Scenario

17 Retirement and Estate Planning

YOU MUST BE KIDDING, RIGHT?

Rachel Jones is 27 years old, and she recently took a new job. Rachel had accumulated $6000 in her previous employer's 401(k) retirement plan, and she withdrew it to help pay for her wedding. How much less money will Rachel have at retirement at age 67 if she could have earned 8 percent on the $6000?

A. $6000

B. $24,000

C. $96,000

D. $130,000

The answer is D. Spending retirement money for discretionary purposes, instead of keeping it in a tax-deferred account where it can compound for many years, is unwise. The lesson is to keep your retirement money where it belongs!

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

 Estimate your Social Security retirement income benefit.

 Calculate the amount you must save for retirement in today's dollars.

 Distinguish among the types of employersponsored tax-sheltered retirement plans.

 Explain the various types of personally established tax-sheltered retirement accounts.

 Describe how to avoid penalties and make your retirement money last.

 Plan for the distribution of your estate and, if needed, use trusts to lower estate taxes.

WHAT DO YOU RECOMMEND?

Juliana Pérez Rodríguez, age 48, worked for a previous employer for eight years. When she left that job, Juliana left her retirement money in that employer's definedcontribution plan. It is now worth $120,000. After getting divorced and remarried four years ago, she has been working as an assistant food services manager for a convention center in Chicago, earning $70,000 per year. Juliana contributes $233 each month (4 percent of her salary) to her account in her employer's 401(k) retirement plan. Her employer provides a 100 percent match for the first 4 percent of Juliana's salary contributions. Company rules allow her to contribute a total of 8 percent on her own. Juliana's 401(k) account balance at her new employer is $21,000. Her husband Fernando, with whom she shares the same birthday, is a computer programmer working on contract for various companies and earns about $90,000 annually. When Juliana returned from a vacation with her husband, she found that her father had suffered a serious stroke. Despite undergoing physical therapy, he is now in a nursing home and likely will be there the rest of his life. Juliana is hoping that she and Fernando can retire when they both are age 65.

What do you recommend to Juliana and Fernando on the subject of retirement and estate planning regarding:

1. How much in Social Security benefits can each expect to receive?

2. How much do they each need to save for retirement if they want to spend at a lifestyle of 80 percent of their current living expenses?

3. In which types of retirement plans might Fernando invest for retirement?

4. What withdrawal rate might they use to avoid running out of money during retirement?

5. What three types of actions might they take to go about transferring their assets by contract to avoid probate?

YOUR NEXT FIVE YEARS

In the next five years, you can start achieving financial success by doing the following related retirement and estate planning:

1. Save continuously within a taxsheltered employer-sponsored retirement plan at least the amount required to obtain the full matching contribution from your employer.

2. Accept enough risk in investing to increase the likelihood that you will have enough money in retirement.

3. Contribute to Roth IRA accounts to supplement your employer-sponsored plans.

4. Keep your hands off your retirement money. Do not borrow it. Do not withdraw it. When changing employers, roll over the funds into the new employer's plan or a rollover IRA account.

5. To ease the transfer of your assets upon your death, learn how to use contracts to avoid probate court and make a valid will.

Retirement  is the time in life when the major sources of income from earned income (such as salary or wages) changes to sources like employerbased retirement benefits, private savings and investments, income from Social Security, and perhaps income from part-time employment. Retirement often is a gradual transition from the workforce rather than sudden cessation. Today, 30 percent of people age 65 to 69 are still working.

retirement The time in life when the major sources of income change from earned income (such as salary or wages) to employer-based retirement benefits, private savings and investments, income from Social Security, and perhaps part-time employment.

Planning for retirement has changed dramatically over the years. Yesterday's employers provided pensions for a lifetime that were commonly a reward for 20 or 30 years of working for one company, but today fewer than one out of five employers still offer them. Instead, half of today's employers offer voluntary retirement plans to which employees may or may not choose to contribute; the other half do not offer a retirement plan. The biggest mistake people make in planning for retirement is they spend too much on other things instead of saving for retirement. Enjoying financial security during 20 or more years of retirement is not a matter of luck. It takes planning and action. The wise financial manager's philosophy should be to save now so you can play later during your golden years.

But many young people do not make such efforts early enough in life. Two-thirds of workers age 25 to 34 are not saving at all for retirement through their employers. The one-third that does save has not saved much. Sixty percent say they have a balance of less than $10,000, reports the Employee Benefits Retirement Institute. A recent survey shows that 34 percent of Americans report that they will work until they are at least 80 or until they are too sick or die.

This is a crazy way to live: spending all one's money to pay for day-to-day consumption expenses instead of saving for retirement. Such people need to learn how to budget, save, and invest. They also need to create a financial plan because if they had a plan, they will save three times more than those without a plan, thus better managing their financial futures.

Saving and investing 10 percent of your pay starting at age 25 can provide a lump sum of $1,540,000 at age 65, while saving just 6 percent will provide only $924,000, more than one-third less. These calculations are based on a salary of $40,000 with 3 percent annual pay increases and investments that earn an 8 percent annual return.

The fact today is that you—and only you—are responsible for meeting your retirement needs. In addition, the responsibility of investing funds for retirement and the risk of making poor investments with these funds have been shifted from the employer to the employee. And if your employer does not offer a retirement plan, you can set one up yourself.

While starting a retirement program is important at a young age so too is the process of estate planning.  Estate planning  comprises the specific arrangements you make during your lifetime for the administration and distribution of your assets when you die. You need to learn how to transfer assets in such a way that they go to your desired heirs and avoid unnecessary probate court procedures. Most of your assets can be set up to transfer automatically. For the remainder, you need to prepare a will. Estate planning need not be overly complicated but you do need to do it. Details on all these topics are in this chapter.

estate planning The definite arrangements you make during your lifetime that are consistent with your wishes for the administration and distribution of your estate when you die.

17.1 UNDERSTANDING YOUR SOCIAL SECURITY RETIREMENT INCOME BENEFITS

LEARNING OBJECTIVE 1

Estimate your Social Security retirement income benefit.

The whole retirement and estate planning process must begin with improving your understanding of Social Security. This is the program that fully one-half of young workers do not believe will be around for them when they retire. Don't worry because it will be! Older people are voters, too, and they (as well as young people) will push to keep Social Security. In fact, some politicians are arguing that the benefits should be expanded and increased.

The Social Security program has become the most successful and popular domestic government program in U.S. history. Funding for Social Security benefits comes from a compulsory payroll tax split equally between employees and employers. Social Security taxes withheld from wages are called  FICA taxes  (named for the Federal Insurance Contributions Act). The amounts withheld are put into the Social Security trust fund accounts from which benefits are paid to current program recipients by the Social Security Administration (SSA).

FICA taxes A 6.2 percent tax paid by both the worker and employer on the worker's employment income up to the maximum taxable yearly earnings.

17.1a Your Taxes Support Social Security and Medicare Benefits

Wage earners pay both FICA and Medicare taxes to the SSA. The FICA tax is paid on wage income up to the  maximum taxable yearly earnings (MTYE) , which comprises the maximum amount to which the FICA tax is applied. The MTYE figure—$117,000 for the most recent year—is adjusted annually for inflation. The FICA tax rate is 12.4 percent, consisting of 6.2 percent paid by employees and 6.2 percent paid by employers for their workers. Self-employed workers pay a FICA tax rate of 12.4 percent, twice that of wage earners, because they are their own employers.

maximum taxable yearly earnings (MTYE) The maximum amount to which the FICA tax is applied.

Wage earners and their employers also each pay a 1.45 percent  Medicare tax  on all earnings. The MTYE limit does not apply to the Medicare tax; thus the 1.45 rate applies to all employment income. Most workers pay 7.65 (6.2 + 1.45) percent of their earnings to the SSA. For example, a person earning $50,000 pays a combined FICA and Medicare tax of $3825 ($50,000 × 0.0765), and a person earning $100,000 pays $7650 ($100,000 × 0.0765).

Medicare tax A 1.45 percent tax paid by both the worker and employer on all the worker's employment income.

17.1b It Takes a Minimum of Ten Years to Qualify for Full Social Security Retirement Benefits

The Social Security program covers nine out of every ten U.S. employees, although employees of some state governments are exempt and instead are covered by their state's plan. To qualify for Social Security retirement, survivors, or disability insurance benefits for you and your family, you must accumulate sufficient credits for employment in any work subject to the FICA taxes. The periods of employment in which you earn credits need not be consecutive. Military service also provides credits. You earn  Social Security credits  for a certain amount of work covered under Social Security during a calendar year. For example, workers receive one credit if they earned $1200 (for the most recent year) during any time during the year. You receive a maximum of four credits if you earned $4800 (4 × $1200) during the year. The dollar figure required for each credit earned is raised annually to keep pace with inflation.

Social Security credits Accumulated quarterly credits to qualify for Social Security benefits obtained by paying FICA taxes.

The number of credits you have earned determines your eligibility for retirement benefits and for disability or survivors benefits if you become disabled or die. The SSA recognizes four statuses of eligibility.

FINANCIAL POWER POINT  

Financing Social Security

Based on the Social Security Administration Trustees' best estimate, program costs are projected to allow 100 percent of scheduled benefits until 2033. While it is true that the Social Security system has a long-term deficit, there is zero chance that the program will be eliminated in its entirety. While many young people doubt that Social Security will provide them with benefits, there are solutions to the problem. Simple fixes that actually will work and are favored by people of both political parties and all age groups are to increase the wage cap, increase the payroll tax, and change the benefit formula.

1. Fully Insured  Fully insured  status requires 40 credits (10 years of work) and provides the worker and his or her family with eligibility for benefits under the retirement, survivors, and disability programs. Once obtained, this status cannot be lost even if the person never works again. Although it is required to receive retirement benefits, “fully insured” status does not imply that the worker will receive the maximum benefits allowable.

fully insured Social Security status Requires 40 credits and provides workers and their families with benefits under the retirement, survivors, and disability programs; once status is earned, it cannot be taken away even if the eligible worker never works again.

2. Currently Insured To achieve currently insured status, six credits must be earned in the most recent three years. This status provides for some survivors or disability benefits but no retirement benefits. To remain eligible for these benefits, a worker must continue to earn at least six credits every three years or meet a minimum number of covered years of work established by the SSA.

3. Transitionally Insured Transitionally insured status applies only to retired workers who reach the age of 72 without accumulating 40 credits (ten years). These people are eligible for very limited retirement benefits.

4. Not Insured Workers younger than age 72 who have fewer than six credits of work experience are not insured.

17.1c You Can Obtain an Estimate of Your Social Security Retirement Benefits

The Social Security Administration makes available your  Social Security Estimate  that includes a record of your earnings history, a record of how much you and your various employers paid in Social Security taxes, and an estimate of the benefits that you and your family might be eligible to receive now and in the future. You can request a Social Security Estimate at www.ssa.gov/estimator/.

Social Security Estimate Online Information that the Social Security Administration makes available to all workers, which includes earnings history, Social Security taxes paid, and an estimated benefit amount.

The actual dollar amount of your eventual Social Security retirement benefits will be based on the average of the highest 35 years of earnings during your working years. In these calculations, your actual earnings are first adjusted, or indexed, to account for changes in average wages since the year the earnings were received. The SSA then calculates your average monthly indexed earnings during the 35 years in which you earned the most. The agency applies a formula to these earnings to arrive at your  basic retirement benefit  (or  primary insurance amount ). This is the amount you would receive at your  full-benefit retirement age —currently 67 for those born in 1960 or later.

basic retirement benefit/ primary insurance amount Amount of Social Security benefits a worker would receive at his or her full-benefit retirement age, which is 67 for those born after 1960.

full-benefit retirement age Age at which a retiree is entitled to full Social Security benefits; 67 for those born in 1960 or later.

You have three options regarding when to begin receiving Social Security retirement benefits.

1. Begin Receiving Benefits at Your Full-Benefit Age Once you have reached your full-benefit retirement age, you are eligible to receive your basic monthly retirement benefit. You can begin collecting these benefits even if you continue working full-or part-time. Your level of employment income will not affect your level of benefits, although it may affect the income taxes that you pay on your Social Security benefits and the amount of your Medicare premiums.

FINANCIAL POWER POINT  

Verify Online the Accuracy of Your Social Security Statement

You have only three years to correct any errors in your Social Security Statement. You should make sure that the SSA's records are up to date and accurate by checking them online. Open an account at the Social Security Administration at www.ssa.gov/myaccount/ and check your Statement.

2. Begin Receiving Reduced Benefits at a Younger Age You can choose to start receiving retirement benefits as early as age 62, regardless of your full-benefit retirement age. If you do so, however, your basic retirement benefit will be permanently reduced approximately 6 percent for each year you start early. Thus, if your full-benefit retirement age is 67, your benefits will be permanently reduced 30 percent (5 years × 6 percent). If you choose to take the earliest Social Security retirement benefits, you will be ahead financially if you do not survive to about age 80. Sixty percent of retirees elect to take their Social Security benefits early.

People considering early Social Security retirement benefits need to be aware that their checks will be further reduced if they have earned income above the annual limit ($15,120 for the most recent year). The reduction is $1 in benefits for every $2 in earnings. A person entitled to $1000 per month ($12,000 per year) in early retirement benefits who has an earned income of $20,000, for example, will be penalized $2440 in benefits on the income above $15,120 ($20,000 − $15,120 = $4880/2). It is possible to earn enough to completely eliminate your benefits, so the decision to take Social Security benefits early requires careful analysis.*

3. Begin Receiving Larger Benefits at a Later Age You can delay taking benefits beyond your full-benefit retirement age. In such a case, your benefit would be permanently increased by as much as 8 percent per year. Once you reach age 70 the benefit amount will no longer increase so there is no need to delay receiving benefits beyond that age. You can continue to work even after you begin taking these delayed benefits. Again, your level of employment income will not affect your level of benefits, but it may affect the income taxes that you pay on your Social Security benefits and your Medicare premiums.

You can compute your own retirement benefit estimate using a program that you can download to your computer from www.ssa.gov/OACT/anypia/index.xhtml. To determine which option is best for you, you can do the calculations for an early, on-time, or delayed beginning start date. Also see kiplinger.socialsecuritysolutions.com to determine the optimal strategy for claiming benefits.

 CONCEPT CHECK 17.1

1. List the key financial planning actions that individuals must take during their working lives to prepare for retirement.

2. Summarize how workers become qualified for retirement Social Security benefits.

3. Distinguish between the benefits provided under Social Security for a worker who is fully insured and a worker who is currently insured.

4. Explain what happens if you choose to retire earlier than your full retirement age, which is probably 67.

17.2 HOW TO CALCULATE THE AMOUNT YOU MUST SAVE FOR RETIREMENT IN TODAY's DOLLARS

LEARNING OBJECTIVE 2

Calculate the amount you must save for retirement in today's dollars.

To plan for a financially successful retirement, you first need to set a goal. Otherwise, as one of the most quoted figures in sports, baseball legend Yogi Berra, says, “If you don't know where you are going, you will end up somewhere else.” Your  retirement savings goal , or  retirement nest egg , is the total amount of accumulated savings and investments needed to support your desired retirement lifestyle. Financial planners often say that people need 80 to 100 percent of their pre-retirement gross income (including Social Security benefits) to meet their expenses in retirement and maintain their lifestyle. This amount includes what you have to pay in income taxes.

Retirement savings goal (retirement nest egg) Total amount of accumulated savings and investments needed to support a desired retirement lifestyle.

Setting a personally meaningful retirement dollar goal helps motivate people to take the necessary saving and investing actions. If you begin to save and invest for retirement early in life, the compounding effect on money over time will make it fairly easy for you to reach your retirement savings goal. If you start late, it will be difficult.

17.2a Projecting Your Annual Retirement Expenses and Income

“How large a retirement nest egg do I need?” To calculate this amount, you can fill out the Run the Numbers worksheet, “Estimating Your Retirement Savings Goal in Today's Dollars” (page 514). Each spouse in a married couple should prepare a worksheet rather than combine income and savings amounts.

17.2b An Illustration of Retirement Needs

Consider the case of Erik McKartmann, aged 35 and single, the manager of a weight loss and fitness center in South Park, Colorado. Erik currently earns $50,000 per year. He has been contributing $165 per month ($1980 annually) into an IRA account he set up several years ago before beginning his current job. Erik hopes to retire at age 62.

DO IT IN CLASS

DID YOU KNOW 

Women Should Save More for Retirement than Men

Women save less in their 401(k) accounts than men resulting in smaller balances at retirement. Women participate in 401(k) plans at the same rate as men but they save only 6.9 percent compared to 7.6 percent for men, according to consulting firm Aon Hewitt. Women, more than men, also often fail to take advantage of the full matching contribution from their employers.

More than 20 percent of workers are not saving enough in their retirement accounts to take advantage of the company match.

Even in the 21st century women still do not earn as much, on average, as men. Because of their lower incomes and longer longevity women receive less Social Security income than men (about $13,100 annually compared with over $17,200 annually for men). Women reaching age 65 are expected to live, on average, an additional 21.4 years compared to 19.1 for men; therefore women should save more for retirement than men.

1. Erik has chosen not to develop a retirement budget at this time. Instead, he simply multiplied his current salary by 80 percent to arrive at an estimate of the annual income (in current dollars) needed in retirement of $40,000 ($50,000 × 0.80). This amount was entered on line 1 of the worksheet. If Erik wants to increase the amount of dollars to support a higher retirement lifestyle, he can simply increase the percentage in the calculation.

2. Erik checked the Social Security Administration to estimate his benefits in today's dollars. At age 62, he could expect a monthly benefit of $1100 (in current dollars). Multiplying by 12 gave an expected annual Social Security benefit of $13,200 (in current dollars), which Erik entered on line 2 of the worksheet.

3. Line 3 of the worksheet, which calls for Erik's expected pension benefit, is appropriate for defined-benefit plans. After discussing his expected employer pension with the benefits counselor at work, Erik found that his anticipated benefit under the plan would amount to approximately $5800 annually, assuming that he remained with the company until his retirement, so he entered that figure on line 3.

4. Erik adds lines 2 and 3 to determine his total estimated retirement income from Social Security and his employer pension. The amount on line 4 would be $19,000 ($13,200 + $5800).

5. Subtracting line 4 from line 1 reveals that Erik would need an additional income of $21,000 ($40,000 − $19,000) in today's dollars from savings and investments to meet his annual retirement income needs.

6. At this point, Erik has considered only his annual needs and benefits. Because he plans to retire at age 62, Erik will need income for 20 years based on his life expectancy. (Of course, Erik could live well into his 80s, which would mean that he would need to save even more.) Using Appendix A-4 and assuming a return that is 3 percent above the inflation rate, Erik finds the multiplier 14.8775 where 3 percent and 20 years intersect. He then calculates that he needs an additional amount of $312,427 (14.8775 × $21,000) at retirement. That's a big number! And it is in current dollars. The number does not dissuade Erik from saving because he knows he has time and the magic of compounding on his side.

7. Erik's current savings and investments can be used to offset the $312,427 he will need for retirement. Erik has zero savings in his employer's 401(k) account; however, he does have some money invested in an IRA ($24,000), plus some other investments ($13,000). These amounts are totaled ($37,000) and recorded on line 7E.

8. If left untouched, the $37,000 that Erik has built up will continue to earn interest and dividends until he retires. Because he has 27 more years until retirement, Erik can use Appendix A-1 and, assuming a growth rate of 3 percent over 27 years, find the factor 2.2213 and multiply it by the total amount in line 7. Erik's $37,000 should have a future value of $82,188 at his retirement, so he puts this amount on line 8.

9. Subtracting line 8 from line 6 reveals that Erik's retirement nest egg will need an additional $230,239 ($312,427 − $82,188) at the time of retirement.

10. Using Appendix A-3 and a growth rate of 3 percent over 27 years, Erik finds a factor of 40.7096. When divided into $230,239, it reveals that he needs savings and investments of $5656 per year until retirement.

11. Erik records his current savings and investments of $1980 per year on line 11.

12. Erik subtracts line 11 from line 10 to determine the additional amount of annual savings that he should set aside in today's dollars to achieve his retirement goal. His shortfall totals $3676 per year. By saving an extra $306 each month ($3676 ÷ 12), he can reach his retirement goal established in step 1.

17.2c Suggestions for Funding Erik's Retirement Goal

Erik needs to continue what he is doing—saving and investing—plus save a little more so he can enjoy his lifestyle when his full-time working career ends. Erik should discuss with his benefits counselor how much he can save and invest via the company's new 401(k) program.

Erik needs to save more for retirement. He should contribute an additional $3676 per year, which is only another $306 per month, into his employer's 401(k) plan—that is, about 7.3 percent of his salary. To create an extra margin of safety he could save even more of his salary, if the rules of his employer's retirement plan permit it. His employer might also make a matching contribution (discussed later) of some or all of Erik's 401(k) contributions.

Understanding your Social Security and employer-based retirement benefits is a first step in retirement planning.

DID YOU KNOW 

Online Retirement Planning Calculators

Research suggests that those who calculate how much they need to save often end up having a more financially successful retirement. In your assumptions, perhaps use a 5 percent long-term rate of return minus a 3 percent annual inflation rate, and try more than one calculator:

• AARP ( www.aarp.org/work/retirement-planning/retirement_calculator.xhtml )

• American Savings Education Council's Ballpark Estimate ( www. choosetosave.org/ballpark/)

•  CNNMoney.com  ( www.money.cnn.com/calculator/retirement/retirement-need/ )

• E*Trade ( www.us.etrade.com/e/t/plan/retirement/quickplan?vanity=quickplan )

• Fidelity ( www. fidelity. com/calculators-tools/retirement-quick-check)

• The Motley Fool ( www.partners.leadfusion.com/tools/motleyfool/retire02a/tool.fcs?v=76620 )

•  MarketWatch.com  ( www.marketwatch.com/retirement/tools/retirement-planning-calculator )

• T. Rowe Price's ( www3.troweprice.com/ric/ricweb/public/ric.do?WTAFeaturedResult=retirement%20calculator )

RUN THE NUMBERS

Estimating Your Retirement Savings Goal in Today's Dollars

This worksheet will help you calculate the amount you need to set aside each year in today's dollars so that you will have adequate funds for your retirement. The example here assumes that a single person is now 35 years old, hopes to retire at age 62, has a current income of $50,000, currently saves and invests about $1980 per year, contributes zero to an employer-sponsored retirement plan, anticipates needing a retirement income of $40,000 per year assuming a spending lifestyle at 80 percent of current income ($50,000 × 0.80), and will live an additional 20 years beyond retirement. Investment returns are assumed to be 3 percent after inflation—a reasonable but conservative estimate for a typical portfolio. The financial needs would differ if the growth rate of the investments were less than 3 percent. This approach simplifies the calculations and puts the numbers to estimate retirement needs into today's dollars. The amount saved must be higher if substantial inflation occurs.

	Example	Your Numbers
1. Annual income needed at retirement in today's dollars (Use carefully estimated numbers or a certain percentage, such as 70% or 80%.)	$ 40,000	_______
2. Estimated Social Security retirement benefit in today's dollars	$ 13,200	_______
3. Estimated employer pension benefit in today's dollars (Ask your retirement benefit adviser to make an estimate of your future pension, assuming that you remain in the same job at the same salary, or make your own conservative estimate.)	$   5,800	_______
4. Total estimated retirement income from Social Security and employer pension in today's dollars (line 2 b line 3)	$ 19,000	_______
5. Additional income needed at retirement in today's dollars (line 1-line 4)	$ 21,000	_______
6. Amount you must have at retirement in today's dollars to receive additional annual income in retirement (line 5) for 20 years (from Appendix A-4, assuming a 3% return over 20 years, or 14.8775 × $21,000)	$312,427	_______
7. Amount already available as savings and investments in today's dollars (add lines 7A through 7D, and record the total on line 7E)
A. Employer savings plans, such as a 401(k), SEP-IRA, or profit-sharing plan	0	_______
B. IRAs and Keoghs	$ 24,000
C. Other investments, such as mutual funds, stocks, bonds, real estate, and other assets available for retirement	$ 13,000
D. If you wish to include a portion of the equity in your home as savings, enter its present value minus the cost of another home in retirement	0
E. Total retirement savings (add lines A through D)	$ 37,000
8. Future value of current savings/investments at time of retirement (using Appendix A-1 and a growth rate of 3% over 27 years, the factor is 2.2213; thus, 2.2213 × $37,000)	$ 82,188	_______
9. Additional retirement savings and investments needed at time of retirement (line 6-line 8)	$230,239	_______
10. Annual savings needed (to reach amount in line 9) before retirement (using Appendix A-3 and a growth rate of 3% over 27 years, the factor is 40.7096; thus, $230,239/40.7096)	$   5,656	_______
11. Current annual contribution to savings and investment plans	$   1,980	_______
12. Additional amount of annual savings that you need to set aside in today's dollars to achieve retirement goal (in line 1) (line 10-line 11)	$   3,676	_______

One of the reasons Erik needs to save more is that he plans to retire at age 62. If he were instead to plan to retire at 67 (his full-benefit Social Security retirement age), he could save about $1500 less per year and have income until age 87 rather than 82. This is a decision he can defer until he gets older. If he is in good health at age 62, he can consider waiting to retire.

The additional $3676 in current dollars assumes that the growth of Erik's investments will be 3 percent higher than the inflation rate. As his income goes up, Erik should continue saving about 7.3 percent of his income to reach his goal of retiring at age 62. In this way, he will have a larger amount of income at retirement, thereby replacing his higher level of employment income. Redoing the calculations every few years will help keep Erik informed and on track for a financially successful retirement. If Erik has a paid-for home at retirement, he will need less income.

 CONCEPT CHECK 17.2

1. List the steps in the process of estimating your retirement savings goal in today's dollars.

2. In the text example, what can Erik do to save more for his retirement?

17.3 ACHIEVE YOUR RETIREMENT GOAL BY INVESTING THROUGH EMPLOYER-SPONSORED RETIREMENT PLANS

LEARNING OBJECTIVE 3

Distinguish among the types of employer-sponsored taxsheltered retirement plans.

17.3a The Basics of Tax-sheltered Retirement Accounts

The funds you put into regular investment accounts represent  after-tax money . Assume, for example, that a person in the 25 percent tax bracket earns an extra $1000 and is considering investing those funds. She will pay $250 in income taxes on the extra income, which leaves only $750 in after-tax money available to invest. Furthermore, the earnings from the invested funds are also subject to income taxes each year as they are accrued.

after-tax money Funds put into regular investment accounts after paying income taxes.

The situation is much different when you invest in  tax-sheltered retirement accounts . The contributions may be “deductible” from your taxable income in the year they are made. Here you pay zero taxes on the contributed amount of income in the current year. This means that you are investing with  pretax money , and the salary amount you defer, or contribute, to a tax-sheltered retirement account comes out of your earnings before income taxes are calculated. Thus, you gain an immediate elimination of part of your income tax liability for the current year. The advantage of using tax-deductible contributions is illustrated in Table 17-1.

tax-sheltered retirement accounts Retirement account for which all earnings from the invested funds are not subject to income taxes.

pretax money Investing before income taxes are calculated, thus gaining an immediate elimination of part of your income tax liability for the current year.

In addition, income earned on funds in tax-sheltered retirement accounts accumulates  tax deferred . In other words, the individual does not have to pay income taxes on the earnings (interest, dividends, and capital gains) every year as they accrue as long as they are reinvested within the retirement account. Contributors to tax-deferred accounts often assume that they will be in a lower tax bracket when retired and making withdrawals.

tax deferred The individual does not have to pay current income taxes on the earnings (interest, dividends, and capital gains) reinvested in a retirement account.

A  tax-free withdrawal  is a removal of assets from an account with no taxes assessed. IRS regulations permit tax-free withdrawals from certain after-tax retirement accounts, such as the Roth IRA, which is discussed later. Tax-free means that withdrawals are not taxed. Tax-free withdrawals sometimes occur for certain medical and education expenses and for first-time homebuyers. Details are later in the chapter.

tax-free withdrawals Removal of assets from a retirement account with no taxes assessed.

Table 17-1 Samantha Smarty Invests $6300 in Employer's 401(k) Plan and Earns 41 Percent, Really!

Samantha Smarty participates in her employer's 401(k) retirement plan, and contributes 7 percent, or $6300, of her $89,000 income. Since her contributions are tax deductible and she is in the 25 percent federal tax bracket, this reduces her federal income taxes by $1 575 ($6300 × .25 = $1 575), and it reduces her state income tax another $252 ($6300 × 0.04 = $252). Thus, for a net outflow of $4473 ($67,334 − $62,861), Samantha gets to invest $6300. That's a 41 percent return ($6300 − $4473 = $1827/$4473) on her “investment.” Whoa! What a great deal!

	Not Participating in 401(k) Plan	Participating in 401(k) Plan
Income	$89,000	$89,000
Contribution to plan	- 0 -	6,300
Taxable income	89,000	82,700
Federal income tax*	18,106	16,531
State income tax (4%)	3,560	3,308
Take-home pay	$67,334	$62,861

* From Table 4-2 on page 114.

17.3b Employer-Sponsored Retirement Plans Are Government Regulated

An  employer-sponsored retirement plan  is an IRS-approved plan offered by an employer. These are called qualified plans, meaning that they qualify for special tax treatment under regulations of the  Employer Retirement Income Security Act (ERISA) . They are also known as salary-reduction plans because the contributed income is not included in an employee's salary. In effect, the contributions to an employer-sponsored retirement plan are an interest-free loan from the government to help you fund your retirement.

employer-sponsored retirement plan An IRS-approved retirement plan offered by an employer (also called qualified plans).

Employee Retirement Income Security Act (ERISA) Regulates employer-sponsored plans by calling for proper plan reporting and disclosure to participants in defined-contribution, defined-benefit, and cash-balance plans.

employer-sponsored retirement plan An IRS-approved retirement plan offered by an employer (also called qualified plans).

Employee Retirement Income Security Act (ERISA) Regulates employer-sponsored plans by calling for proper plan reporting and disclosure to participants in defined-contribution, defined-benefit, and cash-balance plans.

ERISA does not require companies to offer retirement plans, but it does regulate those plans that are provided. ERISA calls for proper plan reporting and disclosure to participants. Participating in a plan, such as a 401(k) plan, can serve as the cornerstone of your retirement planning.

Beneficiary Designation and Account Trustee When you open a retirement account, you must sign a beneficiary designation form. This document contractually determines who will inherit the funds in that retirement account in case you die before the funds are distributed. This designation contractually overrides any provisions in a will.

A special rule applies to 401(k) plans and other qualified retirement plans governed by the ERISA federal law. Your spouse is entitled to inherit all the money in the account unless he or she signs a written waiver, consenting to your choice of another beneficiary. It is not enough just to name someone else on the beneficiary form that your employer provides you.

The contributions into an employee's retirement account are deposited with a trustee (usually a financial institution, bank, or trust company that has fiduciary responsibility for holding certain assets), which according to the employee's instructions invests the money in various securities, including mutual funds, and sometimes the stock of an employer. Each employee's funds are managed in a separate account.

Vesting The worker always has a legal right to own the amount of money he or she contributes to his or her account in the employer's plan. This also means that the employee determines how the funds are to be invested and withdrawn.

Vesting  is the process by which employees accrue non-forfeitable rights over their employer's contributions that are made to the employee's qualified retirement plan account. Some employers permit immediate vesting, or ownership, although most employers delay the vesting of their contributions to the employee for three to four years.

vesting Ensures that a retirement plan participant has the right to take full possession of all employer contributions and earnings.

According to ERISA, the employer can require that the worker must work with the company for three years before vesting begins or he or she will lose any employer contributed money. Employers sometimes permit no vesting for the first two years and then one is fully vested after the third year. This is known as cliff vesting. Or it can choose to have the 20 percent of the contributions vest each year over five years, known as  graduated vesting .

If an employee has not worked long enough for the employer to be vested before leaving his or her job, the employer's contributions are forfeited back to the employer's plan. The employee has no rights to any of those funds.

graduated vesting Schedule under which employees must be at least 20 percent vested after two years of service and gain an additional 20 percent of vesting for each subsequent year until, at the end of year six, the account is fully vested.

There are three common types of employer-sponsored retirement plans: (1) defined-contribution, (2) defined-benefit, and (3) cash-balance.

17.3c Type 1: Defined-Contribution Retirement Plans Are Most Common Today

A  defined-contribution retirement plan  voluntarily offered by an employer is designed to provide a retiring employee a lump sum at retirement. This is the most popular retirement plan today, and it is offered by close to half of all employers. It is distinguished by its “contributions”—that is, the total amount of money put into each participating employee's individual account. The eventual retirement benefit in such an employer-sponsored plan consists solely of assets (including investment earnings) that have accumulated in the various individual accounts.

defined-contribution retirement plan A retirement plan designed to provide a lump-sum at retirement; it is distinguished by its “contributions”— the total amount of money put into each participating employee's individual account.

Contributory and Noncontributory Plans In a noncontributory plan, money to fund the retirement plan is contributed only by the employer. In a  contributory plan , money to fund the plan is provided by both the employer and the participant or solely by the employee. Most plans are contributory.

contributory plan The most common type of employee-sponsored defined-contribution retirement plan; accepts employee as well as employer contributions.

In a contributory plan the employer chooses to make a  matching contribution  that may fully or partially match (up to a certain limit) the employee's contribution to his or her employer-sponsored retirement account. The matching contribution may be up to a certain dollar amount or a certain percentage of compensation. For example, the match might be $1.00 for every $1.00 the employee contributes up to the first 3 percent of pay. More common is $0.50 per $1.00 up to the first 6 percent of pay. Better employers contribute $1 for every $1 you contribute up to 6 percent, or more. The employer contributions effectively increase your income without increasing your tax liability because you pay no income taxes on matching contributions until they are withdrawn during retirement.

matching contribution Employer benefit that offers a full or partial matching contribution to a participating employee's account in proportion to each dollar of contributions made by the participant.

When your employer makes a contribution to your account every time you do, you in effect obtain an “instant return” on your retirement savings. Saving $4000 a year with a $0.50 employer match immediately puts $2000 more into your retirement account, giving you a 50 percent return ($2000/$4000). This concept is illustrated in Table 17-2, arguing strongly that you should work only for companies whose policy is to offer healthy matching employer retirement contributions. Employers sometimes reduce or eliminate their matching contributions to retirement plans during times of poor profits. That is when employees often leave for other employment opportunities.

Some employers make their contributions in lump-sum payments to employees' accounts, at the end of the year rather than at the time of each paycheck As a result, all employees miss out on compounding for 12 months and those who leave during the year never receive the funds.

Automatic Enrollment Many employers offer automatic enrollment, which is a feature in a retirement plan that allows an employer to “enroll” all eligible employees in the employer's plan. As a result, part of the employees' wages are contributed to the retirement plan on the their behalf. An employee may affirmatively choose not to contribute at the plan's default percentage rate or to contribute a different amount. The default percentage could start at 3 percent and gradually increase annually.

FINANCIAL POWER POINT  

Save 12 to 15 Percent for Retirement Including Employer Contributions

People who start saving and investing for retirement during their 20s should aim to reserve 12 to 15 percent of their pretax income every year, including employer contributions, for this purpose. Those who have delayed planning for retirement until their late 30s or 40s should begin investing 20 to 25 percent annually in an effort to catch up. They have no choice.

Table 17-2 Only Work for Companies Who Offer Healthy Matching Employer Retirement Contributions

You should make contributions to your employer-based retirement account at least up to the amount where you obtain the largest matching contribution from your employer. The matching 100 percent employer contributions shown below increase the retirement account balance after 30 years from $317,000 to $476,000 with a 2 percent match and to $634,000 with a 4 percent match. By increasing the employee's contribution from 4 percent ($70,000 × 0.04 = $2800) to 6 percent ($70,000 × 0.06 = $4200) to obtain the full 100 percent employer match on the first 6 percent of salary, the sum rises to almost $1 million after 30 years earning an 8 percent annual return. Be smart. Work only for employers who offer healthy matching contributions to your retirement account.

Self-Directed Defined-contribution retirement plans are described as  self-directed  because the employee controls where the assets in his or her account are invested. The individual typically selects where to invest, how much risk to take, how much to invest, how often contributions are made to the account, as well as when to buy and sell. Over time, the balance amassed in such an account consists of the contributions plus any investment income and gains, minus expenses and losses. The contributions devoted to the account are specified (“defined”). The future amount in the account at retirement will not be known until the individual decides to begin making withdrawals. This uncertainty occurs because the sum available to the retiree depends on the success of the investments made. At retirement, the retiree thus has a lump sum to manage and spend down during the rest of his or her lifetime.

self-directed In defined-contribution plans, employees control the assets in their account—how often to make contributions to the account, how much to contribute, how much risk to take, and how to invest.

Risks of Defined Contribution Plans Defined contribution plans are not without risks. In fact, they are considerable because you must decide how much to save, how to invest, and how much to withdraw in retirement so you do not run out of money. And you do not know what the stock markets will do over the next 30 or 40 years.

ADVICE FROM A PROFESSIONAL

Buy Your Retirement on the Layaway Plan

The large retirement savings goal dollar amount scares some people. To allay such concerns, the following novel approach to thinking about retirement saving has been suggested. You can look at your retirement as something you “buy.” The “retail price” is the retirement nest egg goal itself. From that amount, you can subtract “discounts” for anticipated income from Social Security, employer-sponsored retirement accounts, personal retirement accounts, and any other funds you expect to have accumulated. Then you identify the difference—the shortfall indicated on line 9 of the Run the Numbers worksheet—and buy it on a “layaway plan.” The additional amounts you periodically save and invest are, therefore, the “layaway payments” with which you “buy” your retirement. This is smart thinking!

Dennis R. Ackley

Ackley & Associates, Kansas City, Missouri

Names of Defined-Contribution Plans Several types of employer-sponsored defined-contribution plans exist. These include the 401(k), 403(b), and 457 plans (named after sections of the IRS tax code) and the SIMPLE IRA and SIMPLE 401(k). Each plan is restricted to a specific group of workers. You may contribute to these plans only if your employer offers them.

The  401(k) plan  is the best-known defined-contribution plan. It is designed for employees of private corporations. (You can compare the quality of your employer's 401(k) plan with others at BrightScope (www.brightscope.com). Eligible employees of nonprofit organizations (colleges, hospitals, religious organizations, and some other not-for-profit institutions) may contribute to a 403(b) plan that has the same contribution limits. Employees of state and local governments and non-church controlled tax-exempt organizations may contribute to 457 plans; only employees (not employers) make contributions to 457 plans. An employer offering 401(k), 403(b), and 457 plans may also offer Roth versions of these plans calling for after-tax (rather than tax-deferred) contributions but with provisions for tax-free withdrawals during retirement.

401(k) plan Defined-contribution plan designed for employees of private corporations.

When the employing organization has 100 or fewer employees, it may set up a Savings Incentive Match Plan for Employees IRA (SIMPLE IRA). Employers with 25 or fewer employees can offer a Salary Reduction Simplified Employee Pension Plan (SARSEP) plan similar to a 401(k) plan. Regulations vary somewhat for each type of plan.

Limits on Contributions There are limits on the maximum amount of income per year that an employee may contribute to an employer-sponsored plan. The maximum contribution limit to 401(k), 403(b), 457, and SIMPLE IRA plans is $17,500.

Catch-Up Provision A catch-up provision permits workers age 50 or older to contribute an additional $5500 to most employer-sponsored plans. Millions of people who are getting a late start on saving—including women who have gone back to work after raising children—can put more money away for retirement.

DID YOU KNOW 

Enormous Hidden 401(k) Fees Reduce Employee's Returns

A median-income, two-earner household will pay nearly $155,000 over the course of their lifetime in 401(k) fees, according to an analysis by Demos, a public policy organization. Retirement Savings Drain: The Hidden and Excessive Costs of 401(k)s, details how savers are vulnerable to losing almost one-third of their investment returns to inefficient stock and bond markets.

Many working employees are not aware that their employer's 401(k) retirement plan charges them fees for recordkeeping, administrative services, and trading and transaction costs. All employers assess fees that are deducted each year from each account before employees see their net returns. According to the Investment Company Institute the average is 0.72% for bond mutual funds and 0.95% for stock mutual funds. That amounts to $72 to $95 in fees on every $10,000 of your 401(k) balance every year! Small employers' 401(k) fees average 1.33% compared to 0.15% for large employers.

High fees can reduce one's ending total 401(k) balance by 15 to 20 percent. That cuts $150,000 to $200,000 from an expected balance of $1,000,000, which over the years reduces your account to $800,000 to $850,000. If this hidden fee issue impacts you, contact your employer's human resource department to find out how much in fees you pay each year, what the fees pay for, and what it will take to get them reduced.

All investors are similarly challenged. If you start with $10,000 and invest $500 a month for 30 years into a low-fee index fund charging only 0.2 percent annually and it grows at 8 percent each year, your account will total $818,000. If the fund charges a moderate 1.2 percent, your account total will reach $663,000. That's $155,000 less money because 23 percent of the total went to fees!

DID YOU KNOW 

Relying on Today's Voluntary 401(k)/IRA Retirement Saving Plans Has Been a Failure

According to the Center for Retirement Research, only half of the nation's 115 million private sector employees work for an employer that offers a 401(k) plan. More than one-third have no retirement coverage through their employers at all throughout their working lives. Thirty-eight million working-age households do not have any money saved for retirement.

Seventy-five percent of Americans nearing retirement have less that $30,000 in their retirement accounts. Data from the Employee Benefit Research Institute show that only 22 percent of workers 55 or older have more than $250,000 put away for retirement account. A full 60 percent of workers in that age bracket have less than $100,000 in a retirement account. Even with Social Security pension payments, $100,000 is not going to last very long, certainly not 20 more years.

Of all those who have saved in 401(k) retirement plans, 30 percent have taken out loans for an average of 20 percent of the sum in the account. Plus, two-thirds of those who leave their jobs are unable to pay off the balance borrowed. Their loans then are in default, thus triggering additional income taxes and a 10 percent tax penalty.

Fifty percent of workers who are eligible to save and invest in a retirement plan don't save at all. And 56 percent of younger workers (ages 18 to 34) don't either. Less than 3 percent of all eligible employees contributed the maximum amount to their employee-sponsored retirement accounts.

The 401(k) plans are a retirement account that was supposed to help workers end up with enough money for a person or couple to retire on. The trouble is that it is clear that the shift from defined-benefit plans to 401(k)s has been a gigantic failure. Employers took advantage of the switch to increase profits by cutting retirement benefits. Millions do not manage or invest their money wisely. The returns on investments for workers have been far less than they were told to expect.

The 401(k) program seems to have been designed to fail and it has. As a result, we are facing a looming retirement crisis, with tens of millions of Americans facing a sharp decline in living standards at the end of their working lives. Many will choose to work until they cannot continue or until they die.

Just as a voluntary Social Security system would have been a disaster, relying on today's do-it-yourself, voluntary 401(k)/IRA retirement savings system has been a failure for the American society.

Avoid the disaster by getting as smart as you can about investing. You can and must plan for retirement, save, and invest as much as possible, and keep your fingers crossed for good luck. Maybe one day Congress will require that employers again offer defined-benefit plans to workers. Or, as Bloomberg's Business Week says in “Australia Gets Retirement Right” that increased contributions now required by both employers and employees will assure all Australians financially successful retirements.

Portability An added benefit of employer-sponsored plans is portability.  Portability  means that upon termination of employment, an employee can transfer the retirement funds from the employer's account to another tax-sheltered account without taxes or penalty.

portability Upon termination of employment, employees with portable benefits can keep their savings in tax-sheltered accounts, transferring retirement funds from employer's account directly to another account without penalty.

DOL's Lifetime Income Calculator The Department of Labor (DOL) is considering proposing a rule that would require companies to provide estimated income illustrations for workers participating in defined contribution pension plans such as 401(k)s and 403(b)s. Simply put, you would get a snapshot of how your savings in these plans would work out to a monthly dollar amount, given certain assumptions. Instead of waiting, check out the DOL's draft “Lifetime Income Calculator” (www.dol.gov/ebsa/regs/lifetimeincomecalculator.xhtml).

Blackrock's CoRI™ Retirement Income Planning Tool A major challenge facing those saving for retirement is “How much to save?” Blackrock's CoRI™ helps savers calculate how much they need to save to generate a specific lifetime income starting at age 65. See www.blackrock.com/cori-retirement-income-planning.

17.3d Type 2: Defined-Benefit Plans Are Yesterday's Standard

The second type of employer-sponsored retirement plan, a  defined-benefit retirement plan (DB) , pays lifetime monthly payments to retirees based on a predetermined formula. Defined-benefit plans are commonly called pensions. A pension is a sum of money paid regularly as a retirement benefit. The Social Security Administration, various government agencies, and some employers pay pensions to retirees, and sometimes to their survivors.

defined-benefit retirement plan (DB) Employer-sponsored retirement plan that pays lifetime monthly annuity payments to retirees based on a predetermined formula.

Defined-benefit plans were the standard retirement plan for previous generations, but today such pensions are offered by only 15 percent of employers. DB plans were offered by 38 percent of U.S. companies 35 years ago. These employers guaranteed employer-paid monthly retirement payments for life.

Pension benefits in defined-benefit plans are based on the years of service at the employer, average pay during the last few working years, and a percentage. For example, an employee might have a defined annual retirement benefit of 2 percent multiplied by the number of years of service and multiplied by the average annual income during the last five years of employment. In this example, a worker with 20 years of service and an average income of $48,000 over the last five years of work would have an annual pension benefit of $19,200 (20 × 0.02 × $48,000), or $1600 per month.

Since the employer contributes all the money, it assumes all the investment risks associated with creating sufficient funds to pay future benefits. Some better employers still offer a non-optional defined-benefit retirement plan and a voluntary defined-contribution plan to their employees.

Critics of defined-benefit plans incorrectly claim that recipients of such a retirement plan, such as firefighters, policemen, and teachers, are bankrupting states and localities. In fact it is the politicians who over the years and despite signed agreements have failed to vote to contribute to the plans each and every year. Pensions currently take up only 3.8 of state resources annually while states give away over 4 times that amount each year in corporate subsidies.

Should You Take Normal or Early Retirement Under a Defined-Benefit Plan? The earlier you retire, the smaller your monthly retirement pension from a defined-benefit plan will be because you will likely receive income for more years as a retired person. To illustrate, assume you are eligible for a full retirement pension of $28,800 per year at age 65. Your benefit may be reduced 3 percent per year if you retire at age 62. Smaller monthly pension payments are paid to the early retiree in a defined-benefit plan so that he or she will receive, in theory, the same present value amount of pension benefits as the person who retires later.

The financial advantage of taking early retirement depends in part on the person's life expectancy and the rate at which benefits are reduced. People who expect to live for a shorter period than the average expectancy may achieve a better financial position by retiring early.

Disability and Survivors Benefits Survivors and disability benefits also represent concerns for workers who have spouses or children or are financially responsible for caring for others. A person's full retirement pension forms the basis for any benefits paid to survivors and, when part of a retirement plan, for disability benefits as well.  Disability benefits  may or may not be paid to employees who become disabled prior to retirement. People receiving either survivors or disability benefits from a company pension are entitled to an amount that is substantially less than the full retirement amount. For example, if you were entitled to a retirement pension benefit of $2000 per month, your disability benefit might be only $1100 per month.

disability benefits Substantially reduced benefits paid to employees who become disabled prior to retirement.

DID YOU KNOW 

Tax Consequences in Retirement Planning

Tax-deferred retirement plans, like 401(k) plans and traditional IRAs, provide these benefits:

• Your contributions are tax deductible and are not subject to federal, state, and local income taxes.

• No income taxes are due on any earnings on the assets until withdrawn.

• Withdrawals are subject to income taxes at your marginal tax rate, which in retirement may be lower than your tax rate today.

• Other retirement income, such as from Social Security, pensions, employment, interest, dividends, and capital gains, is subject to income taxes.

• When you die, any qualified beneficiary may choose to roll your 401(k) and IRA assets into an IRA tax-free.

If a survivor is entitled to benefits the pension amount must be paid over two people's lives instead of a single person's life; consequently, the monthly payment is different. Using the benefit described in the preceding example, if your surviving spouse is five years older than you, he or she might be entitled to $1300 per month. In contrast, if your spouse is five years younger, he or she might be entitled to only $900 per month.

A qualified  joint and survivor benefit  (or  survivor's benefit ) is an annuity whose payments continue to the surviving spouse after the participant's death, often equal to at least 50 percent of the participant's pension benefit. This requirement can be waived if desired, but only after marriage—not in a prenuptial agreement. Federal law dictates that a spouse or ex-spouse who qualifies for benefits under the plan of a spouse or former spouse must agree in writing to a waiver of the spousal benefit.

joint and survivor benefit/survivor's benefit Annuity whose payments continue to a surviving spouse after the participant's death; often equals at least 50 percent of participant's benefit.

This  spousal consent requirement  protects the interests of surviving spouses. If the spouse does waive his or her pension survivor benefits, the worker's retirement benefit will increase. Upon the worker's death, the spouse will not receive any survivor benefits when a waiver has been signed. Unless a spouse has his or her own retirement benefits, it is usually wise to keep the spousal pension benefit.

spousal consent requirement Federal law that protects the surviving rights of a spouse or ex-spouse to retirement or pension benefits unless the person signs a waiver of those rights.

17.3e Type 3: Cash-Balance Plan Is a Hybrid Employer-Sponsored Retirement Plan

A third type of retirement plan is a hybrid of the defined-contribution and defined-benefit plans. A  cash-balance plan  is a defined-benefit plan that gives each participant an interest-earning account credited with a percentage of pay on a monthly basis. It is distinguished by the “balance of money” in an employee's account at any point in time. The employer contributes 100 percent of the funds, and the employee contributes nothing.

cash-balance plan Defined-benefit plan funded solely by an employer that gives each participant an interest-earning account credited with a percentage of pay on a monthly basis.

DID YOU KNOW 

Retirement Plan Insurance

ERISA established the Pension Benefit Guaranty Corporation (PBGC; www.pbgc.gov). The nation's 27,500 employer-sponsored defined-benefit pension plans pay insurance premiums to the PBGC, which guarantees a certain minimum amount of benefits of up to $4900 a month to 44 million eligible workers should those plans become financially unable to pay their obligations. The PBGC has taken over about 3800 plans. PBGC insurance never insures defined-contribution plans, but it does insure some cash-balance plans.

DID YOU KNOW 

How Poorly Prepared Are Today's “Near Retirees”?

One-third of people age 55 to 64 have not saved a penny for retirement. The National Institute on Retirement Security reports that 90 percent of American workers will not be able to afford to retire on savings and Social Security. These people cannot catch up financially. Time, not money, is still the most important concept in saving and investing for retirement. You do not want to become one of these statistics. So, begin to start saving early in life for your retirement. Prepare today by saving to do tomorrow what you love.

The Pension Protection Act regulates the percentage earned on such accounts. The employer contributes a straight percentage of perhaps 4 percent of the employee's salary every payday to his or her specific cash-balance account. Interest on cash-balance accounts is credited at a rate guaranteed by the employer, and the employer assumes all the investment risk. As a result, the amount in the account grows at a regular rate. Employees can look ahead 5 or 25 years and calculate how much money will be in their account.

17.3f Additional Employer-Sponsored Retirement Plans

Some employers offer other supplemental savings plans to employees.

ESOP An  employee stock-ownership plan (ESOP)  is a benefit plan through which the employer donates company stock into a trust, which are then allocated into accounts for individual employees. When employees leave the company, they get their shares of stock and can sell them. In effect, the retirement fund consists of stock in the company.

employee stock-ownership plan (ESOP) Benefit plan in which employers make tax-deductible gifts of company stock into trusts, which are then allocated into employee accounts.

Profit-Sharing Plan A  profit-sharing plan  is an employer-sponsored plan that shares some of the profits with employees in the form of end-of-year cash or common stock contributions into employees' 401(k) accounts. The level of contributions made to the plan may reflect each person's performance as well as the level of profits achieved by the employer.

profit-sharing plan Employer-sponsored plan that allocates some of the employer profits to employees in the form of end-of-year cash or common stock contributions to employees' 401(k) accounts.

DID YOU KNOW 

Money Websites for Retirement and Estate Planning

Informative websites for retirement planning, including calculators to estimate how much to save are:

AARP on estate planning (www.aarp.org/money/estate-planning/)

American Savings Education Council's ballpark estimate (www.choosetosave.org/ ballpark/)

Blackrock's CoRI retirement income planning tool (www.blackrock.com/cori-retirement-income-planning)

BrightScope (brightscope.com)

EstatePlanning.com (www.estateplanning.com/)

Nolo on wills, trusts and estates (www.nolo.com/legal-encyclopedia/wills-trusts-estates)

Pension Benefit Guaranty Corporation (PBGC; www.pbgc.gov)

QuickAdvice (www.guidedchoice.com/quickadvice/)

Social Security Administration (www.ssa.gov and www.ssa.gov/estimator/)

T. Rowe Price (troweprice.com)

Vanguard (vanguard.com)

 CONCEPT CHECK 17.3

1. Distinguish among after-tax money put into investments, pretax money, and vesting.

2. Explain what is meant by tax-sheltered investment growth on money invested through qualified retirement accounts.

3. Summarize the main differences between defined-contribution and defined-benefit pension plans.

4. Explain why defined-contribution retirement plans are called self-directed.

5. Offer your impressions of working for an employer that offers a sizable matching contribution compared with one that does not.

17.4 ACHIEVE YOUR RETIREMENT SAVINGS GOAL THROUGH PERSONALLY ESTABLISHED RETIREMENT ACCOUNTS

LEARNING OBJECTIVE 4

Explain the various types of personally established tax-sheltered retirement accounts.

If you do not have access to an employer plan, you easily can, and should, set up your own plan. IRS regulations allow you to take advantage of personally established, self-directed tax-sheltered retirement accounts such as an individual retirement account (IRA). The total maximum annual contribution you may make to any IRA account is $5500 (or $6500 for those over age 50). These personally established retirement accounts include Roth IRA accounts, IRAs, and Keogh and SEP-IRA plans.

If your employer does not have a retirement plan, you must open one or more accounts to fund your own retirement. You are required to make a contribution before April 15th of the tax year following the year you will take the tax deduction.

17.4a Roth IRA Accounts Provide Tax-Free Growth and Tax-Free Withdrawals

A  Roth IRA  is a nondeductible, after-tax IRA that offers significant tax and retirement planning advantages, especially for those who expect to be in a lower tax bracket in retirement. Contributions to Roth IRAs are not tax deductible, but funds in the account grow tax-free. You do not pay taxes each year on capital gains, dividends, and other distributions from securities held within a Roth IRA account.

Roth IRA IRA funded with after-tax money (and thus it is not tax deductible) that grows on a tax-deferred basis; withdrawals are not subject to taxation.

Withdrawals from a Roth IRA also are tax-free if taken at age 59½ or later (or if you are disabled) from an account held at least five years. Tax-free withdrawals may be made for qualifying first-time homebuyer costs, medical expenses, or to pay for educational expenses. Once you remove money from a Roth IRA, it is a withdrawal (not a loan), and you cannot put it back. There is no mandatory withdrawal schedule for Roth IRAs, and money in the account can pass to an heir free of estate taxes. You may open a Roth IRA even if you (or your spouse) have a retirement plan at work. About half of employers offer Roth IRAs, and some employers offer Roth 401(k) accounts.

17.4b Individual Retirement Accounts (IRAs) Result in Tax-Free Growth and Taxable Withdrawals

An  individual retirement account (IRA)  is a personal retirement account into which a person can make one or more annual contributions. An IRA is not an investment but rather an account in which to hold investments, like stocks and mutual funds. It is much like any other account opened at a bank, credit union, brokerage firm, or mutual fund company. You can invest IRA money almost any way you desire, including collectibles like art, gems, stamps, antiques, rugs, metals, guns, and certain coins and metals. You may invest once and never do it again or you may contribute regularly for many years, and you may change investments whenever you please.

individual retirement account (IRA) Personal retirement account to which a person can make contributions that provide tax-deferred growth.

DID YOU KNOW 

MyRAs is a Starter Savings Opportunity

The Obama Administration created a new type of employer-based, no-fee savings account for retirement called MyRAs (pronounced “My-R-As).” It is aimed at the more than half the civilian labor force lacking access to a work-based retirement plan. The minimum after-tax investment is $25 and payroll deductions may be $5 or more. Funds in the account earn a rate of interest comparable to a federal government securities program, and the principal cannot be lost. Once the account balance reaches $15,000, or after 30 years, the funds must be moved to a Roth IRA account. MyRA rules are the same as for Roth IRA accounts. Distributions are always penalty free.

DID YOU KNOW 

Invest Retirement Money Only in “Low-Cost” Choices to Earn 28 Percent More

Investing for retirement in low-cost or ultra-low-cost funds, such as an index fund or exchange-traded fund, is the single most effective strategy to fatten your retirement nest egg. Assume you are 30 years old, earn $40,000, and invest 6 percent of your salary with a $0.50 match on $1.00. Your salary increases 3 percent annually, and your investments earn 8 percent a year. Low mutual fund expenses dramatically increase your retirement nest egg: 28 percent more in this example ($852,000 − $664,000 = $188,000/$664,000).

Cost of Mutual Fund Expenses	Retirement Nest Egg at Age 65
High expenses (1.5%)	$664,000
Moderate expenses (1.0%)	$732,000
Low expenses (0.5%)	$819,000
Ultra-low expenses (0.25%)	$852,000

To fund the account, you may make a new contribution or transfer a lump-sum distribution received from another employer plan or another IRA account to your IRA account. Taxpayers can even opt on their federal tax return to allocate part or all of their refund for direct deposit into an IRA account. You may not borrow from an IRA.

A  traditional  (or  regular )  IRA  offers tax-deferred growth. Your contributions may be tax deductible, which means that you can use all or part of your contributions to reduce your taxable income. If you (or your spouse) have a retirement plan at work, your contributions to an IRA account may be limited.

traditional (regular) IRA Account that offers tax-deferred growth; the initial contribution may be tax deductible for the year that the IRA was funded.

A nonworking spouse can make a deductible IRA contribution to a  spousal IRA  account of up to $5500 ($6500 if age 50 or older) as long as the couple files a joint return, and the working spouse has enough earned income to cover the contribution. The IRS requires that withdrawals from all types of IRA accounts begin no later than age 70½.

spousal IRA Account set up for spouse who does not work for wages; offers tax-deferred growth and tax deductibility.

17.4c Keoghs and SEP-IRA Accounts Are for Self-Employed Individuals

A  Keogh  (pronounced “Key-oh”) is a tax-deferred retirement account designed for high-income self-employed and small-business owners. Depending on the type of Keogh established (defined benefit or defined contribution), an individual may save as much as 25 percent of self-employment earned income, with contributions capped at $52,000 per participant. If the income comes from self-employment, contributions can still be made after age 70½.

Keogh Tax-deferred retirement account designed for high-income self-employed and small-business owners.

DID YOU KNOW 

Spouses and Children Inheriting an IRA

When you as a spouse inherit an IRA you must retitle it in your name. If it is a traditional IRA, retitle it in the following format “John Doe IRA (deceased January 2, 2016) for the benefit of Jane Doe, beneficiary.” This means you may make withdrawals penalty-free regardless of age or you may plan to leave the money in the account until you are 70½ years old, when required withdrawals must begin. The account must be retitled again when you reach age 59½ so you may defer withdrawals until age 70½.

When a child inherits an IRA it, too, must be retitled in a similar format. Every year, however, the child must make a withdrawal based upon the age of the donor.

If you do not retitle the assets, you will be immediately taxed on all of the funds in the IRA rather then having the money tax-deferred. The same retitling guidelines apply to inherited 401(k) accounts.

The money in an inherited Roth IRA comes out tax-free. You may not roll inherited IRAs and 401(k)s into your IRA or 401(k) accounts.

DID YOU KNOW 

Sean's Success Story

Sean is now 52 years old. He has held four jobs, and two of his employers offered no retirement plan. When working at those jobs, he made monthly deposits into a Roth IRA account with low-fee mutual fund investments. He participated fully in the plans offered by the other two employers. Total annual contributions to retirement savings usually totaled about 12 percent, including the matches from his employers who offered retirement plans. When Sean changed employers, he always transferred the vested amounts in his retirement accounts to a rollover IRA account, which now has a value of $412,000.

Sean has been with his current employer for ten years, and his 401(k) account balance is $175,000. He has been careful to diversify his retirement investments. He started investing almost solely in stock funds, especially stock index funds. During the last two years, Sean started to move some of his money into lower risk options by focusing on high-rated bond funds. His current allocation is about 60 percent equities, 30 percent bonds, and 10 percent in a money market fund. His target percentages at a planned retirement at age 65 are 45 percent equities, 40 percent bonds, and 15 percent money market. Sean is looking forward to retirement in about 12 years with a nest egg of about $2 million.

DID YOU KNOW 

How to Invest Your Retirement Money

When you open any kind of defined-contribution retirement plan, you may invest in a number of alternatives. Options within employer-based plans are usually mutual funds and employer stock. With mutual funds, you will likely have, at a minimum, a stock fund, a growth stock fund, an index fund, a bond fund, and a money market fund from which to choose. You will want to pay close attention to the costs of each investment as well as stock index funds.

In Chapter 13, we described several long-term investment strategies employed by wise investors (pages 392–401). The most notable of these for retirement investing is the buy and hold philosophy funded by a dollar-cost averaging approach with broad diversification using an asset allocation strategy.

One important principle in investing for retirement is to recognize that you can accept more risk in your investments the farther away you are from retirement. Investing too conservatively almost guarantees low returns and not enough funds at retirement.

Here are some examples of accepting more risk. A young, risk-tolerant, long-term 401(k) or IRA investor with an aggressive investment philosophy might have a portfolio with 100 percent in a growth stock fund. A more moderate approach might have a stock fund/bond fund/money market fund portfolio allocated at 60/30/10 percent, respectively.

If you are just starting out in a 401(k) plan or have no other retirement assets, you might consider investing in a low-fee “target-date retirement fund” (see Chapter 15). These funds are the ultimate in disciplined, hands-off investing. To start, you pick a date that matches the year you plan to retire, perhaps in 2054. The fund will place your money in a diversified portfolio that automatically shifts the asset mix away from equities and toward more conservative fixed-income investments as you approach the year of your retirement. Be sure to avoid high fees!

Instead of being a do-it-yourself investor, a worker can sign up for the services of a “limited managed account” (see Chapter 13). You and your advisor decide on your preferred asset allocation. Then the company on your behalf sells and buys your mutual fund assets, usually quarterly, to adjust your portfolio back to your specified asset allocation percentages. You can do this for less than $100 annually.

When investing for retirement you should never be jumping in and out of investment choices. Relax and be confident that plenty of money will be available for retirement if you save and invest using long-term investment approaches described in Chapter 13. The key suggestion is that you must start to save early in life and choose to invest in low-cost index mutual funds and/or exchange-traded funds and hold them forever.

A simplified employee pension-individual retirement account (SEP-IRA) is a retirement savings account for a sole proprietor's self-employment income and those with one or more employees who are looking to save only in profitable years. A SEP-IRA is easier to set up and maintain than a Keogh. The total contribution to a SEP-IRA account should not exceed the lesser of 25% of income or $52,000. All employees must receive the same benefits under a SEP plan.

 CONCEPT CHECK 17.4

1. Why should workers choose to save for retirement through a personally established retirement account?

2. Summarize the importance of low-cost investment fees to long-term retirement success.

3. List two differences between a Roth IRA and a traditional IRA.

4. Who would use a Keogh rather than a SEP-IRA to save for retirement?

17.5 AVOID PENALTIES AND DO NOT OUTLIVE YOUR MONEY

LEARNING OBJECTIVE 5

Describe how to avoid penalties and make your retirement money last.

Once you have accumulated a substantial retirement nest egg, you can congratulate yourself. For many years, you sacrificed some of your spending and instead saved and invested. However, retirement planning does not end when retirement saving ends.

You will also need to plan your retirement spending so you—and perhaps a significant other—can live during retirement without running out of money. To do so, you must avoid withdrawing your money early, carefully manage your retirement assets, plan appropriate account withdrawals once you do retire, and consider purchasing an annuity with a portion of your retirement funds at retirement.

17.5a Avoid Withdrawing Tax-Sheltered Retirement Money Early

For many people, the money accumulated in a 401(k) or IRA retirement account represents most—if not all—of their retirement savings. Withdrawing money early from a retirement account or borrowing some diverts the funds from their intended purpose, and the money is no longer there to grow tax-deferred. When other financial needs present themselves, there is often a desire to tap into the funds for nonretirement purposes. Such uses were not the intent of Congress when it set up the tax-favored status of the accounts. Making early withdrawals means that you either must retire later or retire at a lower level of living. You want to avoid both.

Beware of the Negative Impacts of Early Withdrawals Early withdrawals—typically defined as a premature distribution before age 59½—are taxed as ordinary income. When money is directly withdrawn from a tax-sheltered retirement account before the rules permit—perhaps to buy a car, take a vacation, remodel a home, or pay off a credit card debt—three bad things happen:

DID YOU KNOW 

How Long Will You Live?

People routinely underestimate the number of years they will be retired. This is because their life expectancy at birth is not the same as their life expectancy as they get older. Your life expectancy at birth is age 74 if you are a man (it's 79 for women).

If you are among the 80 percent of Americans who reach age 65, your life expectancy is now 81 if you are a man (84 for women). Half will live to that long (81 or 84) and half will not. A 65-year-old couple faces a 4 in 5 chance that one of them will live to age 85. The chance that one will reach age 97 is 1 in 4.

Contrary to popular thinking only 4 percent of the elderly are in nursing homes.

1. More taxes are due to the government. The IRS's 20 percent withholding rule applies whenever a participant takes direct possession of the funds grown from pretax contributions to a retirement account. This amount is forwarded to the IRS to prepay some of the income taxes that will be owed on the withdrawn funds. You may avoid the 20 percent withholding rule by transferring the money into a rollover IRA, which is an account set up to receive such funds. You must make a  trustee-to-trustee rollover  whereby the funds go directly from the previous account's trustee to the trustee of the new account, avoiding any payment to the employee.

trustee-to-trustee rollover Retirement funds go directly from the previous account's trustee to the trustee of the new account, with no direct payment to the employee occurring, thereby deferring taxation and the early withdrawal penalty.

Planning an active retirement can include working part-time at something you enjoy.

Assume William Wacky, a 35-year-old with $25,000 in a tax-sheltered retirement account, withdraws $8000 out of the account. If he pays federal and state income taxes at a combined 30 percent rate, his $8000 withdrawal must be included as part of his taxable income. That will cost him an extra $2400 ($8000 × 0.30) in income taxes. Twenty percent of the $8000 will be withheld by William's employer.

2. Penalties are assessed. The IRS assesses a 10 percent  early withdrawal penalty  on such withdrawals. Because William withdrew $8000, he must also pay a penalty tax of $800 ($8000 × 0.10).

early withdrawal penalty A ten percent penalty over and above the taxes owed when money is withdrawn early from a qualified retirement account.

3. The investment does not grow. Withdrawing money means that the investment can no longer accumulate. The lost time for compounding will substantially shrink one's retirement nest egg. William's withdrawal of $8000 out of the account that could have grown at 8 percent over the next 30 years costs him the forgone return of a whopping $80,502 (from Appendix A-1).

Summing up this example, William's early withdrawal of $8000 nets him only $4800 after taxes and penalties ($8000 − $2400 − $800), and he gave up a future value of more than $80,000 in his retirement account. Never withdraw funds early from your retirement account!

Some Penalty-Free Withdrawals Do Exist The IRS imposes no penalty for early withdrawals in three situations:

1. Expenses for medical, college, and home buying. You can make penalty-free withdrawals from an IRA account (but not an employer-sponsored plan) if you pay for medical expenses in excess of 7.5 percent of your adjusted gross income, you pay medical insurance premiums after being on unemployment for at least 12 weeks, you are disabled, you pay for qualified higher-education expenses, or the distribution of less than $10,000 is used for qualifying firsttime home-buyer expenses.

DID YOU KNOW 

Taking Money Out of Your Retirement Plan When Changing Jobs Is A Huge Mistake!

More than 60 percent of workers age 18 to 34 take all the money out of their employer's tax-sheltered retirement account when they change jobs. Taking out perhaps $30,000 to pay for a wedding or to buy a car results in perhaps $10,000 in income taxes and penalties leaving you a net of $20,000. Worse, you forever have lost over $300,000 to use during retirement (Appendix A-1, 8%, 30 years: 10.0627 × $30,000). Early withdrawals are a big mistake!

DID YOU KNOW 

What To Do With Your Retirement Money When Changing Employers

When changing employers or retiring, you may have four choices:

1.  Leave it . You may be able to leave the money invested in your account at your former employer (about half do) until you wish to begin taking withdrawals.

2.  Transfer it . You may be able to transfer the money to a retirement account at a new employer.

3.  Transfer it . You can transfer the money to a rollover IRA.

4.  Take it . You can take the money in cash and pay income taxes and penalties.

Options 2, 3, and 4 result in a lump-sum distribution because all the money is removed from a retirement account at one time. Such a transfer must be executed correctly according to the IRS's rollover regulations or the taxpayer will be subject to a substantial tax bill and perhaps a need to borrow money to pay the IRS. A rollover is the action of moving assets from one tax-sheltered account to another tax-sheltered account or to an IRA within 60 days of a distribution. This procedure preserves the benefits of having funds in a tax-sheltered account.

2. Account loan. You may borrow up to half of your accumulated assets in an employer-sponsored account, not to exceed 50 percent of your vested account balance, or $50,000, whichever is less. The borrower pays interest on the loan, which is then credited to the person's account. Loans must be repaid with after-tax money. If the employee changes employers, he or she must repay the unpaid balance of the loan within 30 days. Otherwise, the loan is reclassified as a withdrawal, which will result in additional taxes and penalties.

3. Early retirement. You may avoid a penalty if you retire early (but not earlier than 59.5 years) or are totally or permanently disabled and you are willing to receive annual distributions according to an IRS-approved method for a time period of no less than five years.

DID YOU KNOW 

Bias Toward Overreacting

People engaged in retirement and estate planning have a bias toward certain behaviors that can be harmful, such as a tendency toward overreacting to both investment gains and losses in retirement accounts. What to do? Retirement is a long-term goal so never think short-term at all. Instead automate the investments in your retirement plan and hire a company to regularly rebalance your account.

DID YOU KNOW 

Turn Bad Habits into Good Ones

Do You Do This?

Put off saving for retirement

Avoid risk when saving for retirement

Rely only on your employer's plan when saving for retirement

Withdraw or borrow money from your retirement accounts when money is desired for other reasons

Put off writing your will and keeping it up to date

Do This Instead!

Save early and often

Accept risk knowing that you have time to ride out the highs and lows of the stock market

Contribute to a Roth IRA to supplement your employer-sponsored plans if necessary to reach your calculated retirement savings goal

Keep your hands off your retirement money

Go online and create a will and revise when needed

17.5b Figure Out How Many Years Your Money Will Last in Retirement

As you near retirement, you will want to ask “How long will my retirement nest egg last?” The answer to this question will depend on three factors: (1) the amount of money you have accumulated, (2) the real (after inflation) rate of return you will earn on the funds, and (3) the amount of money to be withdrawn from the account each year.

Appendix A-4 provides factors that can be divided into the money in a retirement fund to determine the amount available for spending each year. Consider the example of Wayne and Melodee Neu, young retirees from Prescott, Arizona, who want their $500,000 retirement nest egg to last 20 years. They assume that the nest egg will earn a 6 percent annual return in the future and assume an annual inflation rate of 3 percent. The present value factor in the table in the “20 years” column and the “3 percent (6 percent investment return minus 3 percent inflation)” row in Appendix A-4 is 14.8775. Dividing $500,000 by 14.8775 reveals that Wayne and Melodee could withdraw $33,608, or $2800 per month ($33,608 ÷ 12 months), for 20 years before the fund was depleted.

Because they adjusted their rate of return for inflation, the Neus can safely increase their income by two or three percent each year to safeguard the spending power of their retirement income. But what if they live for 30 more years? The factor for 30 years is 19.6004, and the answer is $25,510, or $2126 per month; almost $700 less initially.

One of the mistakes that new retirees make is withdrawing money too fast. Table 17-3 shows how long one's retirement money will last using various withdrawal rates.

DID YOU KNOW 

Bias Toward Loss Aversion

People engaged in retirement and estate planning have a bias toward certain behaviors that can be harmful, such as a tendency toward avoiding losses. Research suggests that losses are twice as powerful, psychologically, as gains. Many of us are too willing to give up the potential upside of better paying investments just to be confident the downside is protected. What to do? When investing for retirement take some risk so you earn higher returns and redo the calculations of retiring on a lump sum with a 2 percent withdrawal rate instead of 4 percent.

DO IT IN CLASS

Table 17-3 How Long Will My Retirement Money Last?

The higher your withdrawal rate, the more likely it is that your portfolio will not last until you die. The basis for the following calculations is research by T. Rowe Price, Vanguard, and other online retirement planning websites. Here are the rates of withdrawals and the likelihood that a diversified portfolio earning a long-term historical rate of return will last through retirement, assuming 3 percent annual increases in withdrawals for inflation.

17.5c You Can Use an Annuity to “Guarantee” a Portion of Your Retirement Income

The fear of running out of money in retirement looms large for people approaching retirement and during retirement. How can you be sure that declines in the stock market will not cause you to have to significantly decrease your level of living as you age? Rather than continuing to manage their own investments and withdrawals in an effort to make the money last, some people use a portion of their retirement nest egg (such as one-third or one-half) to buy an annuity.

An  annuity  is a contract made with an insurance company that provides for a series of payments to be received at stated intervals (usually monthly) for life or a specified time period. For retirees who buy an annuity, this means that an insurance company will receive a portion of their retirement nest egg and, in return, promise to send monthly payments according to an agreed-upon schedule, usually for the life of the person covered by the annuity (the annuitant).

annuity Contract made with an insurance company that provides for a series of payments to be received at stated intervals (usually monthly) for a fixed or variable time period.

Payments Start Right Away When You Buy an Immediate Annuity Retirees typically buy an  immediate annuity  at or soon after retirement. The annuity income payments will then begin at the end of the first month after purchase and any gains will accumulate tax-deferred. You do pay income taxes on the payments.

immediate annuity Annuity, often funded by a lump sum from the death benefit of a life insurance policy or lump sum from a defined-contribution plan, that begins payments one month after purchase.

Fixed and Variable Annuities Annuities offer several options for receiving the annuity benefits. With a fixed annuity, the insurance company guarantees a specified rate of return on your invested funds. The rate is relatively low, perhaps 2 or 4 percent. This is a low investment risk to the company. Because of such low payment rates, fixed annuities do have substantial inflation risk to the recipient annuitant.

In the following examples of hypothetical fixed income payments, assume that a 70-year-old retiree has purchased an annuity for $100,000. A straight annuity might provide a lifetime income of perhaps $790 monthly for the rest of the life of the annuitant only. An installment-certain annuity might provide a payment of $680 monthly for the rest of the life of the annuitant with a guarantee that if the person dies before receiving a specific number of payments, his or her beneficiary will receive a certain number of payments for a particular time period (such as ten years in this example). A  joint-and-survivor annuity  might provide $640 monthly for as long as one of the two people—usually a husband and wife—is alive.

joint-and-survivor annuity Provides monthly payments for as long as one of the two people— usually a husband and wife—is alive.

A more common type of annuity sold by insurance salespeople is called a  variable annuity . This is an annuity whose value rises and falls like mutual funds. Variable annuities do carry investment risk but are better able than fixed annuities to protect against inflation risk. Annuities are sold aggressively because sellers earn very high commissions and the insurance company charges substantial annual fees. An investor may have to wait 15 to 20 years before a variable annuity becomes as efficient as a equivalent investment in a mutual fund. When buying a variable annuity, make sure that you fully understand the fees, commissions, and other rules of the contract.

variable annuity Annuity whose value rises and falls like mutual funds and pays a limited death benefit via an insurance contract.

Annuities Carry Sales Commissions and Fees All annuities charge a variety of fees which reduce the amount of income paid out. First-year sales commissions exceeding 10 percent are typical. Annual expenses are often 3 percent or more. The trade-off the consumer makes is between the guaranteed payouts from an annuity that often carry high costs and the potential substantial risks of managing one's own retirement investments, such as making poor investment choices.

The company knows that in a given pool of 100,000 annuitants that half will die before they reach median life expectancy, and half after. People often do not buy annuities because they prefer to keep money for their heirs. Anyone considering the purchase of an annuity might be wise to begin with Vanguard, Fidelity or TIAA-CREF, all of which are low-fee industry leaders.

DID YOU KNOW 

What Happens If You Don't Save for Retirement?

If you do not save for retirement or do not save enough, there are consequences. You must begin by accepting the fact that how you are living today is not they way you are going to live in retirement. You will be poorer. Your choices will be to:

1. Reduce your level of living in retirement, perhaps by eliminating cable television and vacations;

2. Delay filing for Social Security retirement benefits until past your normal full-benefits age, perhaps to 70, to obtain a larger monthly benefit;

3. Sell your home and move into a smaller, cheaper place, perhaps in a rural community;

4. Move to a geographic area that has a lower cost of living, such as a state with no state income taxes and low real estate property taxes;

5. Delay your retirement and continue working full-time in your present job;

6. Work part-time for your present employer or in a grocery store; and/or

7. Work until you are 80+ years of age or in failing health, or until you die.

Alternatively, you could begin saving for retirement early in life and, therefore, invest enough to live on during your retirement. Plus, you could gain an extra $2000 a month in retirement income by paying off your home and car and getting out of credit card debt before you retire.

 CONCEPT CHECK 17.5

1. What are some negative impacts of taking early withdrawals from retirement accounts?

2. Name two types of penalty-free withdrawals from retirement accounts.

3. Summarize how long one's retirement money will last given certain withdrawal rates.

4. Offer some positive and negative observations on the wisdom of buying an annuity with some of your retirement nest egg money when you retire.

DO IT IN CLASS

17.6 HOW TO PLAN FOR THE DISTRIBUTION OF YOUR ASSETS

LEARNING OBJECTIVE 6

Plan for the distribution of your estate and, if needed, use trusts to lower estate taxes.

Estate planning comprises the specific arrangements you make during your lifetime for the administration and distribution of your estate when you die. It involves both financial and legal considerations, and a primary goal is to minimize both taxes and legal expenses. It is both smart and practical to take the fundamental steps while you are young and then update them as your life progresses.

Upon your death your surviving family members will not conduct the distribution of your assets. Most of these procedures are set up before your death, as described below. Others are set up through  probate  by which a special probate court allows creditors, such as a credit card company, an auto financing company or a mortgage lender, to present claims against an estate and ensures the transfer of a decedent's assets to the rightful beneficiaries. The probate court will make the distributions according to a properly executed and valid will or, when no will exists, to the people or organizations as required by state law.

probate Court-supervised process that allows creditors to present claims against an estate and ensures the transfer of a decedent's assets to the rightful beneficiaries according to a properly executed and valid will or, when no will exists, to the people, agencies, or organizations required by state law.

17.6a Start Right Now by Setting Up Most of Your Assets as Nonprobate Property

Figure 17-1 illustrates the different ways that your property can be distributed after your death. Importantly,  nonprobate property  is not transferred by the probate court. Nonprobate property includes assets transferred to survivors by contract such as by naming a beneficiary for your retirement plan or by owning assets with another person through joint tenancy with right of survivorship. Trusts (discussed below) can also be used to transfer assets outside of probate court.

nonprobate property Does not go through probate; includes assets transferred to survivors by contract (such as beneficiaries listed on retirement accounts and bank accounts held with another person).

Figure 17-1  How Your Estate Is Distributed After Your Death

One of the primary benefits of setting up assets as nonprobate property is time. Nonprobate property transfers immediately upon your death, whereas probate can take between 6 months and a year, or longer if there is no will. Avoiding probate court may also save money since your estate pays the cost of the probate process based on the value of the assets it must distribute, and this ranges from hundreds to perhaps thousands of dollars. Avoiding probate also maintains your privacy because a public record is maintained of the probate process.

17.6b Most Assets Are Transferred by Contract

People of average economic means should be able to transfer by contract most or all of their assets outside of probate. Transferring your estate by contract is an easy, do-it-yourself project. You just have to take a few minutes of time to fill out the appropriate forms. There are three ways to transfer assets by contract:

1. Transfers by Beneficiary Designation When you open up investment accounts, you are given a form to complete in order to name your beneficiaries. Changes are made in the same way; you complete a new beneficiary designation form. Examples of accounts like this are IRAs, 401(k) plans, Keogh plans, pension plans, bank and credit union accounts, stock brokerage accounts, mutual funds, annuities, and life and disability income insurance policies.

A beneficiary is a person or organization designated to receive a benefit. A beneficiary designation is a legal form signed by the owner of an asset providing that the property goes to a certain person or organization in the event of the owner's death. The form also contains a place to designate a  contingent (or secondary) beneficiary  in case the first-named beneficiary, also known as the primary beneficiary, dies after the form is filled out. If no one has been named as beneficiary for a particular asset or if that person and a named contingent beneficiary has died, the property will go to one's estate and to probate court for distribution. The lesson here: Be certain to name contingent beneficiaries as well as beneficiaries in contracts.

contingent (or secondary) beneficiary The beneficiary in case the first-named beneficiary has died; also called the secondary beneficiary.

2. Transfers by Property Ownership Designation  Joint tenancy with right of survivorship  (also called  joint tenancy;  see page 152) is the most common form of joint ownership of assets, especially for husbands and wives. In this case, each person owns the whole of the asset, such as a bank account or home, and can dispose of it without the approval of the other owners. Assets owned in this way often include bank accounts, stocks, bonds, real estate, mutual funds, government bonds, and other assets.

joint tenancy with right of survivorship/joint tenancy Most common form of joint ownership, especially for husbands and wives, in which each person owns the whole of the asset, such as a bank account or home, and can dispose of it without the approval of the other owner(s).

FINANCIAL POWER POINT  

Estate Planning for Unmarried Couples

Most states do not recognize the rights of unmarried partners. However, couples who choose to live together without being married have only a few ways to distribute their estates to their partner. Such couples should arrange to transfer assets to each other as nonprobate property using the advantages of beneficiary and payable-on-death designations, joint ownership with right of survivorship, and trusts.

Upon the death of one owner, the surviving owners receive the property by operation of law rather than through the provisions of a will. Simply stated, the surviving owner(s) owned the entire asset before the death and own all of it after death. The lesson here: If you want an asset to immediately transfer to a particular person upon your death, own it as joint tenants with right of survivorship.

3. Transfers by Payable-on-Death Designation With a  payable-on-death designation  on a bank account the beneficiary has no rights to the funds until you pass on. Until that time, you are free to use the money kept in the bank account, to change the beneficiary, or to close the account. The named beneficiary simply needs to present a copy of your death certificate to the bank and show proper identification, and access to the account will be granted.

payable-on-death designation Status granted to individuals who are not joint tenants and who might need to access accounts without going through probate; the deceased signs the designation before death, and the designee simply presents a death certificate to access the accounts.

17.6c The Rest of Your Estate Can Be Transferred via Your Will

Your  probate property  is simply all assets other than nonprobate property. Your probate property consists of what you owned individually and totally in your name, as well as the value of assets jointly owned through tenancy in common. In the latter case, your heirs will receive your share, but not the co-owner's share.

probate property All assets other than nonprobate property.

Transfers with a Will Go to Your Desired Heirs A will (defined below) is the smartest way to transfer your nonprobate assets upon your death. You definitely need a will unless all of your property is nonprobate property and/or will be transferred by contract. A will is not estate planning. It is written after all the other aspects of estate planning are completed.

A  will  is a written document in which a person, the testator, tells how his or her remaining assets should be given away after death. In your will, you name an  executor  (or  personal representative ). The executor identifies assets, collects any money due, open up an estate bank account, pays off debts, obtains life insurance proceeds, liquidates assets, files for Social Security burial benefits, prepares final income tax and estate tax returns, and with the court's permission distributes the balance of any remaining money and property to the beneficiaries.

will Written document in which a person tells how his or her remaining assets should be given away after death; without a will, the property will be distributed according to state probate law.

executor/personal representative Person responsible for carrying out the provisions of a will and managing the assets until the estate is passed on to heirs.

Relatives and friends are not necessarily the best choice to perform the executor's duties, and many people name an accountant or attorney to play this role since the work is time consuming and challenging for novices and may require the hiring of experts. The person should ideally live in the state where the will is to be probated. A legal background is not necessary, but honesty and maturity are key attributes of a good executor. The executor's basic fee for carrying out these complicated tasks is about 6 percent of the estate (more for smaller estates or less for larger ones) plus a corpus commission of perhaps 5 percent of the value of the estate. Or they can charge an hourly fee.

A simple will that is prepared by an attorney can cost $125 to $400. Minor changes in a will may be made with a  codicil  instead of revoking the existing will and writing a completely new one, as you would when making major changes.

codicil Legal instrument with which one can make minor changes to a will.

A Valid Will Is Not Likely to Be Challenged If you die with a valid will, the probate court will transfer or distribute your property according to your wishes. A person who inherits or is entitled by law or by the terms of a will to inherit some asset is called an  heir . A will that is properly drafted, signed, and witnessed is unlikely to be successfully challenged by someone who is dissatisfied with the intended distribution of assets, thus reducing the likelihood of family disputes. If you have a complicated estate, you should seek the assistance of an attorney who specializes in estate planning.

heir Person who inherits or is entitled by law or by the terms of a will to inherit some asset.

DID YOU KNOW 

Writing a simple will is not that complicated. Here is how Harry Johnson from this book's Harry and Belinda continuing case wrote his.

Last Will and Testament of Harry Johnson

1 Introduction

Being of sound mind and memory, I Harry Johnson, do hereby publish this as my Last Will and Testament. I am married to Belinda Johnson, and my mother is Melinda Johnson.

2 Payment of Debts and Expenses

I hereby direct my Executor to pay my medical expenses, funeral expenses, debts, and the costs of settling my estate.

3 Distribution of Assets

I give my wife one-half of my possessions and all my personal effects. I give my mother one-quarter of my possessions. I give to Common Cause, a nonprofit organization, one-quarter of my possessions. If my wife, Belinda Johnson, predeceases me, I give her share to my mother, Melinda Johnson.

4 Simultaneous Death of Beneficiary

If any beneficiary of this Will, including any beneficiary of any trust established by this Will, other than my wife, shall die within 60 days of my death or prior to the distribution of my estate, I hereby declare that I shall be deemed to have survived such person.

5 Appointment of Executor and Guardian

I appoint my father-in-law, Martin Anderson, to be the Executor of this will and my estate, and provide if this executor is unable or unwilling to serve then I appoint the Trust Department of the Bank of America as alternate Executor. My Executor shall be authorized to carry out all provisions of this Will and pay my just debts, obligations, and funeral expenses.

6 Power of the Executor

The executor of this will has the power to receive payments, buy or sell assets, and pay debts and taxes owed on behalf of my estate.

7 Payment of Taxes

I direct my executor to pay all taxes imposed by governments.

8 Execution

In witness therefore, I hereby set my hand to this last Will and Testament, which consists of one page, this 31st day of January 2015.

_______	_______
Signature	Date

9 Witness Clause

The above-named person signed in our presence and in our opinion is mentally competent.

_______	_______	_______
Witness 1	Address	Date
_______	_______	_______
Witness 2	Address	Date

DID YOU KNOW 

Checklist for Topics to Include in Your Will

• Decide what property to include.

• Decide who will inherit which assets.

• Identify an executor.

• Choose a guardian for your children.

• Select someone to manage children's inherited assets.

• Sign your will in front of witnesses who also will sign.

• Store your original will in an attorney's office or safe deposit box.

FINANCIAL POWER POINT  

Prepare Your Will Online

People who know exactly what they want to do with their property upon their death can use software and online programs to prepare an uncomplicated will. Examples include BuildaWill.com, LegacyWriter, LegalZoom, Kiplinger's Quicken Will-Maker, and WillPower. Some excellent resources for estate planning are on the Web: American Bar Association (www.americanbar.org/portals/public_resources.xhtml), Cornell Law School (www.law.cornell.edu/), National Association of Estate Planners & Councils (www.naepc.org/home/for-public), and Nolo (www.nolo.com/).

You Need to Appoint a Guardian in Your Will if You Have Minor Children If you have minor children, you should appoint a legal  guardian  for each child in your will. This person is responsible for caring for and raising any child under the age of 18 and for managing the child's estate. The guardian should be someone who shares your values and views on child rearing. You might avoid as potential guardians those who are too old, too ill, or too tired from raising their own children, and those who don't really know the children. Consider naming an alternate candidate in case your first choice cannot take on this responsibility. If you have not taken steps to name a legal guardian, the court will appoint one, perhaps someone you do not know.

guardian Person responsible for caring for and raising any child under the age of 18 and for managing the child's estate.

Without a Will, State Law Determines the Distribution of Your Property If you do not care about what happens to your property, children, and favorite pieces of jewelry, the state will make those decisions. When a person dies without a valid will, the deceased is assumed to have died  intestate . Dying intestate can cost much more in taxes and cause legal, bureaucratic, and emotional struggles for survivors. In such a case, the probate court first ensures that the debts, income taxes, and expenses of the deceased are paid. Then, the probate court will divide all property and transfer assets to the legal heirs according to state law. If no surviving relatives exist, the estate will go to the state by right of escheat. One's friends and charities will get nothing.

intestate When a person dies without a legal will.

17.6d Spouses Have Legal Rights to Each Other's Estates

The partnership theory of marriage rights is an assumption in state law that presumes that wedded couples share their fortunes equally. Thus, property acquired during the marriage and titled in the name of only one partner (other than property acquired by gift or inheritance) becomes the property of both spouses.

A decedent who disinherits a surviving spouse or who leaves that person with less than a fair share of the estate is judged to have reneged on the partnership. A surviving spouse disinherited in this manner has some claim in probate court to a portion of the decedent's estate if he or she chooses to elect that option. All states give a surviving spouse the right to claim one-fourth to one-half of the other spouse's estate, no matter what a will provides. The remaining portion may pass to other heirs.

In states with community property laws, the law assumes that the surviving spouse owns half of everything that both partners earned during the marriage, no matter how much was actually contributed by either partner and even if only one spouse held legal title to the property. States with community property laws provide the same spousal rights for marriages that end in divorce.*

17.6e Who Should Consider Setting Up a Trust?

People who should consider setting up a trust include those who have complex estates, hold relatively few liquid assets, desire privacy for their heirs, fear a battle over the provisions of a will, or live in a state with high probate costs or cumbersome probate procedures.

Use Trusts to Transfer Assets Trusts may be created to safeguard the inheritances of survivors, fund a child's education, provide the down payment on someone's home, provide financial assistance for minor children, manage property for young children or disabled elders, and provide income for future generations. They also can reduce estate taxes (the subject of the following section.) Properly drawn trusts can save you and your family time, trouble, and money. These laudable objectives can be achieved only with the assistance of an experienced attorney who specializes in carefully drafting, planning, and executing strategies and techniques in estate planning.

A  trust  is a legal arrangement between you as the  grantor  or creator of the trust and the  trustee , the person designated to control and manage any assets in the trust. The agreement requires the trustee to faithfully and wisely manage and administer the assets to the benefit of the grantor and others. Trusts can be established to take effect during the grantor's life as well as upon his or her death.

trust Legal arrangement between you as the creator of the trust and the trustee, the person designated to faithfully and wisely manage any assets in the trust to your benefit and to the benefit of your heirs.

grantor Creator of a trust—the person who makes a grant of assets to establish a trust. Also called the settler, donor, or trustor.

trustee Person charged with carrying out the trust for the benefit of the grantor(s) and heirs.

DID YOU KNOW 

Legally Married Same Sex Couples and Retirement and Estate Planning

The U.S. Supreme Court decision provides that legally married same sex couples may file for both spousal and survivor’s Social Security benefits. They also qualify for survivor and death benefits under pension, 401(k), and similar plans. Such spouses may inherit each other’s IRAs. They may file joint federal income tax returns in all 50 states, and state income tax forms may be filed in states that recognize their marriages.

Living Trusts Are Established while Grantor Is Alive There are two types of trusts: (1)  living trusts  that take effect while the grantor is alive and (2) testamentary trusts (see next section) that go into effect upon death.

living trust A trust that takes effect while the grantor is still alive.

Revocable Living Trusts  A  revocable living trust  is used to protect and manage a person's assets. The person creating the trust maintains the right to change its terms or cancel the trust at any time, for any reason, during his or her lifetime. Thus, living trusts often establish the grantor as the trustee. A revocable living trust can provide for the orderly management and distribution of assets if the grantor becomes incapacitated or incompetent. A new trustee can easily be named. A revocable living trust operates much like a will and proves difficult to contest. Its assets stay in the estate of the grantor at his or her death.

revocable living trust Grantor maintains the right to change the trust's terms or cancel it at any time, for any reason, during his or her lifetime.

Use an Irrevocable Charitable Remainder Trust to Boost Your Current Income  Effective use of an irrevocable charitable remainder trust (CRT) is popular for people who want to leave a portion of their estate to charity because doing so can boost one's income during the grantor's lifetime. You set up the trust and irrevocably give it assets. The trust then pays you income from the assets in the trust for a set period, usually for life, and possibly your spouse's life as well. The charity eventually receives the assets of the CRT when you (and your spouse, if so arranged) die. For example, Brianna Winston, a widow from San Jose, California, increased the after-tax income on her $600,000 investment portfolio from $1800 to $4800 per year by creating a CRT, thus giving the assets to the National Wildlife Federation. According to her attorney, Benjamin Pauly, the CRT then reinvested the proceeds, thus earning a higher return for the organization and providing more to Brianna.

A CRT works well for people who show wealth on paper because of appreciated assets. The projected future value of the gift can be discounted to a present value. This amount can then be written off as a charitable contribution on Brianna's current income tax return, saving her even more money. It is wise to give to a CRT because the donor can avoid capital gains taxes while still realizing the full benefit of the asset's current value.

Irrevocable Living Trusts  An  irrevocable living trust  is an arrangement in which the grantor relinquishes ownership and control of property. Usually this involves a gift of the property to the trust. It cannot be changed or undone by the grantor during his or her lifetime. The grantor gives up three key rights under an irrevocable living trust: (1) control of the property, (2) change of the beneficiaries, and (3) change of the trustees. Because irrevocable trusts are generally considered separate tax entities, the trust pays any income taxes due. Transfers to a trust made within three years of death may be brought back into the decedent's estate.

irrevocable living trust Arrangement in which the grantor permanently gives up ownership and the right to control of the property, to change the beneficiaries, and to change the trustees.

DID YOU KNOW 

Money Questions to Discuss with Mom and Dad

Parents usually do not want their children to know about how they spend every nickel and dime, but there are some basic money questions that are worthwhile discussing so you all can avoid financial problems in the future:

1. How much total income do they expect to have in retirement, including 401(k)s, IRAs, pensions, and Social Security?

2. How much do they have in reserve in cash and other investments?

3. Do they think they will need financial support from their children?

4. What kinds of insurance do they have (e.g., life, health, disability, long-term care, and where are the policies)?

5. Are the beneficiaries on life insurance and investment accounts (mutual funds, brokerage, IRAs, 401(k)s, pensions) up to date and as they want them to be?

6. Where is a list of parents' financial accounts, passwords, financial institutions, safe deposit box (and key), and contact information for advisors, brokers, accountants, and lawyers?

Testamentary Trusts Go into Effect Only Upon the Death of the Grantor The other broad category of trusts used in connection with estate planning comprises  testamentary trusts . A testamentary trust becomes effective upon the death of the grantor according to the terms of the grantor's will or a revocable living trust. Such trusts can be designed to provide money or asset management after the grantor's death, to provide income for a surviving spouse and children, and to give assets to grandchildren or great-grandchildren while providing income from the assets to the surviving spouse and children, among other things.

testamentary trust Becomes effective upon death of the grantor according to the terms of the grantor's will or a revocable living trust. Such trusts can provide money or asset management after the grantor's death for the heirs' benefit.

17.6f Your Letter of Last Instructions Provides Guidance to Those Left Behind

Many people prepare a  letter of last instructions  along with their will that may contain preferences regarding funeral and burial instructions, organ donation wishes, material to be included in the obituary, contact information for relatives and friends, and other information useful to the survivors, such as the location of important documents. Family members and others are not legally bound by details in a letter of last instructions, but such a letter relieves them of the stress of making some emotional decisions. A letter of last instructions may specify that certain pieces of jewelry or art not specified in your will that have more sentimental than monetary value are to go to specific people. If the will contains different instructions on these matters, the will prevails.

letter of last instructions Nonlegal instrument that may contain preferences regarding funeral and burial, material to be included in the obituary, and other information useful to the survivors, such as the location of important documents.

Your letter of last instructions and original will should be kept in a safe place, such as a lockable filing cabinet or home safe or at an attorney's office. Copies may be given to certain family members or friends.

17.6g Estate Taxes Impact Only 3500 People Each Year Out of a Population of 321 Million

Only about 3500 of the nation's wealthiest estates each year are required to pay federal estate taxes as each owner dies, thus 99.9999 percent are exempt. The  federal estate tax  is assessed against the estate of a deceased person before property (real estate, stocks and bonds, business interests, and so on) is transferred to heirs or assigned according to terms of a will or state intestacy laws. It is a tax on the deceased's estate, not on the beneficiary who is to receive the property.

federal estate tax Assessed against a deceased person's estate before property (real estate, stocks and bonds, business interests, and so on) is transferred to heirs or assigned according to terms of a will or state intestacy laws.

17.6h Basic Exclusion Amount Is $5.34 Million

The estate and gift tax exemption is the amount that one can give away during a lifetime or bequest at death without being subject to the federal estate tax. The tax law exempts the first $5,340,000 of an individual's gifts made and estates of decedents dying. This is also called the basic exclusion amount. The tax rate on estates valued above this amount is 40 percent.

DID YOU KNOW 

Your Worst Financial Blunders in Retirement and Estate Planning

Based on others' financial woes, you will make mistakes in personal finance when you:

1. Wait until your thirties, or worse, your forties to start saving for retirement.

2. Forget to update forms that contractually award assets upon your death, like life insurance and retirement and checking accounts.

3. Invest in mutual funds that charge high fees and expenses.

The law also offers “portability” of the exemption between married couples as it allows them to add any unused portion of the $5.34 million estate tax exemption of the first spouse to die to carry forward to the surviving spouse's estate tax exemption. Thus married couples may pass $10.68 million on to their heirs free from estate taxes with no planning whatsoever.

DID YOU KNOW 

Gift Tax Exclusion Is $14,000 Annually

People with extremely high asset values may reduce the total of their estate by donating up to $14,000 annually to a relative or a friend. This is called the exclusion amount. When paid directly to an institution the funds could pay for someone's school tuition and/or medical expenses, including insurance premiums. There are no tax consequences for gifts up to $14,000 to a recipient or up to $28,000 if members of a couple give individually to a recipient.

17.6i State Estate Taxes and Inheritance Taxes

Nineteen states and the District of Columbia also have a state estate tax, and most are coupled with the federal estate tax. So, when the federal estate tax is zero, those taxes are also zero. States with estate taxes typically exempt much less per estate from their tax and impose a top rate of 12 to 19 percent. Like the federal estate tax, bequests to a spouse are tax-free.

Once the executor of the estate has divided up the assets and distributed them to the beneficiaries, the inheritance tax comes into play. Eight states* impose an  inheritance tax  assessed by the decedent's state of residence on beneficiaries who receive inherited property. This tax is based on how much the beneficiaries get and their right to receive it, and the rates range from 15 to 18 percent. However, transfers to spouses, children, parents, and other close relatives may be either exempt or subject to a lower state inheritance tax rate. The beneficiaries are responsible for paying inheritance taxes.

inheritance tax A tax imposed by eight states that is assessed on the decedent's beneficiaries who receive inherited property.

 CONCEPT CHECK 17.6

1. What is probate, and give three examples of how people should transfer assets by contract to avoid probate.

2. Distinguish between probate and nonprobate property.

3. What topics go into a properly drafted will?

4. Distinguish between an irrevocable living trust and testamentary trusts?

5. What is the likelihood of average people paying estate or inheritance taxes?

WHAT DO YOU RECOMMEND NOW?

Now that you have read the chapter on estate planning, what do you recommend to Juliana and Fernando on the subject of retirement and estate planning regarding:

1. How much in Social Security benefits can each expect to receive?

2. How much do they each need to save for retirement if they want to spend at a lifestyle of 80 percent of their current living expenses?

3. In which types of retirement plans might Fernando invest for retirement?

4. What withdrawal rate might they use to avoid running out of money during retirement?

5. What three types of actions might they take to go about transferring their assets by contract to avoid probate?

BIG PICTURE SUMMARY OF LEARNING OBJECTIYES

LO1 Estimate your Social Security retirement income benefit.

You can and, indeed, must save adequately for your retirement. To do so, during your working years you should diversify your investments, keep investment costs low, and live below your means so you can save and invest. The Social Security program is funded through FICA taxes on employees and employers, and the amounts withheld are put into trust fund accounts from which benefits are paid to current program recipients. You must be fully insured under the Social Security program before retirement benefits can be paid.

LO2 Calculate the amount you must save for retirement in today's dollars.

Your retirement nest egg is the total amount of accumulated savings and investments needed to support your desired retirement. This is calculated by projecting your annual retirement expenses and income and determining the amount of annual savings you need to set aside in today's dollars to achieve your retirement goal.

LO3 Distinguish among the types of employer-sponsored tax-sheltered retirement plans.

The three major types of employer-sponsored retirement plans are defined-contribution, defined-benefit, and cash-balance. Some employers make matching contributions to their employees' accounts. To receive benefits, an employee must be vested in an employer-sponsored retirement plan.

LO4 Explain the various types of personally established tax-sheltered retirement accounts.

IRS regulations allow you to take advantage of personally established tax-sheltered retirement plans, including the traditional individual retirement account, or IRA, for which contributions are tax deductible and withdrawals are taxed. After-tax contributions may be made to Roth IRAs in which earnings accumulate tax-free and withdrawals are not taxed. Keogh plans and SEP-IRA plans are available for the self-employed and small business owners.

LO5 Describe how to avoid penalties and make your retirement money last.

You can save on taxes and make sure your retirement money is maximized by not withdrawing it prior to retirement. Then, your choices at retirement are to carefully manage your retirement account withdrawals and consider purchasing an annuity with a portion of your retirement funds. There are tables and techniques to calculate how long your money will last.

LO6 Plan for the distribution of your estate and, if needed, use trusts to lower estate taxes.

Nonprobate property, which does not go through the court process of probate, includes assets transferred to survivors by contract, such as naming a beneficiary for your retirement plan or with bank accounts owned with another person through joint tenancy with right of survivorship. Assets can be transferred by beneficiary designation, by property ownership, and by payable-on-death designation. By creating one or more trusts, portions of an estate can be transferred in a contractual manner to others in a way that avoids probate. A trust is a legal arrangement between you as the grantor or creator of the trust and the trustee, the person designated to control and manage any assets in the trust. Recognize that relatively few people, about 3500, pay federal estate taxes and only 8 states have inheritance taxes on recipients.

LET'S TALK ABOUT IT

1. Retirement Investing Today. What are your thoughts on this comment? “Younger workers today face some serious challenges in deciding where to invest their retirement funds.”

2. Why Calculate? Do you know anyone who has estimated his or her retirement savings goal in today's dollars? Offer two reasons why many people do not perform those calculations. Offer two reasons why it would be smart for people to determine a financial target.

3. Retirement Planning Mistakes. Of all the mistakes that people make when planning for retirement, which one might be likely to negatively affect your retirement planning? Give two reasons why.

4. Wills for College Students. Do college students really need a will at this point in their lives? Why or why not? What probably would happen to the typical college student's assets if he or she died without a will?

5. Writing a Letter of Last Instructions. Identify topics that you would cover in your letter of last instructions.

DO THE MATH

1. Tax-Sheltered Returns. Irad Liu, of Commerce, Texas, is in the 25 percent marginal tax bracket and is considering the tax consequences of investing $2000 at the end of each year for 30 years in a tax-sheltered retirement account, assuming that the investment earns 8 percent annually.

(a) How much will Irad's account total over 30 years if the growth in the investment remains sheltered from taxes?

(b) How much will the account total if the investments are not sheltered from taxes? (Hint: Use Appendix A-3 or the Garman/Forgue companion website.)

2. Withdrawal Amount. Over the years, Samuel and Elizabeth Paget, of Elon, North Carolina, have accumulated $200,000 and $220,000, respectively, in their employer-sponsored retirement plans. If the amounts in their two accounts earn a 6 percent rate of return over Samuel and Elizabeth's anticipated 20 years of retirement, how large an amount could be withdrawn from the two accounts each month? Use the Garman/Forgue companion website or Appendix A-4 to make your calculations.

3. Savings Amount Needed. Stephanie and Cody Riley, of Newport, Rhode Island, desire an annual retirement income of $40,000. They expect to live for 30 years past retirement. Assuming that the couple could earn a 3 percent after-tax and after-inflation rate of return on their investments, what amount of accumulated savings and investments would they need? Use Appendix A-4 or the Garman/Forgue companion website to solve for the answer.

4. Annual Earnings. Isabel and Juan Selenas, of Edison, New Jersey, hope to sell their large home for $380,000 and retire to a smaller residence valued at $150,000. After they sell the property, they plan to invest the $230,000 in equity ($380,000 − $150,000, omitting selling expenses) and earn a 4 percent after-tax return. Approximately how much will this nest egg be worth in five years when they retire? Use Appendix A-4 or the Garman/Forgue companion website to solve for the answer.

DO IT IN CLASS PAGE 19

5. Twins Invest. Rachael Ake, of Omaha, Nebraska, plans to invest $3000 each year in a mutual fund for the next 25 years to accumulate savings for retirement. Her twin sister, Rebecca, plans to invest the same amount for the same length of time in the same mutual fund. However, instead of investing with after-tax money, Rebecca will invest through an employer-sponsored retirement plan. If both mutual fund accounts provide an 8 percent rate of return, how much more will Rebecca have in her retirement account after 40 years than Rachael? How much will Rebecca have if she also invests the amount saved in income taxes? Assume both women pay income taxes at a 25 percent rate. Use Appendix A-3 or the Garman/Forgue companion website to solve for the answer.

6. More Aggressive Investing. Shanice Johnson, of Philadelphia, Pennsylvania, wants to invest $4000 annually for her retirement 30 years from now. She has a conservative investment philosophy and expects to earn a return of 3 percent in a tax-sheltered account. If she took a more aggressive investment approach and earned a return of 5 percent, how much more would Shanice accumulate? Use Appendix A-3 or the Garman/Forgue companion website to solve for the answer.

FINANCIAL PLANNING CASES

CASE 1

The Johnsons Consider Retirement Planning

Harry Johnson's father, William, was recently forced into early retirement at age 63 because of poor health. In addition to the psychological drawbacks of the unanticipated retirement, William's financial situation is poor because he had not planned adequately for retirement. His situation has inspired Harry and Belinda to take a look at their own retirement planning. Together they now make about $100,000 per year and would like to have a similar level of living when they retire. Harry and Belinda are both 27 years old and recently received their annual Social Security Benefits Statements indicating that they could expect about $28,000 per year in today's dollars as retirement benefits at age 67. Although their retirement is a long way off, they know that the sooner they put a plan in place, the larger their retirement nest egg will be.

(a) Belinda believes that the couple could maintain their current level of living if their retirement income represented 75 percent of their current annual income after adjusting for inflation. Assuming a 4 percent inflation rate, what would Harry and Belinda's annual income need to be over and above their Social Security benefits when they retire at age 67? (Hint: Use Appendix A-1 or visit the Garman/Forgue companion website.)

DO IT IN CLASS PAGE 19

(b) Both Harry and Belinda are covered by defined-contribution retirement plans at work. Harry's employer will contribute $1170 per year, and Belinda's employer will contribute $1140 per year in addition to the $4620 total that Harry and Belinda can contribute. Assuming a 7 percent rate of return, what would their retirement nest egg total 40 years from now? (Hint: Use Appendix A-3 or visit the Garman/Forgue companion website.)

(c) For how many years would the retirement nest egg provide the amount of income indicated in Question (a)? Assume a 4 percent return after taxes and inflation. (Hint: Use Appendix A-4 or visit the Garman/Forgue companion website.)

DO IT IN CLASS PAGE 530

(d) One of Harry's dreams is to retire at age 55. What would the answers to Questions (a), (b), and (c) be if he and Belinda were to retire at that age?

(e) How would early retirement at age 55 affect the couple's Social Security benefits?

(f) What would you advise Harry and Belinda to do to meet their income needs for retirement?

CASE 2

Victor and Maria's Retirement Plans

Victor, now age 61, and Maria, age 59, plan to retire at the end of the year. Since his retail management employer changed from a defined-benefit retirement plan to a defined-contribution plan ten years ago, Victor has been contributing the maximum amount of his salary to several different mutual funds offered through the plan, although his employer never matched any of his contributions. Victor's tax-sheltered account, which now has a balance of $144,000, has been growing at a rate of 7 percent through the years. Under the previous defined-benefit plan, Victor is entitled to a single-life pension of $360 per month or a joint and survivor option paying $240 per month. The value of Victor's investment of $20,000 in Pharmacia stock eight years ago has now grown to $56,000.

Maria's earlier career as a medical records assistant provided no retirement program, although she did save $10,000 through her credit union, which was later used to purchase zero-coupon bonds now worth $28,000. Maria's second career as a pharmaceutical representative for Pharmacia allowed her to contribute about $37,000 to her retirement account over the past nine years. Pharmacia matched a portion of her contributions, and that account is now worth $130,000; its growth rate has ranged from 6 to 10 percent annually. When Maria's mother died last year, Maria inherited her home, which is rented for $900 per month; the house has a market value of $170,000. The Hernandezes' personal residence is worth $180,000. They pay combined federal and state income taxes at a 30 percent rate.

(a) Sum up the present values of the Hernandezes' assets, excluding their personal residence, and identify which assets derive from tax-sheltered accounts.

(b) Assume that the Hernandezes sold their stocks, bonds, and rental property, realizing a gain of $238,000 after income taxes and commissions. If that sum earned a 7 percent rate of return over the Hernandezes' anticipated 20 years of retirement, how large an amount could be withdrawn each month? How large an amount could be withdrawn each month if they needed the money over 30 years? How large an amount could be withdrawn each month if the proceeds earned 6 percent for 20 years? For 30 years?

(c) Victor's $144,000 and Maria's $130,000 in retirement funds have been sheltered from income taxes for many years. Summarize the advantages the couple realized by leaving the money in the tax-sheltered accounts. Offer them a rationale to keep the money in the accounts as long as possible before making withdrawals.

CASE 3

Julia Price Thinks About Retirement

Julia is now in her early 50s. She has had two jobs in her career so far and participated fully in the defined-contribution plans offered by both employers. When she left her first position, she rolled her retirement account over to the account at her new employer, and it is currently worth about $380,000. Now she is about to change jobs again. But this time, she is taking a job with the Consumer Financial Protection Agency in Washington, DC. She will also be taking about four months off from working before starting that government job. The federal government retirement program is a defined-benefit plan. That means she cannot transfer her private sector plan to the government plan and therefore must decide whether to leave the funds within her current employer's plan or open a rollover IRA account into which to transfer the funds tax- and penalty-free. Another alternative available to her is to withdraw the $380,000 from her current account, pay income taxes on it this year (probably at a high federal marginal tax rate of 39.6), and invest the proceeds (about $228,000) in a new Roth IRA account. Offer your opinions about her thinking.

CASE 4

Calculation of Annual Savings Needed to Meet a Retirement Goal

Jasmine Amberlin, age 40, single, and from Victorville, California, is trying to estimate the amount she needs to save annually to meet her retirement needs. Jasmne currently earns $30,000 per year. She expects to need 80 percent of her current salary to live on at retirement. Jasmine anticipates that she will receive $800 per month in Social Security benefits. Using the Run the Numbers worksheet on page 514, answer the following questions.

DO IT IN CLASS PAGES 511–514

(a) What annual income would Jasmine need for retirement?

(b) What would her annual expected Social Security benefit be?

(c) Jasmine expects to receive $500 per month from her defined-benefit pension at work. What is her annual benefit?

(d) How much annual retirement income will she need from her retirement funds?

(e) How much will Jasmne need to save by retirement in today's dollars if she plans to retire at age 65 and live to age 90?

(f) Jasmine currently has $5000 in a traditional IRA. Assuming a growth rate of 8 percent, what will be the value of her IRA when she retires?

(g) How much additional money will she still need to save for retirement?

(h) What is the amount she needs to save each year to reach this goal?

CASE 5

A Couple Considers the Ramifications of Dying Intestate

Morgan Merryweather of Sioux Falls, South Dakota, is a 34-year-old police detective earning $58,000 per year. She and her husband, Joshua, have two children in elementary school. They own a modestly furnished home and two late-model cars. Morgan also owns a snowmobile. Both spouses have 401(k) retirement accounts through their employers, and their employers also provide them with $50,000 group term life policies. Morgan also has a $50,000 term life policy of her own. The couple has about $5000 in their joint checking account. Neither has a will.

DO IT IN CLASS PAGES 532–536

(a) List four negative things that could happen if either Morgan or Joshua were to die without a will.

(b) What would be the most important negative consequence of not having a will if both Morgan and Joshua were to die together in a car accident?

(c) Which assets could be jointly owned so that they will automatically transfer to the other spouse if either Morgan or Joshua dies?

(d) What qualities should Morgan and Joshua look for when naming the executors of their wills?

(e) Once they have completed and signed their wills, where should the Merryweathers keep the original documents and any copies?

BE YOUR OWN PERSONAL FINANCIAL MANAGER

1. Income Needed in Retirement Adjusted for Inflation.

Based on your expected income in your field after you graduate, make an estimate of the dollar amount you would need to make today to live comfortably as a retiree. Then assume that inflation will average 3 per cent per year until you are age 67. Use Appendix A-1 to calculate the dollar amount you would need that year to live at the level of living you estimate as being comfortable today.

2. Calculate Your Retirement Nest Egg. Use the Run the Numbers worksheet and material on pages 511–515 or Worksheet 65: My Estimated Retirement Savings Goal in Today's Dollars from “My Personal Financial Planner” to estimate the amount you must save each year to reach your retirement goals.

3. How Long Will Your Retirement Money Last? If you currently have begun a retirement savings nest egg and/or are currently setting aside funds into an account each year, use Appendix A-1 (for the nest egg) and Appendix A-2 (for the annual deposits) to estimate your full nest egg at an age that you would like to retire. Then use the material on page 530 and Worksheet 66: How Long Will My Retirement Money Last? from “My Personal Financial Planner” to estimate how long that money will last based on the result you obtained for item 1 above.

4. Questions to Ask About an Employer's Retirement Plan. Are you currently employed and eligible to participate in an employer-sponsored retirement plan? Use the material on pages 511–515 and Worksheet 67: Questions to Ask About Your Employer's Retirement Plan from “My Personal Financial Planner” to assess the plan and make decisions about your enrollment in the plan.

5. Beneficiary Designations. Complete Worksheet 68: My Assets to Be Transferred by Beneficiary Designations

in “My Personal Financial Planner” by recording your intended beneficiaries for the dozen or more types of assets you either own now or would expect to own in a few years.

ON THE NET

Go to the Web pages indicated to complete these exercises.

1. Calculate Your Benefits. Visit the website for the Social Security Administration. There you will find a quick benefits calculator at www.socialsecurity.gov/estimator/ that can be used to estimate your Social Security benefit in today's dollars. Use an income figure that approximates what you expect to earn in the first full year after graduating from college. When the calculator provides your answer, click on “What's the best age?” to see when you would be better off if you had waited until age 67 to begin taking benefits rather than age 62.

2. Charitable Remainder Trusts. View an example of a charitable remainder trust and read the logic behind the donors making such a gift (www.futurefocus.net/crutexample.htm). What are your thoughts about the value to both the donor and the recipient?

ACTION INVOLVEMENT PROJECTS

1. Views Concerning Social Security. Talk to five fellow students who are not taking your personal finance class. Ask them to explain their feelings about the degree to which Social Security will meet their income needs during retirement. Then ask them how they plan to meet their retirement income needs beyond what Social Security might provide. Make a table that summarizes your findings. Then compare their views and plans with what you have learned from reading this chapter.

2. What Is It Like to Be Retired? Survey three individuals or couples who have been retired for more than one year. Ask them how financially well prepared they felt before they retired. Then ask them to assess the financial realities of retirement at the current point in time. Include a discussion of how their investment mix (mutual funds, stocks, bonds, annuities) may or may not have changed since they have retired. Write a summary of their responses and how their experiences may affect your thinking about being retired.

3. Feelings About Approaching Retirement. Survey three individuals or couples who are about 10 to 15 years away from retirement. Ask them to explain what steps they have taken to prepare for retirement and how prepared they feel. Also ask them to describe what they will do financially in the next decade to get ready for retirement. Write a summary of their responses and how their experiences impact your own thinking about getting ready for retirement.

4. Retirement Savings Behavior Early in One's Career. Survey three individuals or couples who are less than ten years into their professional careers. Ask them if they have started saving for retirement and, if not, why not. Also ask them about the types of investments (mutual funds, stocks, bonds) that they are using or would use to save for retirement. Write a summary of their responses and how their efforts, or lack thereof, impact your thinking about saving for retirement.

5. Letter of Last Instructions. Inventory what you own, including items of sentimental value, and write a letter of last instructions telling heirs who gets what items. Sign and date the form. It is not necessary to have it witnessed, but you can if you wish.

6. Loss of Defined-Benefit Plans. What do you think of the long-term trend of employers largely moving away from offering employees defined-benefit retirement plans to defined-contribution plans? Write up you comments.

7. Low-Cost Fees. Review the box “Invest Retirement Money Only in “Low-Cost” Choices to Earn 28 Percent More” on page 525 and offer some comments about the wisdom of its conclusion.

8. How Long Will Money Last? Review Table 17-3 on page 530, and offer your comments on what you see.

9. Transfers. Make a short list of your assets and determine if upon your death they all will transfer to beneficiaries by contract, property ownership designations, or by payable-on-death designations.

10. Letter of Last Instructions. Create a letter of last instructions by giving your personal representative or family member the information needed concerning your personal and financial matters (funeral arrangements, location of will, insurance policies, location of documents, etc.).

Visit the Garman/Forgue companion website at www.cengagebrain.com.

* In the year you reach your full retirement age, you can earn up to $40,080 between January and your birthday without penalty. Above that amount, your Social Security check will be reduced by about 33 cents for every dollar earned. Also, once you reach full retirement age, your benefits may be recalculated to a higher amount to account for your increased earning record.

* Community property jurisdictions include Arizona, California, Idaho, Louisiana, Nebraska, Nevada, New Mexico, Puerto Rico, Texas, Washington, and Wisconsin.

* Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee.