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FIN102-Chapter 4 - Building Wealth
FIN102-Chapter 4 - Building Wealth
FIN102-Chapter 4 - Building Wealth
Chapter 4
Building Wealth
Achieving Independent Wealth and Retirement Planning
Objectives
In the December, 1976 Ensign, President N. Eldon Tanner stated “for those who
have prepared, the declining years of their lives can be the most enjoyable.”
Being properly prepared financially allows you to dedicate yourself to building the
Kingdom in a variety of ways. The Church continues to need far more missionary
couples than are currently serving. Temple work, family history work, encouraging
and enjoying your growing family, and other areas of interest are available to
those who have prepared financially.
The Fidelity Investment newsletter describes the changes that have happened
over the last several years. “Over the course of recent decades, we’ve seen a
seismic shift in the nature of retirement. People are living longer. On average, a
65-year-old woman has 23 years to live; a 65-year-old man 20 years. And those
years are often healthy and active ones.” (Fidelity Viewpoints, January 31, 2011,
p. 1). As a result of our longer and healthier lives, the old adage about how much
your spending will decrease after you retire needs to be reviewed.
2. How much do you need to save each working year or month between
now (or whenever you start saving) and your retirement to accumulate
sufficient savings?
Transportation You may only need one car rather than two, which will
eliminate a major expense for operating, insuring, and
maintaining a second vehicle. However, with 2 active people
going in various directions, you may choose not to reduce this
expense
Employment You will not be paying into your retirement fund and will
not have the clothing and travel expenses associated with
employment.
Leisure activities You will have more time for leisure activities, including
travel and recreational activities, which will be an increased
living expense.
Gifts You may also spend more on gifts as your family expands.
Inflation You will also need to plan for inflation over the years of your
retirement.
Most financial advisors estimate that you can live on about 75 percent of your
pre-retirement income and that you must allow for an inflation rate of 3-5%. There
are many internet sites that will help you analyze your retirement needs. Most of
them follow a format of asking you to consider your plans for retirement and ask
you to translate those plans into budgeted expenses.
You analyze all of your expected sources of retirement income, and develop a
plan to ensure that your retirement income reaches those goals. This includes
planning what needs to be saved today to ensure you meet your goals for
tomorrow. These sources of income include the following:
Social Security
A portion of your retirement needs may be met by social security benefits. Some
key aspects of social security benefits include:
Question/Concer Response
n
How much You can estimate your retirement income using the Social
will I receive? Security Administration website at:
http://ssa.gov/estimator/. It uses a very complicated
formula based on salary, years of work history, age and
other factors.
When do I You must work for ten years (40 quarters) and pay social
qualify for security taxes for at least that long to qualify for retirement
benefits? benefits. A spouse who has not worked the necessary ten
years will receive full survivor benefits after the death of the
When can I get The exact age at which you qualify to receive full benefits
full benefits? is increasing from age 65 to age 67 on a graded scale so
that the younger you are now,
Employer Plans
There are two basic types of employer retirement plans:
1. Defined benefit plan. Your employer pays a specified monthly benefit for life
after you retire. This benefit is like social security and is determined based on
your salary history and length of employment. This is what has commonly
been called a “pension” in the past.
The benefit becomes vested after you have worked for a specified period of
time. Vesting means the benefit paid for by your employers is fully yours. Your
benefit can be partially vested or fully vested depending on the number of
years you have participated in the plan.
2. Defined-contribution plan. Your employer pays into the plan but no specific
benefit is defined. You will receive whatever benefit your account balance
in the plan will provide at retirement. You can generally also contribute to the
plan. The most popular defined- contribution plan is a 401(K) plan (named
after a section in the IRS code which provides for such plans).
Generally, you contribute to the plan from your salary and the amount of your
contribution is deducted from your salary before taxes. This means you are putting
pre-tax funds into your retirement account. Normally the company contributes to
your account, and in most cases it will contribute based on a percentage of your
salary on a matching basis.
For example, you decide to contribute 6% of your salary and the company will
match 50% of that amount, or 3% of your salary. Note: You have already earned
a 50% return on your savings! You should ALWAYS participate in your company’s
401(K) plan at least up to the amount that generates a matching employer
contribution. Remember from Chapter 2 that retirement funds taken from your
paycheck are done BEFORE taxes are calculated.
Your company invests the funds in your account in accordance with your choice
of several options in stock or bond bunds or other securities. The amount
contributed is not taxed nor is the growth or appreciation of the funds taxed in
the account until the funds are withdrawn. This is called tax- deferred income.
Funds withdrawn prior to age 59 ½ are subject to a 10% tax penalty except to buy
a first home or to pay for higher-education expenses. After age 70 ½, withdrawals
and income tax payments are mandatory based on your life expectancy.
If you earned an average of $50,000 per year over your 30-year career and put
6% of your income in a 401 (K) plan and your employer contributed a 50%
matching or 3% of your income, you would have almost $850,000 in your account
at retirement assuming a 10% annual rate of return (which is a reasonable rate of
growth for mutual fund equity investments). If your employer matched the first 6%
of your contribution you would have $1,130,244 in your retirement fund.
Most young couples and individuals starting out their career are in a
relatively low tax bracket. Because your increase grows tax free, this is a very
important investment tool that should be very high on your priority list. In the
Roth IRA example above, you only deposited $72,000 over the 30 years out
of your own pocket and only paid taxes on this amount. However, you end
up with $452,000 in your account that will be withdrawn tax free.
You can also contribute to the Roth IRA beyond age 70 ½, which is not
allowed with a standard IRA. If you expect taxes to be higher when you
retire than during your years of employment, a Roth IRA would be preferred
to a regular IRA.
• If you are self-employed, there are many other options that can be
advantageous in your retirement planning. You can establish a Keogh plan
which works like an IRA but allows for much larger contributions. Others
include your own company retirement plans, SEP plans, etc.
However, if you sell your assets to provide additional income, you will eventually
use up your retirement savings. Hopefully, your savings will produce enough
income to allow you to live comfortably. If you must use some of your savings for
living expenses, you should be certain you will have enough left to last for the rest
for your life.
An illustration of how much extra you could spend over a 20-year period assuming
a 10 percent interest rate by using up your savings versus keeping them invested
is as follows:
Monthly Income
It is obvious that the added short-term benefit is not worth the risk of outliving your
retirement income. If you preserve your savings, and spend only the income they
produce, the income will go on indefinitely.
1. If we assume that you can live on an income of $50,000 per year now and
could live on 75% of your income during retirement that would be $37,500 per
year ($50,000 * 75%).
2. You must determine the impact of inflation on your living expenses. Assuming
a 3% inflation rate, that you are 30 years old, you plan to retire at age 70, and
that you want to provide for 20 years of retirement, you will need to provide
for 50 years of inflation (40 years until retirement and 10 additional years to
provide for an average income during retirement that can grow with
inflation). This means you will need an average retirement income over 20
years of retirement of almost $164,400 per year in 40 years, adjusted for
inflation, to have the same income as $37,500 is today using the Excel Future
Value formula as follows:
FV(.03,50,0,-37500) = $164,396.48
3. Now you must determine how much money you will need in savings to
produce that level of income considering your Social Security income and any
pension benefits you may have coming from your employer. If we assume you
will receive 20% of your retirement income from Social Security, and another
20% from a pension plan, you will need to have savings that will provide 60% of
the $164,396.48, or $98,637.89 per year.
If you expect to be retired for 20 years, you will need to have $839,759.92 in
savings to produce approx. $98,640 per year in retirement income, assuming
you can earn 10% on your savings. This is calculated using the Excel Present
Value formula as follows:
PV(.10,20,-$98,637.89) = $839,759.92
This assumes you will use up all of your savings. If you want to maintain your
savings, you will need almost $986,400 in personal retirement funds, which
would produce $98,640 each year at 10% interest indefinitely.
4. Assuming you want to have $986,378.85 in savings when you retire, how much
will you need to save every month to accumulate that amount if you can earn
10% on your savings? The answer is $155.97 per month.
Starting early is also illustrated by the following example. If you save $2,000 per year
for 10 years and earn 10% interest beginning at age 25, you will have put $20,000 into
savings which will grow to $895,761 by age 70.
If you wait until you are 35 years old to start saving for retirement and then save
$2,000 per year at 10% interest for 35 years, you will have put $70,000 into savings
which will grow to only $542,049 by age 70.
The result of starting early is that you will to save $50,000 less and have $353,712
more by age
This is the miracle of compounding interest. Of course, if you start at age 25 saving
$2,000 per year and continue until age 70 you will have $1,437,810, or the total of the
above two illustrations.
2. What will happen to your spouse when you die? What will happen to your
assets and your debts?
3. How much money do you think you will need each month after you retire?
What sources of retirement money do you expect to have?
4. Will it be necessary for you to pay debts with your monthly money after you
retire?
5. Will you have a mortgage on your home after you retire? Will you have to pay
rent?
6. How much money can you expect from Social Security? Will it be enough to
live on?
7. What will be the sources of retirement money for your spouse? Suppose a
wife never enters the work place. What retirement can she expect if her
husband dies before she does?
8. How long will your retirement savings last? Will your savings last as long as
you and your spouse live? What factors will determine how long your
retirement savings will last?
9. What does it mean to have tax deferred income? How does it help you?
10. How long will your spouse live? Will there be enough monthly income if
it is 10 years longer than you?
Possible Assignments
NOTE: Your instructor may assign any or all of the following. Check your Learning
Management System to find out what has been assigned.
1. Talk with your parents or older adults and ask what they have learned about
retirement planning.
2. Talk with your parents or older adults and ask what they have learned about
investing for retirement.
3. Work through the following Sample Problems to prove that you understand
the material presented in this chapter. If you cannot answer any of the
Sample Problems, bring your questions to class. The next unit will walk through
the answers so that you can understand what you are doing wrong.
Retirement Planning
Assume you are 25 years old, currently earning $48,000 per year, and
intend to retire at age 70. You, therefore, expected your retirement
1 annual earnings in today’s dollars to be $36,000 per year ($48,000 x
75%). If the inflation rate is 2.5% over your working years and during
your 20 years of retirement, how much annual income would be
required to meet your hopes for a comfortable retirement? (Use
Exhibit 7)
=FV(rate,nper,pmt)
=FV(2.5%,55,0,-36000)
Answer = $139,995.83
Retirement Planning
Assume you will live 20 years after retirement and your interest rate is
9% and you will need to provide four-tenths of your retirement from
personal savings (NOTE: This assumes that the other six-tenths needed
is provided by your employer and/or the government). At the end of
2a
the 20 years of retirement, you will have used up the entire
savings account.
Years in retirement = 20
Retirement Planning
Assume you will live 20 years after retirement and your interest rate is
9% and you will need to provide four-tenths of your retirement from
personal savings (NOTE: This assumes that the other six-tenths needed
is provided by your employer and/or the government). At the end of
2b
the 20 years of retirement, you will have used up the entire
savings account.
Years in retirement = 20
Retirement Planning
Assume you will live 20 years after retirement and your interest rate is
9% and you will need to provide four-tenths of your retirement from
personal savings (NOTE: This assumes that the other six-tenths needed
is provided by your employer and/or the government). At the end of
2c
the 20 years of retirement, you will have used up the entire
savings account.
Years working: 70 – 25 = 45
Answer = ($69.03)
Inflation Rate = 2.5%
Years in retirement = 20
Retirement Planning
3
If you invested $200 per month at 10% interest, how many years would
be required to achieve the $511,183.33 calculated in Problem #2?
Retirement Planning
Assume you need $1 million in savings for your desired retirement
4
fund. If you start saving at age 25 and you want to complete the
investment in savings by age 65, how much would you have to
invest each month at 10% to accumulate the $1 million?
Answer = ($158.13)
Retirement Planning
Assume you put an average of $250 per month into a Roth IRA for
your retirement. You invest it wisely and receive an annual return of
5a
10% APR. You start to save regularly at age 26, and plan to retire at
66.
How much will you have in your retirement fund at age 66?
Answer = $1,581,019.90
Retirement Planning
Assume you put an average of $250 per month into a Roth IRA for
your retirement. You invest it wisely and receive an annual return of
5b 10% APR. You start to save regularly at age 26, and plan to retire at
66.
How much can you withdraw monthly without taking out any of the
principal?