Unit 3, Lesson 3
Common Workplace Retirement Plans
401(k) 403(b) Keogh Plan Others
401(k)
A 401(k) is the most common employer-sponsored retirement plan; as of 2011, individuals are allowed to contribute up to $14k per year of pretax income; most employers offering a 401(k) plan to its workers make matching or partial matching contributions; funds can be withdrawn without penalty starting at age 59.5
Keogh Plan
A retirement plan option for those who are self-employed; with this plan, individuals can contribute up to 25% of their annual income, with a maximum annual contribution of $49k
Roth IRA
Another type of Individual Retirement Account; was not an option until 1997 A defined-contribution plan for retirement savings, but the characteristics of a Roth IRA are slightly different; the most important differences are the taxation rules Setup: Individuals set up an account with a representative of the financial company through which the account will be managed; before any contributions are made, the individual & account manager discuss retirement goals, risk tolerance, & asset allocation Contributions: Individuals can contribute up to $5k per year (as of the 2011 tax year) of posttax income; that is, income tax must be paid at the current tax rate in the year the contributions are made; this is a distinct difference from a Traditional IRA, in which contributions are tax-deferred Investments: Money accumulating in the account is invested in various financial products, including stocks, bonds, & mutual funds; the amount of money allocated to various investments is discussed when the account is set up; the goal is to have growth over the long term Management: The performance of the IRA investments is assessed regularly over time; the account manager advises the client & makes changes to the asset allocation, as needed, & at the request of the individual; typically, the investment proportions shift from more risky to less risky as retirement approaches
Details of Life Annuity
As with any other insurance arrangement, a life annuity takes out the risk involved with most retirement plans A fixed annuity provides a level of certainty that many people desire in retirement earnings and spending, but because the rate of return is typically modest, this conservative investment isn't recommended for younger people starting their retirement plans, nor is it suggested as a stand-alone plan A good option is to save for retirement using a defined-contribution plan, then once you reach retirement age, put the funds into an annuity so you receive regular lifetime payments of your savings
Traditional IRA
Distributions: At age 59.5, individuals can start withdrawing funds from the account as a form of retirement income, but withdrawals don't have to begin until age 70.5; at this time, the distribution is taxed as ordinary income; because taxes are not paid on Traditional IRA funds until retirement, it's called a tax-deferred plan Setup: Individuals set up an account with a representative of the financial company through which the account will be managed; before any contributions are made, the individual & account manager discuss retirement goals, risk tolerance, & asset allocation Contributions: Individuals can contribute up to $5k per year (as of the 2011 tax year) of pretax income; that is, the contributions can be deducted from taxable income, therefore reducing tax liability for the year; this means that up to $5k of one's income each year can be sheltered from the current year's taxes, if placed in a Traditional IRA Investments: Money accumulating in the account is invested in various financial products, including stocks, bonds, & mutual funds; the amount of money allocated to various investments is discussed when the account is set up; the goal is to have growth over the long term Management: The performance of the IRA investments is assessed regularly over time; the account manager advises the client & makes changes to the asset allocation, as needed, & at the request of the individual; typically, the investment proportions shift from more risky to less risky as retirement approaches
Future Value of an Annuity Formula
FVOA = C x [((1 + i)^nt - 1)/i] FVOA = the future value of an annuity C = cash flow i = periodic interest rate n = number of compounding periods per year t = time in years
IRA
Individual Retirement Account; a defined-contribution plan set up by individuals to help meet their personal retirement goals
Examples of Defined-Benefit Plans
Pension plan Fixed annuity Social Security
Examples of Defined-Contribution Plans
Roth IRA 401(k) Traditional IRA 403(b)
Factors that Determine Which is More Advantageous to your Individual Circumstances
Time horizon - When will the account be opened and for how long? Tax rates - Will you be in a higher or lower tax bracket when distributions occur?
Tax Consequences of IRAs
Traditional IRAs have the front-end tax benefit of tax-deductible contributions Roth IRAs have the back-end benefit of tax-free earnings
403(b)
Very similar to a 401(k), but is the offering of nonprofit employers; for example, a school system may offer a 403(b) plan to its teachers & staff, or a charitable organization may offer this retirement plan to its full-time employees
The net value of a Traditional IRA is the same as its effective value because
a Traditional IRA doesn't subtract taxes until you start withdrawing from it
life annuity
a type of retirement plan, commonly referred to as just an annuity; a financial contract between an individual & an insurance company that provides guaranteed regular payments
What are the two main types of retirement plans?
defined-benefit plan and defined-contribution plan
What is the "effective value" of a Traditional IRA?
the final value of a Traditional IRA; how much the retirement account is worth, after adding all contributions and deducting all taxes
It's impossible to calculate the exact value of a defined-contribution plan into the future, but
you can estimate the value of a Roth IRA, making some assumptions & using simplified values
Defined-Contribution Plan
A worker & sometimes an employer contribute regularly to an individual account; the worker decides how the money is invested; the payout at retirement is then dependent on the performance of the investments, so there are no guarantees; essentially, the contribution is known (defined), but the worker doesn't know the benefit precisely until withdrawing it Unlike a defined-benefit plan, the worker manages the account, so they bear the risk & potential gains or losses, not the employer; but if the worker manages the money carefully, defined-contribution plans can be a very valuable tool for meeting retirement goals; with the future of Social Security uncertain, saving for retirement on one's own is important
Characteristics of a Fixed Annuity
Fixed annuity is the most common annuity During the accumulation phase, the individual makes a lump-sum payment or multiple payments over time to the insurance company The insurance company invests the money as it sees fit, along with the money of other participants, forming a pool of invested funds The insurance institution guarantees the investor a fixed minimum rate of interest; the gains on the annuity are tax-deferred until payments are received During the distribution phase, the individual receives income in the form of regular, equal payments that last for the remainder of their life, no matter how long or short that may be
Workplace Retirement Plans
In addition to individual retirement accounts, some people have the option of participating in a retirement plan that their employer pays for; much like IRAs, these are defined-contribution plans managed by the individual with the help of a financial advisor; & like Traditional IRAs, the contributions to most workplace retirement plans are tax-deferred; that is, the contributors don't pay taxes on the funds until they withdraw them The main difference is that the plan is offered through the employer, who often contributes funds; in fact, some employers even make "matching" contributions; that is, whatever the employee contributes to their retirement account each year, the employer contributes an equal amount Taking part in an employer-sponsored retirement plan is optional, but it would be wise to opt in; & if the employer matches contributions, it's recommended that you make the maximum allowable contributions for that plan; otherwise, you're essentially turning down free money
Defined-Benefit Plan
Individuals have a specific (defined) benefit in the form of retirement income; for example, some employers pay a defined-benefit plan called a pension; with a pension, the employee receives a monthly amount, called a distribution, upon retirement based on years of service, salary, pay rate, age, & other factors; these payouts to individual retirees come from a common fund, which the employer manages These plans used to be a common offering of large employers to employees; however, this is no longer true; they are mostly offered by government employers, benefiting federal, state, & local government workers, including police & firefighters All workers in the US are participants in the Social Security program, which is also a defined-benefit plan; workers receive annual statements from the federal government indicating how much they'll receive per month upon retirement given their current status in the Social Security system
How to Calculate the Value of a 401(k) at Retirement
Step 1: Determine the annual contributions to the 401(k) Step 2: Determine the value of the 401(k) including contributions & growth (use future value of an ordinary annuity formula) Step 3: Calculate the tax due on the distributions of the account (for simplicity, calculate the tax as 25% of the entire 401(k) value) Step 4: Find the effective value of the 401(k) after taxes (Effective Value = 401(k) - Tax)
How to Calculate the Final Value of a Roth IRA
Step 1: Determine the value of the IRA including contributions & growth (because these are annual cash flows, you can use the future value formula for an annuity; assume contributions are at the end of each year (ordinary annuity) & the rate of return is compounded annually) Step 2: Now, calculate the taxes paid on the contributions over the years Step 3: Find the final value of the IRA, considering taxes paid (Final Value = IRA - Tax)
How to Calculate the Value of a Traditional IRA
Step 1: Determine the value of the IRA including contributions and growth (because these are annual cash flows, you can use a future value formula for an annuity; assume contributions are at the end of each year (ordinary annuity) and the rate of return is compounded annually) Step 2: Calculate the tax due on the Traditional IRA income (for the sake of simplicity, calculate the tax as 15% of the entire IRA value) Step 3: Find the effective value of the IRA, after taxes (Effective Value = IRA - Tax)
Other Workplace Retirement Plans
There are many other versions of workplace retirement plans, including the SEP (Simplified Employee Plan) for small businesses In addition, some companies offer profit sharing based on a set formula, or an ESOP (Employee Stock Ownership Plan), in which the company contributes some of its stock to its employees' retirement accounts
Retirement Income Limits
There is no maximum income limit for Traditional IRAs; however, there is for Roth IRAs; although most people don't contribute an amount even close to the maximum, some do The amount changes each year, but as of 2011, a single filer begins to see limitations on their contribution after $107k a year; no more annual contributions are allowed whatsoever after $122k
Marginal Tax Rates
US citizens pay taxes using this; this means an income tax bracket only applies to the part of income that falls between a certain range of values As an example, in 2010, if an individual person earned between $82,400 & $171,850, that person would be in the 28% tax-rate bracket; however, they don't pay 28% on all this income, just the amount over $82,400; that person would be taxed 10% for the first $8,375, 15% for the income between $8,375 & $34k, & 25% for the income between $34k & $82,400
