate for Joe's company

Target benefit pension plan A target benefit pension plan is likely most appropriate. It would permit Joe to favor older participants and allow for a vesting schedule. A cash balance pension plan does not favor older participants and provides employees with a guaranteed rate of return on investments (thus, not transferring the risk of investment performance to the employees). SEP plans and SIMPLE 401(k) plans both provide for 100% immediate vesting of employer contributions.

Which of the following statements regarding a nonspouse designated beneficiary of an IRA is CORRECT?

The nonspouse beneficiary may elect to distribute the IRA over the remaining life expectancy of the beneficiary commencing the year following the year of death, reduced by one for each subsequent year. The nonspouse beneficiary may not rollover the IRA into his own IRA. While a lump-sum distribution or the five-year payout are options for the nonspouse beneficiary, they are not mandatory.

Which of the following statements regarding the anticipated effective income tax rate a planner should use for required retirement plan distributions is CORRECT? The projected rate should be based only on a blend of current federal and state marginal income tax rates. The projected rate should be based only on current federal marginal income tax rates. Precisely predicting future income taxes is not feasible. A planner should only use before-tax rate of return assumptions on retirement plan distributions.

The projected rate should be based only on a blend of current federal and state marginal income tax rates. Precisely predicting future income taxes is not feasible.

Alice participates in a qualified retirement plan at work. The plan provides Alice with life insurance. If Alice dies, which of the following statements correctly describes the income tax treatment of the life insurance death benefit paid to Alice's beneficiary?

The pure insurance element of the death benefit is income tax free to the beneficiary.

In the allocation of assets to determine the best portfolio composition for a qualified plan, what is a major factor to be considered?

The type of plan and who bears the investment risk A major factor to be considered in the asset allocation process of qualified plans is the type of plan (defined contribution or defined benefit) and who bears the investment risk (the employee or employer). Very broadly, a more conservative allocation is appropriate for a defined benefit plan than in the defined contribution approach

Bernie and Tim, both age 53, are partners in a computer software consulting firm. They have 20 employees whose average age is 25 and average length of employment is three years. The firm is highly profitable and enjoys stable cash flows. Of the following retirement plan options, which is best suited to the partners' business?

Traditional defined benefit pension plan Of the listed plans, only a traditional defined benefit pension plan is available to Bernie and Tim's business. A Section 403(b) plan may only be adopted by a Section 501(c)(3) organization. An eligible Section 457 plan may only be adopted by a private, tax-exempt organization or a state or local governmental organization. A partnership cannot use a stock bonus plan because this form of business does not issue stock. Notice how subtlety the form of business was introduced in the question. The form of business is very important in selecting a retirement plan.