Essentials of Investments: Chapter 20 - Taxes, Inflation, and Investment Strategy

Essentials of Investments: Chapter 20 - Taxes, Inflation, and Investment Strategy includes Saving for the Long run, Basic Considerations in Developing a Plan, Finding Your Retirement Annuity, Accounting For Inflation.

Chapter 20

Taxes, Inflation, and

Investment

Strategy

21.1 Saving for the Long

Run

Basic Considerations in Developing

a Plan

• The major goal is retirement planning.

• Time until retirement

– When do you plan to retire?

– When can you collect Social Security?

Finding Your Retirement

Annuity

21.2 Accounting For

Inflation

Planning with Inflation

• Inflation reduces the real value of the retirement benefit by eroding

the purchasing power of the dollars earned.

– Real consumption = Nominal consumption / Price Deflator

– Suppose inflation = 3% per year and the nominal rate of return is 6% What is the real rate of return?

return nominal

ROR

inflation i

return;

real r

; i 1

) i ROR (

r

ROR ROR

) 03 06 (.







Planning with Inflation

• The investor in the example is 30 years old

What is the size of the price deflator with 3%

inflation at age 35?

• By age 65?

16.103

.1)

i1(  n  5 

81.203

1 35 

Interest Rates, Inflation, and Real

Interest Rates, 1926-2008

Planning with Inflation

• To overcome inflation requires either

higher savings or higher rates of return on

investment or both

• Because taxes are paid out of nominal

returns, inflation reduces the after tax rate

of return even further.

A Real Retirement Plan

Another Problem with Inflation

• Inflation continues after retirement

• If you have a level annuity during retirement you will

have a declining standard of living:

• Purchasing power of the $192,244 at age 65 is:

• Purchasing power of the $192,244 at age 90 is:

630 ,

32

$ 8916

5

1 244

, 192

$ 03

1

1 244

, 192

320 ,

68

$ 8138

2

1 244

, 192

$ 03

1

1 244

, 192

The Solution?

• Should an investor take on more risk to offset inflation? What are

the effects of increasing the riskiness of your retirement portfolio?

• Real returns based on historical averages

• As you approach retirement what should you do with the risk level

of your portfolio?

– Is this easy to do?

• The best solution is simply to save more and start early.

21.3 Accounting For Taxes

Planning with Taxes

• Taxes further reduces the retirement benefits available

• To overcome the impact of taxes requires larger

allocations to savings or higher returns on investments

• As mentioned, inflation combined with taxes further

reduces the benefits available

• Flat versus graduated tax rates

Saving With a Simple Tax Code

The Effect of Double Taxation

• Investors pay income taxes and pay taxes on some of their savings.

• We can use the numbers in Spreadsheet 21.4 to illustrate the effect

on the overall tax rate:

Income (1) Lifetime labor income $7,445,673 Total exemptions during

21.4 The Economics of Tax

Shelters

Tax Shelters

• Means of postponing taxes as long as possible

• Potential benefits of shelters

– Postponing payment of tax,

– Additional earnings on the investment of postponed

tax payments

• Effectiveness of the shelter

– Depends on investment performance and how tax

rates change

Savings with a Flat Tax and an IRA Style

Tax Shelter

Savings With a Progressive Tax Rate

IRA with a Progressive Tax Code

21.5 A Menu of Tax

Shelters

Tax Sheltered Accounts

• Individual Retirement Accounts (IRAs)

– Created by the Tax Reform Act of 1986,

currently allow investors to contribute up to

$5,000 per year to a retirement account.

• Individuals age 50 and older may contribute another $1,000 per year,

• 10% tax penalty for withdrawal of funds prior to age 59 ½,

• Must begin withdrawals by age 70 ½

Types of IRAs

• Traditional IRAs

– Contributions to traditional IRAs are tax

deductible, the earnings are tax deferred until withdrawn.

• Roth IRAs

– Contributions to Roth IRAs are not tax

deductible but earnings on the account are

not taxed when withdrawn.

Spreadsheet 21.8 Roth IRA

with Progressive Tax Code

Table 21.2 Traditional vs Roth IRA Tax Shelters Under a Progressive Tax Code

Defined Benefit Plans

• Defined Benefit Plans

– Employer promises to pay a defined or known benefit to employees when they retire.

• Typically a percentage of salary based on years of service

• The employer must fund the pension obligation

• Pension Benefit Guaranty Corporation (PBGC) guarantees pension benefits in the event of

corporate bankruptcy, but often get an inferior

Defined Contribution Plans

• Defined Contribution Plans

• 401k and 403b Plans are examples

– Employee and employer contribute set amounts to an investment plan The employee’s retirement benefit

depends on the investment performance

– Employees are typically given a choice of mutual

funds managed by a fund family such as Vanguard or Fidelity

– Because of the employer contributions you want to

take advantage of these plans

Table 21.3 Investing Roth IRA

Contributions into Stock and Bonds

Table 21.4 Investing Traditional IRA

or 401k Contributions in Stocks and Bonds

21.6 Social Security

Social Security (SS)

• Federal pension plan established to provide minimum

retirement benefits to all workers

– It is unfunded although it is in surplus on a current

year basis, projected to go in the red around 2016,

– You pay 6.2% of your income to SS, plus 1.45%

toward Medicare; your employer matches your

contribution,

– SS is a means of redistributing income In dollar

terms taxes are regressive and low income workers

receive a relatively larger share of preretirement

income upon retirement

SS, What You Earn

• You pay in every working year but only top

35 years of earnings & contributions count

for determining benefits.

• Lifetime real annuity paid in full if you retire

at age 67, you receive a reduced amount if you retire earlier (62) or your receive a

larger benefit if you retire later (70)

SS, What You Earn

Four steps to calculate your benefits:

1 The series of your taxed annual earnings is compiled

2 Indexing Factor Series

– All past earnings are converted to today’s dollars

using the Average Wage Index (AWI)

3 Average Indexed Monthly Earnings (AIME)

– The 35 highest annual indexed contributions are

summed and then divided by (35 x 12) = 420 This number is the AIME

SS, What You Earn

Four steps to calculate your benefits:

4.Primary Insurance Amount (PIA)

– The annuity value received each year,

– The income replacement rate is the

percentage of the working income received in retirement,

– Income replacement rate is substantially

higher for low income individuals, – Benefits may be taxed if household income >

SS Annuities if You Were to Retire

in 2009 at Age 66

Additional Considerations in

Planning

• Financing a child’s education

– Same procedure as funding retirement

• Rent or buy decision

– You gain no equity in renting,

– Equity is a safeguard for tough times,

– Don’t try to buy too much house,

– Houses are illiquid investments whose value

does not always increase.

Additional Considerations in

Planning

• Uncertain longevity

– Life annuity versus fixed term annuity

– Payment received on a life annuity is reduced due to

adverse selection

• Marriage, bequests and intergenerational transfers

– Marriage increases motivation for saving for old age

– Dependents increase need to save

– Desire for bequests increase need to save

– 75% of intergenerational transfers are involuntary

(due to earlier than planned demise or under