Assignment Content Life situations: 1. Husband/wife, two kids, 1 income, mortgage, good salary, some savings, and no college fund. Create a 700- to 1,050-word analysis in which you do the following: o Describe the risk tolerance and recommended asset allocation to match that risk for each of the life situations selected. o Develop an investment portfolio that meets their needs. o Consider and recommend any insurance that is appropriate, and any estate planning tools necessary to protect the family and their assets. 4 Managing Income Taxes YOU MUST BE KIDDING, RIGHT? Bharat Persaud's employer gave him a $2000 bonus last year, and when Bharat was filling out his federal income tax form, he discovered that $1000 of it moved him from the 15 percent marginal tax rate to 25 percent. How much additional income tax will Bharat pay on the $2000? A. $150 B. $180 C. $250 D. $400 The answer is C. The federal marginal tax rate is applied to your last dollar of earnings. The first $1000 of Bharat's bonus is taxed at the marginal tax rate of 15 percent ($150), but the second $1000 is taxed at 25 percent ($250). Be aware of your marginal tax rate! LEARNING OBJECTIVES After reading this chapter, you should be able to: Explain the nature of progressive income taxes and the marginal tax rate. Differentiate among the eight steps involved in calculating your federal income taxes. Use appropriate strategies to avoid overpayment of income taxes. WHAT DO YOU RECOMMEND? Timothy Edgar and Amber Szpanka plan to get married in two years. Timothy earns $44,000 per year managing a fast-food restaurant. He also earns about $10,000 per year selling jewelry that he designs at craft shows held monthly in various nearby cities. Right after they get married, Timothy plans to go back to college full time to finish the last year of his undergraduate degree. Amber earns $58,000 annually working as an institutional sales representative for an insurance company. Both Timothy and Amber each contribute $100 per month to their employer-sponsored 401 (k) retirement accounts. Timothy has little additional savings, but Amber has accumulated $18,000 that she wants to use for a down payment on a home. Amber also owns 300 shares of stock in an oil company that she inherited six years ago when the price was $90 per share; now the stock is worth $130 per share. Timothy and Amber live in a state where the state income tax is 6 percent. What would you recommend to Timothy and Amber on the subject of managing income taxes regarding: 1. Using tax credits to help pay for Timothy's college expenses? 2. Determining how much money Amber will realize if she sells the stocks, assuming she pays federal income taxes at the 25 percent rate? 3. Buying a home? 4. Increasing contributions to their employer-sponsored retirement plans? 5. Establishing a sideline business for tax purposes for Timothy's jewelry operation? YOUR NEXT FIVE YEARS In the next five years, you can start achieving financial success by doing the following related to managing income taxes: 1. Sign up for tax-advantaged employee benefits at your workplace. 2. Contribute to your employer-sponsored 401(k) retirement plan at least up to the amount of the employer's matching contribution. 3. Buy a home to reduce income taxes. 4. Prepare your own tax return so you can learn how to reduce your income tax liability. 5. Maintain good tax records. Managing your money includes not paying unnecessary sums to the government in taxes. Learning about tax-saving techniques will provide you with more money to do with what you want. “The avoidance of taxes is the only intellectual pursuit that carries any reward,” wrote economist John Maynard Keynes. You should pay your income tax liabilities in full, but that's all—there is no need to pay a dime extra. To achieve this goal, you need to adopt a tax planning perspective designed to eliminate, reduce, or defer some income taxes. To get started, you should recognize that you pay personal income taxes only on your taxable income. This amount is determined by subtracting various exclusions, adjustments, exemptions, and deductions from total income, with the result being the income upon which the tax is actually calculated. Details for these calculations are provided later. For now, simply remember that the main idea in managing income taxes is to reduce your taxable income as much as possible while maintaining a high level of total income. The result will lower your actual tax liability. Then you will have more money available every year to manage, spend, save, invest, and donate—activities that are the focus of this whole book. tax planning Seeking legal ways to reduce, eliminate, or defer income taxes. taxable income Income upon which income taxes are levied. 4.1 PROGRESSIVE INCOME TAXES AND THE MARGINAL TAX RATE Taxes are compulsory charges imposed by a government on its citizens and their property. The U.S. Internal Revenue Service (IRS) is the agency charged with the responsibility for collecting federal income taxes based on the legal provisions in the Internal Revenue Code. taxes Compulsory government-imposed charges levied on citizens and their property. 4.1a The Progressive Nature of the Federal Income Tax LEARNING OBJECTIVE 1 Explain the nature of progressive income taxes and the marginal tax rate. Taxes can be classified as progressive or regressive. The federal personal income tax is a progressive tax because the tax rate progressively increases as a taxpayer's taxable income increases. A higher income implies a greater ability to pay. As Table 4-1 shows, the higher portions of a taxpayer's taxable income are taxed at increasingly higher rates under the federal income tax. progressive tax A tax that progressively increases as a taxpayer's taxable income increases. A regressive tax operates in the opposite way. It is a tax imposed in such a manner that the tax rate stays the same for all income with the result that lower-income people pay proportionately more in taxes. An example is the state sales tax, since a rate of perhaps 7 percent might have to be paid by everyone regardless of income. One who earns $30,000 and spends $6,000 on food pays 1.5 percent on food purchases (7% × $6000 = $420/$30,000 = 1.4%). This compares to another person who earns $80,000 and spends $10,000 on food, thus paying less than 1 percent on sales tax on food purchases (7% × $10,000 − $700/$80,000 = 0.87%). 4.1b The Marginal Tax Rate Is Applied to the Last Dollar Earned Note that the marginal tax brackets are progressive. The first portion of someone's income is taxed at the rate in the lowest bracket; the next portion is taxed at the next lowest rate; and the final portion of income is taxed an even higher rate. Because our tax system has graduated tax rates, you do not pay the same tax rate on every dollar subject to tax. The marginal tax bracket (MTB) (or marginal tax rate) is illustrated with the seven income-range segments are taxed at increasing rates as income goes up. The tax rates apply only to the income within each tax bracket range. Recall from Chapter 1 that your marginal tax rate is the one that is applied to your last dollar of earnings. marginal tax bracket (MTB)/ marginal tax rate One of seven income-range segments at which income is taxed at increasing rates. Also known as marginal tax rate. Depending on their income, taxpayers fit into one of the brackets (as shown in Table 4-1) and, accordingly, pay at one of those marginal tax rates: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent, or 39.6 percent.* In addition, each year the dollar amounts for the taxable income brackets are adjusted for inflation to reduce the effects of inflation in a process called indexing. This keeps taxpayers from being forced to pay more taxes as they receive raises. indexing Yearly adjustments to tax brackets that reduce inflation's effects on tax brackets. Table 4-1 The Progressive Nature of the Federal Income Tax Single Individuals If taxable income is: Marginal Tax Rate Up to $9,075 10% Over $9,075 but not over $36,900 15% Over $36,900 but not over $89,350 25% Over $89,350 but not over $186,350 28% Over $186,350 but not over $405,100 33% Over $405,100 but not over $406,750 35% Over $406,750 39.6% Your marginal tax rate is perhaps the single most important concept in personal finance. It tells you the portion of any extra taxable earnings—from a raise, investment income, or money from a second job—you must pay in income taxes. It also measures the tax reduction benefits of a tax-deductible expense that allows you to reduce your taxable income. Consider this example of how the marginal tax rate might apply. Victoria Bassett is from Syracuse, New York (see Figure 4-1). Because of the progressive provisions in the tax laws, part of her $60,000 income ($10,150 [$6200 1 $3950]) is not taxed, the next $9075 is taxed at 10 percent, the next $27,825 is taxed at 15 percent, and the remaining $12,950 of Victoria's $60,000 income is taxed at 25 percent. Thus, Victoria is in the 25 percent marginal tax bracket because the last dollar that she earned is taxed at that level. Her tax liability is $8,318.75 based on her $60,000 in income. DO IT IN CLASS Figure 4-1 How Your Income Is Really Taxed (Example: Victoria Bassett with a $60,000 Gross Income, and she is in the 25% marginal tax bracket) DID YOU KNOW The United States Is Not a High-Tax Country The tax burden in the United States is the lowest among industrialized countries in the world. Compared to countries that are members of the Organization for Economic Cooperation and Development (OECD), combined taxes in the United States are 33.4 percent. Seventeen countries have higher rates including Denmark (47.6%), Belgium (43.5%), France (42%), Australia (42.0%), Hungary (37.9%), Germany (36.1%), and United Kingdom (34.9%). The United States is far from a high-tax country. In fact, federal taxes on middle-income Americans are near historic lows. The mathematics shown in Figure 4-1 is based either on the IRS tax table (used for tax returns with incomes up to $100,000) or the tax-rate schedules (used for tax returns with incomes above $100,000). All information cited in this chapter is for income tax returns filed in 2015 for the previous year's income, unless otherwise noted. 4.1c Use Your Marginal Tax Rate to Help Make Financial Decisions The marginal tax rate can affect many financial decisions that you make. Consider, for example, what happens if you are in the 25 percent marginal tax bracket and you make a $100 tax-deductible contribution to a charity. The charity receives the $100, and you deduct the $100 from your taxable income. This deduction results in a $25 reduction in your federal income tax ($100 × 0.25). In effect, you give only $75 (not $100) because the government, in effect, “gives” $25 to the charity. 4.1d Your Effective Marginal Tax Rate Is Higher The effective marginal tax rate describes a person's total marginal tax rate on income after including federal, state, and local income taxes as well as Social Security and Medicare taxes. To determine your effective marginal tax rate on income, add all of these other taxes to your federal marginal tax rate. effective marginal tax rate The total marginal rate reflects all taxes on a person's income, including federal, state, and local income taxes as well as Social Security and Medicare taxes. For example, a single taxpayer earning a taxable income between $36,900 and $89,350 will pay federal income taxes at a marginal rate of 25 percent, a combined Social Security 6.2%* and Medicare tax rate of 1.45%** that totals 7.65 percent,*** a state income tax rate of 6 percent,**** and a city income tax rate of 2 percent. These taxes result in an effective marginal tax rate of 40 percent (25 + 7.65 + 6 + 2 = 40.65, about 40). Most employed taxpayers pay an effective marginal tax rate of 40 percent. DID YOU KNOW How to Determine Your Marginal Tax Rate You can determine your marginal tax rate by following this example. 1. Start with a single person who has a taxable income of $39,600, and looking at the illustrated tax table (Table 4-3 on page 119), he/she finds his tax on that amount of income ($5763). 2. Add $100 to that income for a total of $39,700, and find the tax on that amount ($5788). 3. Calculate the difference between the two tax amounts ($5788–$5763). The extra $25 in taxes from a $100 increase in income reflects a federal marginal tax rate of 25 percent. CONCEPT CHECK 4.1 1. Distinguish between a progressive and a regressive tax. 2. What is a marginal tax bracket, and how does it affect taxpayers? 3. Explain why some taxpayers have a marginal tax rate as high as 40 percent. 4.2 EIGHT STEPS IN CALCULATING YOUR INCOME TAXES LEARNING OBJECTIVE 2 Differentiate among the eight steps involved in calculating your federal income taxes. There are eight basic steps in calculating federal income taxes: 1. Determine your total income. 2. Determine and report your gross income after subtracting exclusions. 3. Subtract adjustments to income. 4. Subtract either the IRS's standard deduction amount for your tax status or your itemized deductions. 5. Subtract the value of your personal exemptions. 6. Determine your preliminary tax liability. 7. Subtract tax credits for which you qualify. 8. Calculate the balance due the IRS or the amount of your refund. Figure 4-2 graphically depicts these eight steps in the overall process of federal income tax calculation. The idea is to reduce your income so that you pay the smallest amount possible in income taxes. You do so by reducing total income by removing nontaxable income and then subtracting exclusions, deductions, exemptions, and tax credits, as indicated in the unshaded boxes in Figure 4-2. 4.2a Determine Your Total Income Practically everything you receive in return for your work or services and any profit from the sale of assets is considered income, whether the compensation is paid in cash, property, or services. Listing these earnings will reveal your total income—compensation from all sources— and much of it, but not all, will be subject to income taxes. total income Compensation from all sources. Figure 4-2 The Steps in Calculating Your Income Taxes For most people, earned income is income derived from active participation in a trade or business, including wages, salary, tips, commissions, and bonuses. It is reported to them annually on a Form W-2, Wage and Tax Statement. Employers must provide W-2 information (see Figure 4-3) by January 31 of the year following the earned income. If you also receive income from interest or dividends or other sources, you will receive a Form 1099-INT or 1099-DIV, providing appropriate details. The IRS also receives the information on their Form 1099s, which it uses to verify the income you report. earned income Compensation for performing personal services. Income to Include The following types of income are included when you report your income to the IRS: • Wages and salaries • Commissions • Bonuses • Professional fees earned • Hobby income • Tips earned • Severance pay • Medical insurance rebates because of Patient Protection and Affordable Care Act • Fair value of anything received in a barter arrangement • Forgiven or cancelled debt (unless borrower is insolvent or bankrupt) • Alimony received • Scholarship and fellowship income spent on room, board, and other living expenses • Grants and the value of tuition reductions that pay for teaching or other services • Annuity and pension income received Figure 4-3 W-2 Tax Form • Withdrawals and disbursements from retirement accounts, such as an individual retirement account (IRA) or 401(k) retirement plan (discussed in Chapter 17, “Retirement and Estate Planning”) • Military retirement income • Social Security income (a portion is taxed above certain income thresholds) • Disability payments received if you did not pay the premiums • Damage payments from personal injury lawsuits (punitive damages only) • Value of personal use of employer-provided car • State and local income tax refunds (only if the taxpayer itemized deductions during the previous year) • Employee productivity awards • Awards for artistic, scientific, and charitable achievements unless assigned to a charity • Prizes, contest winnings, and rewards • Gambling and lottery winnings • All kinds of illegal income • Fees for serving as a juror or election worker • Unemployment benefits • Net rental income • Royalties • Investment, business, and farm profits • Interest income (this includes credit union dividends) • Dividend income (including mutual fund capital gains distributions even though they are reinvested) Capital Gains and Losses Are Taxed at Special Low Rates An asset is property owned by a taxpayer for personal use or as an investment that has monetary value. Examples of assets include stocks, mutual funds, bonds, land, art, gems, stamps, coins, vehicles, and homes. The net income received from the sale of an asset above the costs incurred to purchase and sell it is a capital gain. capital gain The net income received from the sale of an asset above the costs incurred to purchase and sell it. A capital loss results when the sale of an asset brings less income than the costs of purchasing and selling the asset. Capital gains and losses on investments must be reported on your tax return. Capital gains from the sale or exchange of property held for personal use, such as on a vehicle or vacation home, must be reported as income, but losses on such property are not deductible. There is no tax liability on any capital gain until the stock, bond, mutual fund, real estate, or other investment is sold. A short-term gain(or loss) occurs when you sell an asset that you have owned for one year or less; it is taxed at the same rates as ordinary income, which is all income other than capital gains. A long-term gain (or loss) occurs when you sell an asset that you have owned for more than one year (at least a year and a day), and it is taxed at special low rates. The long-term capital gains rate is zero for taxpayers in the 15 percent marginal tax bracket. The rate is 15 percent for those in the 25, 28, 33, and 35 percent brackets. It is 20 percent for those in the 39.6 percent tax bracket. long-term gain / loss A profit or loss on the sale of an asset that has been held for more than a year. Capital losses may be used first to offset capital gains on your tax return. If there are no capital gains, or if the capital losses are larger than the capital gains, you can deduct the capital loss against your other income, but only up to a limit of $3000 in one year. If your net capital loss is more than $3000, the excess may be carried forward to be deducted on the next tax year's form, again up to an annual $3000 maximum. Dividends and Interest Are Treated Differently Owners of stocks in a corporation may receive dividends quarterly. These payments to shareholders are made out of current or accumulated earnings of a corporation and are taxable. Shareholders are annually sent tax forms 1099-DIV that explains what amounts must be reported to the IRS when taxes are filed. Dividends from most domestic corporations and many foreign companies are subject to the same favorable rates as capital gains. Dividends in the form of shares of stock are generally not taxable. So called dividends are actually “interest” reported to taxpayers on Form 1099-INT when received from credit unions, cooperative banks, savings and loan associations, building and loan associations, and mutual savings banks. They are subject to ordinary income taxes. Dividends received from a life insurance policy are actually a refund of your premium and are not taxed. 4.2b Determine and Report Your Gross Income After Subtracting Exclusions Gross income consists of all income (both earned and unearned) received in the form of money, goods, services, and property before exclusions and deductions that a taxpayer is required to report to the IRS. To determine gross income, you need to determine which kinds of income are not subject to federal taxation and, therefore, need not be reported as part of gross income. These amounts are called exclusions. gross income All income in the form of money, goods, services, and/or property. exclusions Income not subject to federal taxation. DO IT IN CLASS Income to Exclude The more common exclusions (some are subject to limits) are as follows: • Gifts • Inherited money or property • Income from a carpool • Income from items sold at a garage sale for a sum less than what you paid • Cash rebates on purchases of new cars and other products • Tuition reduction, if not received as compensation for teaching or service • Federal income tax refunds • State and local income tax refunds for a year in which you claimed the standard deduction • Scholarship and fellowship income spent on course-required tuition, fees, books, supplies, and equipment (degree candidates only) • Withdrawals from state-sponsored Section 529 plans (prepaid tuition and savings) used for education • Prizes and awards made primarily to recognize artistic, civic, charitable, educational, and similar achievements • Return of money loaned • Withdrawals from medical savings accounts used for qualified expenses • Earnings accumulating within annuities, cash-value life insurance policies, Series EE bonds, and qualified retirement accounts • Interest income received on tax-exempt government bonds issued by states, counties, cities, and districts • Life insurance benefits received • Combat zone pay for military personnel • Welfare, black lung, workers' compensation, and veterans' benefits • Value of food stamps • First $500,000 ($250,000 if single) gain on the sale of a principal residence • Disability insurance benefits if you paid the insurance premiums • Social Security benefits (except for high-income taxpayers) • Rental income from a vacation home if not rented for more than 14 days • First $5000 of death benefits paid by an employer to a worker's beneficiary • Travel and mileage expenses reimbursed by an employer (if not previously deducted by the taxpayer) • Employer-provided per diem allowance covering only meals and incidentals • Amounts paid by employers for premiums for medical insurance, workers' compensation, and health and long-term care insurance • Moving expense reimbursements received from an employer (if not previously deducted by the taxpayer) • Employer-provided payments of $130 per month for transit passes and $250 a month for parking • Value of premiums for first $50,000 worth of group-term life insurance provided by an employer • Employer payments (up to $5000) for dependent care assistance (for children and parents) • Benefits from employers that are impractical to tax because they are so modest, such as occasional supper money and taxi fares for overtime work, company parties, holiday gifts (not cash), and occasional theater or sporting events • Employer contributions for employee expenses for education (up to $5250 annually) • Employee contributions to flexible spending accounts • Reimbursements from flexible spending accounts • Interest received on Series EE and Series I bonds used for college tuition and fees • Child support payments received • Property settlement in a divorce • Compensatory damages in physical injury cases 4.2c Subtract Adjustments to Income In the process of determining your taxable income, you make adjustments to income (or adjustments). These are allowable subtractions from gross income, and include items such as moving expenses to a new job location (including college graduates who move to take their first job as long as it is at least 50 miles from their old residence); higher-education expenses for tuition and fees (up to $4000); student loan interest for higher education, including that paid by a parent ($2500 maximum); military reservists' travel expenses (for more than 100 miles); contributions to qualified personal retirement accounts (IRA and 401[k] accounts) and health savings accounts (up to $3300 for singles and $6550 for family coverage); alimony payments; interest penalties for early withdrawal of savings certificates of deposit;; and certain expenses of self-employed people (such as health insurance premiums). Adjustments are subtracted from gross income to determine adjusted gross income (AGI). Subtracting adjustments to income from gross income results in a subtotal. adjustments to income Allowable subtractions from gross income. adjusted gross income (AGI) Gross income less any exclusions and adjustments. To illustrate the value of adjustments to income, consider that Jose Martinez from Columbia, South Carolina, has a gross income of $50,000. This past year he spent $1200 moving to Nashville, Tennessee, for a new job, and he also paid $2000 in higher-education expenses working on a graduate degree. The $3200 in adjustments reduces his gross income to $46,800, and therefore Jose saves $800 in income taxes because he is in the 25 percent marginal tax bracket ($3200 × 0.25). Adjustments are called above-the-line deductions because they may be subtracted from gross income even if itemized deductions are not claimed. Adjustments may be taken regardless of whether or not the taxpayer itemizes deductions or takes the standard deduction amount (discussed next). above-the-line deductions Adjustments subtracted from gross income whether taxpayer itemizes deductions or not. ADVICE FROM A PROFESSIONAL A Sideline Business Can Reduce Your Income Taxes A sideline business can open many doors to tax deductions. You should never spend money simply for a tax deduction; however, if you're going to spend the money anyway, you should do everything you can to make it tax deductible. By having your own business, every dollar you spend attempting to make a profit becomes tax deductible. While no deduction is allowed for personal expenses, you can deduct expenses for auto, travel, office, office equipment (e.g., desk, chair, computer), contributions to self-funded retirement accounts, health insurance premiums, educational expenses, entertainment, business gifts, and more. You can deduct salaries of employees, even if they are your children, other relatives, or friends. The business does not have to be your primary employment. If you lose money in the business, you can deduct those losses from your other income. The IRS says that you must do what a “reasonable business person” would do to make a profit. If you do not meet that test, the IRS will classify the operation as a hobby, require you to report the income, and disallow all deductions. James J. Williams Hudson Valley Community College, Troy, New York Table 4-2 Tax Rate Schedules Single Individuals If taxable income is over— But not over— The tax is— $ 0 $ 9,075 10% of the taxable income $ 9,075 $ 36,900 $907.50 plus 15% of the amount over $9,075 $ 36,900 $ 89,350 $5,081.25 plus 25% of the amount over $36,900 $ 89,350 $186,350 $18,193.75 plus 28% of the amount over $89,350 $186,350 $405,100 $45,353.75 plus 33% of the amount over $186,350 $405,100 $406,750 $117,541.25 plus 35% of the amount over $405,100 Over $406,750 No limit $118,118.75 plus 39.6% of the amount over $406,750 Married Couples Filing Jointly If taxable income is over— But not over— The tax is— $ 0 $ 18,150 10% of the taxable income $ 18,150 $ 73,800 $1815 plus 15% of the amount over $18,150 $ 73,800 $148,850 $10,162 plus 25% of the amount over $73,800 $148,850 $226,850 $28,925 plus 28% of the amount over $148,850 $226,850 $450,100 $50,765 plus 33% of the amount over $226,850 $405,100 $457,600 $109,587.50 plus 35% of the amount over $405,100 $457,600 No limit $127,962.50 plus 39.6% of the amount over $457,600 DO IT IN CLASS 4.2d Subtract Either the IRS's Standard Deduction for Your Tax Status or Your Itemized Deductions Taxpayers may reduce income further by the amount of the standard deduction. Or they can list their itemized deductions, which are specific items that may be used to directly reduce income that may reduce the amount of your income subject to tax. You can itemize or use the standard deduction, and you want to use the larger of the two. The standard deduction is a fixed amount that all taxpayers (except some dependents) who do not itemize deductions regardless of their actual expenses may subtract from their adjusted gross income. In effect, it consists of the government's permissible estimate of any likely tax-deductible expenses these taxpayers might have. Two out of three taxpayers take the standard deduction. itemized deductions Tax-deductible expenses. standard deduction Fixed amount that all taxpayers may subtract from their adjusted gross income if they do not itemize their deductions. The standard deduction amount depends on filing status, a description of your marital status on the last day of the year. A return can be filed with a status of a single person, a married person (filing separately or jointly), a head of household, or qualifying widow or widower. Certain tax benefits apply to each filing status. For example, the standard deduction amounts are $6200 for single individuals and twice as much, $12,400, for married people filing jointly. filing status Description of a taxpayer's marital status on the last day of the tax year. Additional standard deductions if age 65 or blind are permitted. The additional standard deduction for those age 65 or older or who are blind is $1200 for married individuals and surviving spouses. It is $1550 for singles age 65 or older or blind filers. Taxpayers can take the greater of the standard deduction or itemizations but not both. For example, a single person might list all of his or her tax deductions and find that they total $6800, which is more than the standard deduction amount of $6200, so he or she takes the $6800. Someone else with calculated deductions of $4900 can instead take the standard deduction of $6200. The tax form lists the following six classifications of itemized deductions: 1. Medical and Dental Expenses 2. Taxes You Paid 3. Interest You Paid 4. Gifts to Charity 5. Casualty and Theft Losses 6. Job Expenses and Most Other Miscellaneous Deductions Examples of deductions in each of these categories follow. Note that the deduction amounts allowed are reduced for very high income taxpayers. DID YOU KNOW Income Taxes and Same-Sex Couples Same-sex couples who are legally married in a state are treated as married for all federal income tax purposes. Thus, they may file joint federal income tax returns in all 50 states. State income forms may be filed only in those states that recognize their marriages. 1. Medical and Dental Expenses (Not Paid by Insurance) in Excess of 10.0 Percent of Adjusted Gross Income* • Medicine and drugs • Insurance premiums for medical, long-term care, and contact lenses • Medical services (doctors, dentists, nurses, hospitals, long-term health care, acupuncture, chiropractor) • Sterilizations and prescription contraceptives • Costs of a physician-prescribed course of treatment for obesity • Expenses for prescription drugs/programs to quit smoking • Medical equipment and aids (contact lenses, eyeglasses, hearing devices, orthopedic shoes, false teeth, wheelchair lifts) Charitable contributions—even in cash—are typically tax deductible if you itemize deductions. FINANCIAL POWER POINT MAGI Is Used for the Health Care Penalty Tax Modified adjusted gross income (MAGI). This is the total of adjusted gross income plus any deductions for IRA contributions, student loan interest or tuition, excluded foreign income, and interest from EE savings bonds used to pay higher education expenses. And it is the figure the IRS uses to calculate one's health care penalty. For most people, MAGI is the same as AGI. • Fees for childbirth preparation classes • Costs of sending a mentally or physically challenged person to a special school • Home improvements made for the physically disabled (ramps, railings, widening doors) • Travel and conference registration fees for a parent to learn about a child's disease • Long-term care policy premiums and nursing home expenses • Transportation costs to and from locations where medical services are obtained, using a standard flat mileage allowance 2. Taxes You Paid • Real estate property taxes (such as on a home or land) • Personal property taxes (such as on an automobile or boat when any part of the tax is based on the value of the asset) • State, local, and foreign income taxes • Health care penalty tax, which is the greater of a flat dollar amount per individual of $325 or 2 percent of the individual's MAGI in 2015 or $695 or 2.5 percent of MAGI in 2016; afterwards it is indexed to inflation. DO IT IN CLASS 3. Interest You Paid • Interest paid on home mortgage loans • “Points” treated as a type of prepaid interest on the purchase of a principal residence • “Points” paid when refinancing a home mortgage (portion deducted over life of the loan) • Interest paid on home-equity loans • Interest paid on loans used for investments 4. Gifts to Charity • Cash contributions to qualified organizations such as churches, schools, and charities (receipt required for $250 or more) • Noncash contributions at fair market value (what a willing buyer would pay to a willing seller); IRS says that personal property must be in “good used condition or better” to qualify • Mileage allowance for travel and out-of-pocket expenses for volunteer charitable work • Charitable contributions made through payroll deduction • Contributions to charity up to $100,000 from one's individual retirement account (IRA) for those age 70½ or older 5. Casualty and Theft Losses (Not Paid by Insurance) in Excess of 10 Percent of Adjusted Gross Income • Casualty losses (such as from storms, vandalism, and fires) in excess of $100 • Theft of money or property in excess of $100 • Mislaid or lost property if the loss results from an identifiable event that is unexpected or unusual (such as catching a diamond ring in a car door and losing the stone) 6. Job Expenses and Most Other Miscellaneous Deductions in Excess of 2 Percent of Adjusted Gross Income (Partial Listing) • Union or professional association dues and membership fees • Subscriptions to magazines, journals, and newspapers used for business or professional purposes • Books, software, tools, and supplies used in a business or profession • Cost of computers and cell phones required as a condition of your job • Clothing and uniforms not suitable for off-the-job usage as ordinary wearing apparel (protective shoes, hats, safety goggles, gloves, uniforms), laundering and cleaning • Unreimbursed employee business expenses (but only a portion of the cost of meals and entertainment), including long-distance telephone calls, cleaning and laundry, and car washes of business vehicle • Investment-related expenses (e.g., computer software, fees for online trading, adviser fees, investment club expenses, IRA fees, safe-deposit box rental, subscriptions to investment magazines and newsletters, tax preparation charges) • Legal fees that pertain to tax advice in a divorce or alimony payments • Travel costs between two jobs, using a flat mileage allowance • Job-related car expenses (but not commuting to a regular job), using a flat mileage allowance or actual expenses • Commuting costs to a temporary workplace • Commuting costs that qualify as a business or education expense • Medical examinations required (but not paid for) by an employer to obtain or keep a job • Appraisal fees for charitable donations or casualty losses • Education expenses if required to keep your job or improve your job or professional skills (but not if the training readies you for a new career) DID YOU KNOW Deduction for Work-Related Education as a Business Expense If you are an employee and can itemize your deductions, you may be able to claim a deduction for the expenses you pay for your work-related education. Your deduction will be the amount by which your qualifying work-related education expenses plus other job and certain miscellaneous expenses is greater than 2% of your adjusted gross income. Work-related education is that which meets at least one of the following two tests: (1) The education is required by your employer or the law to keep your present salary, status or job, and the required education must serve a bona fide business purpose of your employer, and (2) The education maintains or improves skills needed in your present work. However, even if the education meets the above tests, it is not qualifying work-related education if it: (1) Is needed to meet the minimum educational requirements of your present trade or business, or (2) Is part of a program of study that will qualify you for a new trade or business. You can deduct the costs of qualifying work-related education as a business expense even if the education could lead to a degree. If you are self-employed, you deduct your expenses for qualifying work-related education directly from your self-employment income. DID YOU KNOW The Best Tax Guides and Other Help Your Federal Income Tax: For Individuals, Publication 17, is the IRS's detailed 100-plus-page book for preparing your income taxes. A good, readable tax guide is the annual J. K. Lasser's Your Income Tax (www.jklasser.com/). All federal income tax forms, regulations, guides, and answers to frequently asked questions can be obtained from the IRS at (800) TAX-3676, or at www.irs.gov. The IRS help line is (800) TAX-1040. Most taxpayers can obtain free tax preparation from the Volunteer Income Tax Assistance (VITA) program (www.vita-volunteers .org/index.htm, or call (800) 906–9887). • Job-hunting expenses for typing, printing, resume advice, career counseling, want ads, telephone calls, mailing costs, job placement agency fees, and travel for seeking a job in your current career field • 50 percent of food and 100 percent of transportation and entertainment costs for job hunting (which does not have to be successful) in your current career • 100 percent of gambling losses that offset reported gambling income (not subject to 2% AGI floor) • 100 percent of business expenses for workers with disabilities (not subject to 2% AGI floor) 4.2e Subtract the Value of Your Personal Exemptions An exemption (or personal exemption) is a legally permitted amount deducted from adjusted gross income based on the number of people supported by the taxpayer's income. A dependent is a relative or household member for whom an exemption may be claimed. Thus, exemptions may be claimed for the taxpayer and qualifying dependents, such as a spouse (if filing jointly), children, parents, and other dependents earning less than a specific income and for whom the taxpayer provides more than half of their financial support. For example, a husband and wife with two young children would have four exemptions. exemption (or personal exemption) Legally permitted amount deducted from AGI based on the number of people that the taxpayer's income supports. dependent A relative or household member for whom an exemption may be claimed on one's income taxes. A person can serve as an exemption on only one tax return—his or her own or another person's (usually a parent). Each exemption reduces taxable income by $3950. The value of an exemption is phased out for those with extremely high incomes. 4.2f Determine Your Preliminary Tax Liability The steps detailed to this point have explained how to determine your taxable income. Taxable income is calculated by taking the taxpayer's gross income, subtracting the adjustments to income, subtracting the amount permitted for the number of exemptions allowed, and subtracting either the standard deduction or total itemized deductions. The amount of taxable income is then used to determine taxpayers' preliminary tax liability via the tax tables or tax-rate schedules for his or her filing status (such as single or married filing jointly). The following examples illustrate how to determine tax liability. Table 4-3 shows segments of the tax table. DO IT IN CLASS 1. A married couple filing jointly has a gross income of $50,000, adjustments of $4700, two exemptions ($3950 each), and itemized deductions of $8285. They take the standard deduction of $12,400 because their itemized deductions do not exceed that amount. Gross income $50,000 Less adjustments to income −4,700 Adjusted gross income 45,300 Less standard deduction for married couple −12,400 Subtotal 32,900 Less value of two exemptions −7,900 Taxable income 25,000 Tax liability (from Table 4-3) $ 2,846 2. A single person has a gross income of $56,000, adjustments of $4050, one exemption, and itemized deductions of $8400. She subtracts her itemized deductions because the amount exceeds the $6200 standard deduction value. Gross income $56,000 Less adjustments to income −4,050 Adjusted gross income 51,950 Less itemized deductions −8,400 Subtotal 43,550 Less value of one exemption −3,950 Taxable income 39,600 Tax liability (from Table 4-3) $ 5,763 3. A married couple with a gross income of $137,000 has adjustments of $4000, two exemptions, and itemized deductions of $9800. The standard deduction value for a married couple is taken because it exceeds the itemized deductions. Gross income $137,000 Less adjustments to income −4,000 Adjusted gross income 133,000 Less standard deduction −12,400 Subtotal 120,600 Less value of two exemptions −7,900 Taxable income 112,700 Tax liability (from Table 4-2)* $ 19,887.50 * The tax liability is calculated from the tax-rate schedules in Table 4-2 because the taxable income exceeds $100,000. The tax liability is computed on taxable income as follows: $112,700 − $73,800 = $38,900 × 0.25 = $9,725 + $10,162.50 = $19,887.50. Table 4-3 Tax Table* * These segments of the tax table are derived from the IRS tax-rate schedule illustrated in Table 4-2. 4.2g Subtract Tax Credits for Which You Qualify You may be able to lower your preliminary tax liability through tax credits. A tax credit reduces your tax liability dollar for dollar whereas a tax deduction reduces the amount of your taxable income, which is used to calculate your tax liability. Tax credits are more valuable because they reduce your tax liability by one dollar for every dollar of the credit. Tax deductions, on the other hand, reduce your tax liability by your tax rate for every dollar of the deduction. A $1000 tax deduction saves $250 in taxes if you are in the 25 percent bracket, but a $1000 tax credit saves you $1000. tax credit Dollar-for-dollar decrease in tax liability; also known as credit. You may take tax credits regardless of whether you itemize deductions. A nonrefundable tax credit may reduce your tax liability to zero (0), but not below. Thus if the nonrefundable credit amount exceeds the tax you owe, you are not given a refund of the difference. A refundable tax credit can reduce your tax liability to below zero (0), and the excess amount will be refunded. To get a refundable tax credit, you must file an income tax return. Credits are often subject to income limits, meaning that high-income taxpayers may not be eligible for a particular credit. nonrefundable tax credit A tax credit that can reduce one's tax liability only to zero; however, if the credit is more than the tax liability, the excess is not refunded. refundable tax credit A tax credit that can reduce one's income tax liability to below zero with the excess being refunded to the taxpayer. Health Insurance Premium Tax Credit The health Insurance Premium Tax credit is part of the Affordable Care Act provisions, and it provides that individuals and families may take a tax credit to help them afford health insurance coverage purchased through an Affordable Insurance Exchange offered through the federal and/or state government. The health insurance premium tax credit is refundable so taxpayers who have little or no income tax liability can still benefit. The credit also can be paid in advance to a taxpayer's insurance company to help cover the cost of premiums. DID YOU KNOW About the Alternative Minimum Tax The alternative minimum tax (AMT) takes back some of the tax breaks allowed for regular tax purposes for very high-income taxpayers who previously were entirely escaping paying income taxes through legitimate means. Some high-income taxpayers are pushed into paying the higher AMT tax instead of the regular tax when claiming excess itemized deductions, certain tax-exempt interest, and/or a substantial number of exemptions. When the value of those benefits is added back to one's income, it may result in an AMT calculation that exceeds one's regular tax. About four million taxpayers pay the AMT tax rate at 26 or 28 percent, which typically amounts to an additional tax liability of about $3900. American Opportunity Tax Credit The American Opportunity Tax Credit provides an up to $2500 per student tax credit to help defray college expenses for the first four years of postsecondary education. The tax credit is for 100 percent of qualified tuition, fees, books, and course materials paid by the taxpayer during the taxable year not to exceed $2000, plus 25 percent of the next $2000 in qualified tuition, fees, and course materials. The maximum total credit is $2500. The money must have been spent for qualified tuition and expenses for textbooks, supplies, equipment, and student activity fees if required as a condition of enrollment. The credit can be claimed in two taxable years for individuals enrolled on at least a halftime basis during any part of the year. Forty percent of the credit (up to $1000) is refundable. American Opportunity Tax Credit A partially refundable tax credit of up to $2500 a year to help defray college expenses for the first four years of postsecondary education. Lifetime Learning Credit The lifetime learning credit (nonrefundable) may be claimed every year for tuition and related expenses paid for all years of postsecondary education undertaken to acquire or improve job skills. The expenses for one or more courses may be for yourself, your spouse, or your dependents. The student need not be pursuing a degree or other recognized credential. This credit amounts to 20 percent of the first $10,000 paid, for a maximum of $2000 for all eligible students in a family. There is no limit on the number of years the credit may be taken for the student. The Lifetime Learning and American Opportunity credits may not be claimed for the same student expenses for the same tax year. lifetime learning credit A nonrefundable tax credit that may be claimed every year for tuition and related expenses paid for all years of postsecondary education undertaken to acquire or improve job skills. Earned Income Credit The earned income credit (EIC) (or earned income tax credit [EITC]) is refundable, and it may be claimed not only by workers with a qualifying child but also, in certain cases, by childless workers. The maximum credit is $496 with no qualifying children, $3305 with one child, $5460 with two children, and $6143 with three or more children. For married taxpayers with one child, the credit begins to phase out if adjusted gross income is $23,260. earned income credit (EIC) A refundable tax credit that may be claimed by workers with a qualifying child and in certain cases by childless workers. Child and Dependent Care Credit The child and dependent care credit is for workers who pay employment-related expenses if the care for children under age 13 and/or other dependents gives them the freedom to work. Depending on your income, the credit may be up to 35 percent of qualifying care expenses of up to $3000 (or a credit of $1050) for one dependent and of up to $6000 of care expenses for two or more dependents (or a credit of $2100). The credit is limited to the liability, but part or all of the credit may be refundable as an “additional child tax credit,” which is discussed below. child and dependent care credit A nonrefundable tax credit that may be claimed by workers who pay employment-related expenses for care of a child or other dependent if that care gives them the freedom to work seek work, or attend school full time. Child Tax Credits Taxpayers can claim a child tax credit (CTC) of up to $1000 per child under age 17. The child tax credit is nonrefundable. Some parents also may qualify for a refundable additional child tax credit if the child portion of the child and dependent care tax credit exceeds their tax liability. Adoption Credit An adoption tax credit (refundable) of up to $13,190 is available for the qualifying costs of an adoption. DID YOU KNOW Nearly Half of Households Pay No Income Tax The Tax Policy Center reports that between 40 and 50 percent of all households paid no federal income tax in recent years. Thus millions of Americans paid nothing toward our national defense, foreign aid, or federal parks. Of those not paying federal income taxes, 57 percent did not earn enough to pay Social Security payroll and Medicare taxes, 21 percent are elderly, 14 percent earn less than $20,000, and 8 percent are others, which totals 100 percent. The households qualified for enough credits, deductions, and exemptions to eliminate their federal tax liability. These people do pay excise taxes on gasoline and various taxes on telephone services, gasoline, tires, aviation, alcohol, and tobacco, and they may pay state and local income taxes as well as sales taxes. Most Americans work and pay federal income taxes. Three-quarters of them pay more in payroll taxes that fund Social Security and Medicare than they do in federal income taxes. Mortgage Interest Credit A mortgage interest tax credit (nonrefundable) of up to $2000 for mortgage interest paid may be claimed under special state and local government programs that provide a “mortgage credit certificate” for people who purchase a principal residence or borrow funds for certain home improvements. The home must not cost more than 90 to 110 percent of the average area purchase price. Retirement Savings Contribution Credit A nonrefundable retirement savings contribution credit (also known as a saver credit) of up to $1000 is available. The tax credit is calculated based on a percentage of your retirement contributions. For single individuals, a 50 percent credit applies on the amount saved (up to $2000) if AGI does not exceed $18,000, a 20 percent rate applies if AGI does not exceed $19,500, and a 10 percent rate applies if AGI does not exceed $30,000. For married persons, the thresholds are $36,000, $39,000, and $60,000. Elderly or Disabled Tax Credit Lower income individuals who are age 65 or older or who are permanently and totally disabled may claim a nonrefundable federal tax credit that can be as much as $1125. 4.2h Calculate the Balance Due the IRS or the Amount of Your Refund After taking all your tax credits, if the amount withheld (shown on your W-2 form) plus any estimated tax payments you made is greater than your final tax liability, then you are entitled to receive a tax refund. tax refund Amount the IRS sends back to a taxpayer if withholding and estimated payments exceed the tax liability. If the amount is less than your final tax liability, then you have a tax balance due. If you owe money, you pay by check, money order, or credit card. The IRS imposes a convenience fee of 2.5 percent of the amount charged on a credit card. 4.2i Which Tax Form Do You Use to File? To file your income tax return, you record all your tax information on the correct tax form and submit it to the Internal Revenue Service by mail or electronically. Use the IRS tax form that is appropriate for your circumstances: • Form 1040EZ. You are single or married, under age 65, and have no dependents; your income consists of less than $100,000 in wages, salary, and tips, and no more than $1500 in interest; and you do not claim any tax credits or adjustments or itemize deductions. • Form 1040A. Your income is less than $100,000 and you use the standard deduction and/or take adjustments to income or tax credits. • Form 1040. You itemize your deductions and you do or do not make contributions to a qualified retirement plan or take adjustments to income or tax credits. Figure 4-4 shows a completed 1040 Form for a taxpayer. • Form 1040X. You are eligible for a deserved refund or refundable tax credit, or you want to correct any tax filing mistake(s) or claim overlooked deductions for any of the past three years. 4.2j File on Time and Check the Status of Your Refund You should file your return on time—usually by April 15—to avoid a penalty. If you owe the IRS and you are broke, you can borrow to pay the taxes or contact the IRS about setting up an installment plan to repay the debt within three years. Taxpayers hear from the IRS within three weeks if they have failed to sign the return, neglected to attach a copy of the Form W-2, made an error in arithmetic, owe a tax penalty, or figured the tax incorrectly. Once taxpayers file their federal return, they can track the status of their refunds by using the “Where's My Refund?” tool, located on the front page of www.irs.gov. DID YOU KNOW Sean's Success Story Sean is one smart fellow. After learning a lot about how to avoid income taxes, he took action. Sean recently made a down payment and bought a foreclosed home with a $120,000, 4 percent, 20-year mortgage. The more than $14,000 in interest (from Table 9-4 on page 273) and $1500 in real estate property taxes together put him well over the $6200 standard deduction threshold. Therefore, he can take all kinds of other deductions on his tax return, such as cash and non-cash charitable contributions, mileage allowance and out-of-pocket expenses for volunteer charitable work, personal property taxes on his auto and boat, expenses for business magazines and newspapers to better manage his investments, and software to help prepare his income taxes. He started to contribute the maximum $3000 annually to his retirement account. Now Sean is researching all the tax credits to determine if he qualifies for any of them. DID YOU KNOW Money Websites for Managing Income Taxes Informative websites for managing income taxes, including preparing your own income tax form are: Bankrate.com's tax estimator (www.bankrate.com/calculators/tax-planning/1040-form-tax-calculator.aspx) Bankrate.com (www.bankrate.com/finance/taxes/check-taxes-in-your-state.aspx) Center for American Progress (www.americanprogress.org/issues/2012/02/corporate_profits.xhtml) Dinkytown's tax estimator (www.dinkytown.net/java/Tax1040.xhtml) H&R Block's TaxCut (www.hrblock.com/tax-software/index.xhtml) Internal Revenue Service (www.irs.gov) IRS Publication 17 (www.irs.gov/publications/p17/) Lasser's Your Income Tax (www.jklasser.com/) Quicken's TurboTax (turbotax.intuit.com/) TaxACT (www.taxact.com) Volunteer Income Tax Assistance (www.irs.gov/Individuals/Free-Tax-Return-Preparation-for-You-by-Volunteers) Worldwide-Taxes.com (www.worldwide-tax.com/#partthree) 4.2k File Your Income Taxes Electronically for Free and Get Your Refund Within Ten Days Over 70 percent of taxpayers pay someone to prepare the return, even though it is not complicated for most taxpayers. To file your income taxes online by yourself, visit the website of the Internal Revenue Service (www.irs.gov) and click on “IRS E-file.” Alternatively, you may choose to click on “IRS Free File” because it provides options for free brand-name tax software or online fillable forms plus free electronic filing for most taxpayers. E-filers may request that their refund be deposited directly into their bank account, and it usually will be deposited within ten days of filing. Ninety percent of taxpayer's returns are filed electronically. The average refund last year was just over $3000. 4.2l People Pay Their Income Taxes in One or Two Ways The federal income tax is a “pay as you go” tax. Through payroll withholding, an employer takes a certain amount from an employee's income as a prepayment of an individual's tax liability for the year and sends those dollars to the IRS, where they are credited to that particular taxpayer's account. People who are self-employed or who receive substantial income from an employer that is not required to practice payroll withholding, such as lawyers, accountants, consultants, and owners of rental property, must pay estimated taxes. They are required to estimate their tax liability and pay their estimated taxes in advance in quarterly installments on April 15, June 15, September 15, and the following year's January 15. payroll withholding The IRS requirement that an employer withhold a certain amount from an employee's income as a prepayment of that individual's tax liability for the year. It is sent to the government where it is credited to the taxpayer's account. estimated taxes People who are self-employed or receive substantial income from an employer that is not required to practice payroll withholding (such as lawyers and owners of rental property) are required by the IRS to estimate their tax liability and pay their taxes in advance in quarterly installments. CONCEPT CHECK 4.2 1. Give five examples of income that must be included in income reported to the Internal Revenue Service. 2. How are long-term and short-term capital gains treated differently for income tax purposes? 3. Give five examples of income that is excluded from IRS reporting. 4. List three examples of adjustments to income. 5. Distinguish between a standard deduction and a personal exemption. 6. What advice on filing a Form 1040X can you offer someone who did not file a federal income tax return last year or in any one of the past three years? 7. List five examples of tax credits. Figure 4-4 Federal Income Tax Form 1040 (Yasuo Konami) 4.3 STRATEGIES TO REDUCE YOUR INCOME TAXES LEARNING OBJECTIVE 3 Use appropriate strategies to avoid overpayment of income taxes. While the U.S. tax laws are strict and punitive about compliance (although the IRS audits less than 0.5 percent of all returns), they remain neutral about whether the taxpayer should take advantage of every “tax break” and opportunity possible. The strategies described here will help you to reduce your tax liability. 4.3a Practice Legal Tax Avoidance, Not Tax Evasion Tax evasion involves deliberately and willfully hiding income, falsely claiming deductions, or otherwise cheating the government out of taxes owed. It is illegal. A waiter who does not report tips received and a babysitter who does not report income are both evading taxes, as is a person who deducts $150 in charitable contributions but who does not actually make the donations. tax evasion Deliberately and willfully hiding income from the IRS, falsely claiming deductions, or otherwise cheating the government out of taxes owed; it is illegal. Tax avoidance means reducing tax liability through legal techniques. It involves applying knowledge of the tax code and regulations to personal income tax planning. Tax evasion results in penalties, fines, interest charges, and a possible jail sentence. In contrast, tax avoidance boosts your income because you pay less in taxes. As a result, you will have more money available to spend, save, invest, and donate. tax avoidance Reducing tax liability through legal techniques. 4.3b Strategy: Reduce Taxable Income via Your Employer It may seem illogical to suggest that to lower your tax liability you should reduce your income. But it is not. The objective is to reduce taxable income. Reducing your federal taxable income also will reduce the personal income taxes imposed by state and local governments. Four useful ways of reducing taxable income are premium-only plans, transit spending account, dependent care flexible spending accounts, and defined-contribution retirement plans. Premium-Only Plan Many large employers offer a premium-only plan (POP) that allows employees to withhold a portion of their pretax salary to pay their premiums for employer-provided health benefits. Benefits could include health, dental, vision, and disability insurance. Amounts withheld are not reported to the IRS as taxable income. For example, if Nhon Ngo, a restaurant manager in Dallas, has $400 per month ($4800 annually) withheld through his employer to pay for his share of the employer-sponsored health insurance premium, he saves as much as $1920 ($4800 × 0.40 [his effective marginal tax rate]) a year because he does not have to send that amount to the government in taxes. Transit Spending Account A transportation reimbursement plan is a similar pretax program. This employer plan allows you the opportunity to save money by using payroll deduction with pretax salary dollars to pay for work-related transportation expenses, such as transit passes ($130) and qualified parking ($250). If Nhon contributes $380 in pretax income to his employer's transportation plan, he saves as much as $152 ($380 + $130 = $380 × 0.40). Flexible Spending Account A benefit for employees who pay for child care or provide care for a parent is a salary reduction plan known as a flexible spending account (FSA), also called a flexible spending arrangement. An FSA allows an employee (and an employer) to fund qualified expenses on a pretax basis through salary reduction to pay for out-of-pocket unreimbursed expenses for medical and dental expenses (maximum for employees is $2500 annually) and dependent care (maximum is $5000 annually). The expenses are those that are not covered by insurance. Examples are annual deductibles, office co-payments, orthodontia, prescriptions, and over-the-counter drugs for which one has a doctor's prescription. Paper forms or an FSA debit card, sometimes known as a Flexcard, may be used to spend the funds. The salary reductions are not included in the individual's taxable earnings reported on Form W-2, and reimbursements from an FSA account are tax free. FSA debit card (also known as Flexcard) A card used to access and spend funds from a flexible spending account. FINANCIAL POWER POINT File IRS Form 1040X to Obtain Refunds for Previous Years Anyone who was eligible for a refundable tax credit or neglected to take a deduction may file an amended return to receive it retroactively for the previous three tax years using Form 1040X. Use this easy-to-complete form to obtain a deserved refund or correct any tax filing mistakes on an original or previously filed return. amended return A special tax return form (Form 1040X) that may be filed to obtain a deserved refund or correct any tax filing mistakes on an original or previously filed return for the previous three years. FSAs are subject to a “use-it-or-lose-it rule,” which means that any unspent dollars in the account at the end of the year are forfeited and not returned to the employee. As a result, you should make conservative estimates of your expenses when you elect your FSA choices. For example, if you had $1000 withheld for medical expenses but spent only $700 over the year, the balance of $300 will go back to your employer, not to you. The IRS does allow a 21½-month additional “grace period” if one's employer permits such an extension. use-it-or-lose-it rule An IRS regulation requiring that unspent dollars in a flexible spending account at the end of a calendar year be forfeited, unless the employer allows a 2 1/2-month grace period for spending the funds. In summary, suppose Nhon in the preceding example has $4800 annually withheld through his employer's premium only plan to be used to pay out-of-pocket medical expenses, another $380 to the transit reimbursement plan, plus another $3000 to pay out-of-pocket expenses for dependent care of his child. Defined-Contribution Retirement Plan Contributing money to a qualified employer-sponsored retirement plan also reduces income taxes. A defined-contribution retirement plan (discussed in Chapter 17) is an IRS-approved retirement plan sponsored by an employer to which employees may make pretax contributions that lower their tax liability. The most popular plan is known as a 401(k) retirement plan, although other variations exist as well. defined-contribution retirement plan IRS-approved retirement plan sponsored by employers that allows employees to make pretax contributions that lower their tax liability. The amount of money that an employee contributes to his or her individual account via salary reduction also does not show up as taxable income on the employee's W-2 form. For example, if you contribute $2000 to your employer's retirement plan and you are in the 25 percent tax bracket, this immediately saves you at least $500 ($2000 × 0.25) that you will not have to pay in taxes. An extra benefit of a defined-contribution retirement plan is that employers often offer full or partial matching contributions to employees' accounts up to a certain proportion. For example, if you invest $2000 into your 401(k) plan and your employer matches half of what you contribute, that is an immediate return of 50 percent ($1000 / $2000) on your investment! The employer's “match” is essentially free money. matching contributions Employer programs that match employees' 401 (k) contributions up to a particular percentage. All of the dollars in a qualified retirement plan are likely to be invested in mutual funds where they will grow free of income taxes. Income taxes must eventually be paid when withdrawals are made, presumably during retirement when the marginal tax rate may be lower than during one's working years. 4.3c Strategy: Prune Taxable Investments If you have some investments in your portfolio that have lost value, you may want to sell them before the end of the a year. Then you can use those capital losses to offset any capital gains earned that year from other investments. If you do not have gains to offset, you can deduct up to $3000 annually in losses against your regular income. Another strategy is to donate stocks that have appreciated in value to charity. In addition to obtaining the substantial charitable tax deduction, you avoid having to pay taxes on the gain. 4.3d Strategy: Make Tax-Sheltered Investments Investments are often made with after-tax dollars, which means that the individuals earned the money and paid income taxes on it. Then they take their after-tax money and invest it. The returns earned from these investments typically again result in taxable income. Investment alternatives are examined in Chapters 13 through 16. after-tax dollars Money on which an employee has already paid taxes. Tax laws encourage certain types of investments or other taxpayer behaviors by giving them special tax advantages over other activities, and as a result, numerous tax-sheltered investments exist. A tax shelter is any financial arrangement (as a certain kind of investment) that results in a reduction or elimination of taxes due. The tax laws allow certain income to be exempt from income taxes in the current year or permit an adjustment, reduction, deferral of income tax liability. When making investment decisions, investors should consider tax-sheltered investments. tax-sheltered investments A financial arrangement that results in a reduction or elimination of taxes due. DID YOU KNOW Top 1% of Income Earners Are Doing Well IRS data show that the top 1 percent of taxpayers (1.4 million households out of 140 million filing tax returns) earned 20 percent of all the income reported, and they paid 38 percent of federal individual income taxes paid. Their adjusted gross incomes begin about $400,000 for a family of four, and they paid an average tax rate of 29 percent. Invest with Pretax Income Making an investment contribution with pretax income means that you do not have to pay taxes this year on the income. In effect, investing with pretax income is an interest-free deferral of income taxes to another year. Examples include contributions to work-related retirement plans and flexible spending arrangements. Make Your Investments Grow Tax Sheltered When income, dividends, or capital gains are tax sheltered, the investor does not pay the current-year tax liability on the income and instead shifts the income and any tax liability to a later year. This benefit is substantial. Investments can grow faster because the money that would have gone to the government in taxes every year can remain in the investment for many years to accumulate. In effect, the government “loans” taxfree money to taxpayers to help fund their investment and retirement plans. The tax-free growth of such investments is called tax-sheltered compounding. tax sheltered Income, dividends, or capital gains that are allowed to grow without taxes until distributions are taken. FINANCIAL POWER POINT Create Future Tax-Free Income with Your Refund You can instruct the IRS to deposit your tax refund directly into a Roth IRA. This IRA account can be opened online in minutes without making an initial deposit. All the money will grow tax-free, and future withdrawals will be tax-free too. Seven Examples of Tax-Sheltered Investments Numerous tax-sheltered investments exist, and some popular ones follow. Roth IRA Accounts Contributions (up to $5500 annually) to a Roth IRA accumulate tax-free and withdrawals are tax-free. There is no tax break on contributions, as they are made with after-tax money. This is an excellent investment vehicle for people with a long-term investment horizon who want to save more money for retirement than they can through an employer-sponsored retirement plan. All types of IRA accounts and other retirement plans are examined in Chapter 17. IRAs are examined in Chapter 17. Roth IRA An individual retirement account of investments made with after-tax money; the interest on such accounts is allowed to grow tax-free, and withdrawals are also tax-free. Individual Retirement Accounts The amount contributed (up to $5500 annually) to a traditional individual retirement account (IRA) is considered an adjustment to income, which reduces your current-year income tax liability. Investments inside the IRA (such as stocks and stock mutual funds) accumulate tax sheltered. Income taxes are owed on the eventual withdrawals, likely during retirement. individual retirement account (IRA) Investment account that reduces current year income, and the funds in the account accumulate tax-free. Coverdell Education Savings Accounts Contributions of up to $2000 per year of after-tax money may be made to a Coverdell education savings account (also known as an education savings account and formerly known as an “education IRA”) to pay future education costs. Earnings accumulate tax-free, and withdrawals for qualified expenses are tax-free. The money can be used to pay for public, private, or religious school expenses, in college or graduate school. It can pay for tuition, fees, room and board, tutoring, uniforms, home computers, Internet access and related technology, transportation, and extended day care. Coverdell education savings account (or education savings account) An IRS-approved way to pay the future education costs for a child younger than age 18 whereby the earnings accumulate tax-free and withdrawals for qualified expenses are tax-free. Qualified Tuition Programs There are two types of qualified tuition programs, and these are known as 529 plans. Under the prepaid educational service plan, an individual purchases tuition credits today for use in the future. Also known as a state-sponsored prepaid tuition plan, this program allows parents, relatives, and friends to purchase a child's future college education at today's prices by guaranteeing that amounts prepaid will be used for the future tuition at an approved institution of higher education in a particular state. The funds may be used to pay for tuition only—not room, board, or supplies. The second qualified IRS Section 529 tuition program, called a college savings plan, is set up for a designated beneficiary. You may contribute up to $14,000 per year per child of after-tax money to a 529 college savings plan. Withdrawals are tax-free if made for qualified education expenses such as tuition, room, and board. If one child does not go to college, the funds may be transferred to another relative. One may contribute to both a Section 529 plan and a Coverdell education savings account for the same beneficiary in the same year. Government Savings Bonds Series EE and Series I government savings bonds are promissory notes issued by the federal government. The income is exempt from state and local taxes. You may defer the income tax until final maturity (30 years) or report the interest annually. Reporting the interest in a child's name is advisable especially when it can be offset totally by the child's standard deduction. You may exclude accumulated interest from bonds from income tax in the year you redeem the bonds to pay qualified educational expenses. (See Chapter 14 for information on similar bonds.) Tax-Exempt Municipal Bonds Tax-exempt municipal bonds (also called munis) are long-term debts issued by local governments and their agencies that are used to finance public improvement projects. Interest is free from federal and state taxes if the bond is purchased in one's state of residence. Taxpayers in higher-income brackets (28 percent or more) often take advantage of these kinds of investments. (See Chapter 14.) Smart investors choose the bonds that pay the better return after payment of income taxes. The formula to decide whether a taxable investment or nontaxable investment is better for you appears in the box “How to Compare Taxable and After-Tax Yields” on page 129. DID YOU KNOW Saving for a Child's College Education Good ways to save for a child's college education while taking advantage of some income tax breaks are as follows: The Section 529 College Savings Plan is named after the related section of the Internal Revenue Service Code, and all states have established at least one Section 529 college savings plan. Deposits into a 529 plan are not deductible, but withdrawals (including tax-free growth) for qualified educational expenses are tax-free. A Coverdell Education Savings Account accepts nondeductible contributions up to a maximum of $2000 per year for a child younger than 18 to pay his or her future education costs. The money and earnings on the account may be withdrawn tax-free to pay for qualified expenses. Individual Retirement Accounts (IRAs) are designed primarily for retirement savings but under certain circumstances withdrawals can be used to pay for qualified college expenses for the account holder, child or grandchild. Early withdrawal penalties are waived if the funds are used for education expenses. A custodial account may be opened in the name of a child younger than age 14 under the provisions of the Uniform Gifts to Minors Act. College students usually are in the 10 or 15 percent tax bracket and they may be able to sell assets given to them without paying any capital gains taxes. The kiddie tax also applies to income of a minor child earned off the assets (such as interest and dividends). For children younger than age 18, the first $1000 of unearned income (the income earned from an investment) earned on custodial account assets is taxfree to the child. The next $1000 is taxed at the child's tax rate. Income in excess of $2000 is taxed at the parent's (likely higher) rate. When a child is age 18, he or she pays taxes based on his or her own income tax bracket. Discount bonds (also called zeroes or zero coupon bonds) are corporate and government bonds that pay no annual interest. Instead, discount bonds are sold to investors at sharp discounts from their face value, which may be redeemed at full value upon maturity. For example, a $10,000 Series EE savings bond sold by the federal government can be purchased for $5000, one-half its face amount. The interest accumulates within the bond itself, and this phantom income earned by a child is generally so small that little, if any, income taxes are due each year as the bond matures. Taxes on the interest earned each year may be deferred until redemption and are tax-free when the proceeds are used to fund a child's college education. DID YOU KNOW How to Compare Taxable and After-Tax Yields Investors may choose to put their money into vehicles that provide taxable income, such as stocks, corporate bonds, and stock mutual funds. Taxpayers also have the opportunity to lower their income tax liabilities by investing in tax-exempt municipal bonds, money market funds that invest in municipal bonds, and other tax-exempt ventures. (These investment alternatives are discussed in Chapter 14.) Because of their tax-exempt status, these investments offer lower nominal returns than taxable alternatives. But after considering the effects of taxes, the actual return to an investor on a tax-exempt investment may be higher than the after-tax yield on a taxable corporate bond. To find out whether a taxable investment pays a higher after-tax yield than a tax-exempt alternative, the investor must determine the after-tax yield of each alternative. The after-tax yield is the percentage yield on a taxable investment after subtracting the effect of federal income taxes that will need to be paid on the investment. The after-tax yield on a tax-exempt investment is the same as the nominal yield because you do not have to pay income taxes on income from this kind of investment. So the question is, “How does the investor calculate the after-tax yield on a taxable investment?” after-tax yield The percentage yield on a taxable investment after subtracting the effect of federal income taxes that will need to be paid on the investment. DO IT IN CLASS When you know the taxable yield, use Equation (4.1) to determine the equivalent after-tax yield on a taxable investment. Only then can you decide which investment is better. For example, suppose Bobby Bigbucks pays income taxes at the 35 percent combined federal and state marginal tax rate and is considering buying either a municipal bond that pays a 3.5 percent yield or a taxable corporate bond that pays a 5.7 percent yield. Equation (4.1) calculates the equivalent after-tax yield on the corporate bond:* The answer is 3.71 percent. Thus, a 5.7 percent taxable yield is equivalent to an after-tax yield of 3.71 percent. Eureka! Bobby now knows that he should buy the corporate bond paying 5.7 percent because its after-tax yield of 3.71 percent is higher than the 3.5 percent paid by the municipal bond. These differences may look small, and they are, but over time they add up. For example, the extra 0.21 percent (3.71 − 3.50) yield on a $20,000 bond investment for 20 years amounts to $840 [$20,000 × 0.0021 × 20 (bond interest is not compounded)]. That's real money! The higher your federal tax rate, the more favorable tax-exempt municipal bonds become as an investment compared with taxable bonds. The tax-exempt status of municipal bonds does not apply to capital gains. When you sell an investment for more than what you paid for it, you will owe federal income taxes on the capital gain. * This and similar equations can be found and used on the Garman/Forgue companion website. † The formula can be reversed to solve for the equivalent taxable yield when one knows the tax-exempt yield. To continue the example, the return for Bobby on a 3.71 percent tax-exempt bond is equivalent to a taxable yield of 5.7 percent [3.71 ÷ (1.00 − 0.35)]. If Bobby finds a tax-exempt bond paying more than 3.71 percent, he should consider buying it. Capital Gains on Housing A big tax shelter is available to homeowners when they sell their homes. Those with appreciated principal residences are allowed to avoid taxes on capital gains of up to $500,000 if married and filing jointly and on gains up to $250,000 if single. The home must have been owned and used as the taxpayer's private residence for two out of the five years immediately prior to the date of the sale. 4.3e Strategy: Defer Income A popular way to reduce income tax liability is to shelter income by deferring it. You will not have to pay taxes on income earned after December 31st until April the following year or 15 months in the future. This goal is achieved by purposefully making arrangements to receive some of this year's income in the next year, when your marginal tax rate might be lower, perhaps only 25 percent rather than 28 percent. A 3 percent tax savings (paying at the 25 percent rate rather than 28 percent) on $3000 of income is $90 ($3000 × 0.03), enough to pay for a good meal in a restaurant. Your employer might be willing to give you a bonus or commission check in January rather than in December, and those who are self-employed can ask clients and customers to wait until January to pay their bills. DID YOU KNOW Tax Reform Proposals: Flat Tax and Value-Added Tax Politicians and pundits are talking about tax reform that overhauls the huge and complicated U.S. tax code. Many want to eliminate certain tax deductions and simplify the tax code. This is difficult to do since the vested interests that obtained a deduction in the first place will fight to maintain the popular deductions for interest paid on home loans, contributions to charity, interest on loans for investing, contributions to retirement plans, and tax credits for child and dependent care. Some call for a flat tax as a substitute for our current tax system. This is an income tax having but a single rate for all taxpayers regardless of income level and type. Economists suggest that a single rate, perhaps 22 percent, might replace the revenue currently derived from the present multiple tax rates. However, for most taxpayers this would result in a tax increase. flat tax An income tax having but a single rate for all taxpayers regardless of income level and type. Another idea is a federal value-added tax (VAT), which is essentially a federal retail sales tax. It is a tax, perhaps 10 percent, on the calculated “value added” to a product or material at each stage of manufacture or distribution; thus it is a form of consumption tax paid by consumers. Even though every company that handles a product from raw material to finished goods must pay a VAT to the government, businesses would actually pay nothing since they receive tax credits for all the VAT they pay to suppliers. Over 40 industrialized countries have VATs. value-added tax A federal retail sales tax on the estimated “value added” to a product or material at each stage of manufacture or distribution. Capital gains are taxable income but up to $500,000 for couples might be exempt on a profitable sale. You might expect to be in a lower tax bracket in the following year because you anticipate fewer sales commissions or know that you will not work full time. For example, if you return to school, have a child, or decide to travel. Retired people may be able to postpone withdrawals of income from retirement plans, and entrepreneurs may delay billing customers for work. ADVICE FROM A PROFESSIONAL Consider the Tax Consequences of Buying a Home to Reduce Income Taxes Brianna Pallagrosi of Rome, New York, took a sales position at a retail chain store two years ago, where she earned a gross income of $46,736. Brianna wisely made a $1000 contribution to her IRA. Her itemized deductions came to only $4400, so she took the standard deduction and personal exemption amounts. The result was a tax liability of $5425. Brianna was not happy about paying what she thought was a large tax bill that year. Gross income $46,736 Less adjustment to income −1,000 Adjusted gross income 45,736 Less value of one exemption (old figure) −3,800 Subtotal 41,936 Less standard deduction (old figure) −5,950 Taxable income 35,986 Tax liability (from old tax table not shown) $ 5,425 Last year, Brianna did not receive a raise. Nonetheless, Brianna continued to contribute $1000 into her IRA. To reduce her federal income taxes, she also became a homeowner after using some inheritance money to make the down payment on a condominium. During the year, she paid out $9126 in mortgage interest expenses and $1995 in real estate taxes. After studying various tax publications, Brianna determined that she had $3814 in other itemized deductions that, when combined with the interest and real estate taxes, then came to a grand total of $14,935. These deductions reduced Brianna's tax liability dramatically. Gross income $46,736 Less adjustment to income −1,000 Adjusted gross income 45,736 Less itemized deductions −14,935 Subtotal 30,801 Less value of one exemption −3,950 Taxable income 26,851 Tax liability (from Table 4-3) $ 3,573 Brianna correctly concluded that the IRS “paid” $1852 ($5425 − $3573) toward the purchase of her condominium and her living costs because she did not have to forward those dollars to the government. An additional benefit for Brianna is that she now owns a home whose value could appreciate in the future. Buying a home often reduces one's income taxes. Frances C. Lawrence Louisiana State University 4.3f Strategy: Accelerate Deductions This strategy allows you to lower your taxable income sooner rather than later, which is usually a good idea. Many people find that they do not have enough itemized deductions to exceed the standard deduction amount. By shifting the payment dates of some deductible items, you can increase your deductions. For example, if a single person has about $6000 of deductible expenses this year, she could prepay some items in December to push the total over the $6200 threshold and benefit by taking the excess deductions now. The next year, she can take the standard deduction amount instead of itemizing. This process is known as accelerating deductions. Items that may be prepaid include medical expenses, dental bills, real estate taxes, state and local income taxes, the January payment of estimated state income taxes, personal property taxes that have been billed (e.g., on autos and boats), dues in professional associations, and charitable contributions. You may mail the payments or charge them on credit cards by December 31. 4.3g Strategy: Take All of Your Legal Tax Deductions Although you should not spend money just to create a tax deduction, you are encouraged to take all of the deductions to which you are entitled. One way to increase itemized deductions, for example, is to purchase a home with a mortgage loan. The large amounts of money homeowners expend for both interest and real estate taxes are deductible. Plus, if your property taxes and interest exceed the standard deduction amount, then you are able to take additional deductions that were ineligible because of the threshold. DID YOU KNOW Bias Toward Avoiding Risk People engaged in managing income taxes have a bias toward certain behaviors that can be harmful, such as a tendency toward avoiding risk. People often are worried that taking too many deductions on their income tax return will risk an audit so they do not take deductions they actually deserve. What to do? Reject this tendency and take your deductions because the odds of an audit for most of us is well under 1 percent, and even then the IRS is likely to accept all of one's deductions. DID YOU KNOW Your Worst Financial Blunders in Managing Income Taxes Based on others' financial woes, you will make mistakes in personal finance when you: 1. Turn all your income tax planning over to someone else instead of doing it yourself. 2. Over withhold your income taxes to receive a big refund next year. 3. Ignore the impact of income taxes in your personal financial planning. Here are some other approaches to increase your deductions and keep more tax dollars in your pocket. Assume you are in the 25 percent marginal tax bracket and itemize deductions. Cash contributions made to people collecting door to door or at a shopping center during holidays are deductible, even though receipts are not given. Fifty dollars in contributions deducted can save you $12.50 in taxes. Instead of throwing out an old television set, donate it. An $80 charitable contribution for a TV will save you $20 in taxes. These amounts may sound like “small change,” but lots of little tax deductions can quickly add up to more than $100, and that soon becomes real money! Expenses for business-related trips can be a fruitful area for tax deductions. If you are in the 25 percent tax bracket and take one business trip per year, perhaps incurring $800 in deductible expenses, you will save $200 in taxes, assuming your miscellaneous deductions already exceed 2 percent of your AGI. The IRS also permits tax deductions for the costs expended on occasional job-hunting trips. In other words, depending on your tax bracket, the U.S. government pays the bill for 25 percent of such expenditures. 4.3h Strategy: Shift Income to a Child A parent who runs his or her own business may pay a child up to $10,150 ($6200 [value of standard deduction]) + $3950 [value of exemption]) in “earned income” before any income tax liability occurs. This assumes the child has no other income. Thus, the parent can deduct the payments as business expenses. However, giving unearned income to children is treated differently by the IRS. Unearned income is interest from a savings account, bond interest, alimony, and dividends from stock that comes from investments. This excludes income from wages or self-employment. unearned income Investment returns in the form of rents, dividends, capital gains, interest, or royalties. The kiddie tax is applied to a child's unearned income of more than $2,000, and it impacts children under age 19 (or up to 24 for full-time students). The tax is meant to discourage parents from reducing their own taxes by shifting lots of investment income to their children, who generally have lower tax brackets. DID YOU KNOW Turn Bad Habits into Good Habits Do You Do This? Do This Instead! Did not file an income tax return assuming your employer withheld sufficient funds File a return to obtain amounts over withheld Pay too much in income taxes Use the strategies in this chapter to reduce your tax liability Wish you could itemize instead of using the standard deduction Buy a home so you can deduct mortgage interest and property taxes as well as take other deductions Forget to take certain tax credits in the last three years File 1040X amended returns to claim the credits and obtain the refunds Neglect to save for retirement Save money by contributing to a qualified retirement plan Let a tax preparer fill out your income tax forms every year Get smart about how to reduce your income tax liability and to use software and prepare your own taxes Under the Kiddie tax, a parent can shift income-generating investment assets to the name of a child who then may receive $1000 tax-free. The next $1000 of such unearned income is taxed at the child's tax rate, often only 10 percent. All of the child's unearned income in excess of $2000 is taxed at the parent's tax rate, which could be as high as 39.6 percent. 4.3i Strategy: Buy and Manage a Real Estate Investment DO IT NOW! You know more about personal finance after reading this chapter, so get started right now by: 1. Projecting your taxable income and total withholding for this year. 2. Estimating your federal tax liability based on your income projection using this year's tax tables or schedules. 3. Revising your W-4 form with your employer as necessary to withhold more if you estimate owing more in taxes or to withhold less. Tax losses are paper losses in the sense that they may not represent actual out-of-pocket dollar losses, and they are created when deductions generated from an investment (such as depreciation and net investment losses) exceed the income from an investment. tax losses Created when deductions generated from an investment (such as depreciation and net investment losses) exceed the income from an investment. Taxpayers are allowed to deduct certain real estate losses against ordinary taxable income, such as salary, interest, dividends, and self-employment earnings. Deductions are allowed for real estate investors who (1) have an adjusted gross income of $150,000 or less and (2) actively participate in the management of the property. Here the investor may deduct up to $25,000 of net losses from a “passive investment,” such as real estate, against income from “active” sources, such as salary. For example, a residential real estate investment property might generate an annual cash income $1000 greater than the out-of-pocket operating costs associated with it. However, after depreciation expenses on the building are taken as a tax deduction, the resulting $1500 tax loss may then be used to offset other income. (For more details, see Chapter 16, “Real Estate and High-Risk Investments.”) CONCEPT CHECK 4.3 1. Distinguish between two types of tax-sheltered investment returns. 2. Explain how to reduce income taxes via your employer, and name three employer-sponsored plans to do so. 3. Summarize the differences between an individual retirement account (IRA) and a Roth IRA. 4. Identify three strategies to avoid overpayment of income taxes, and summarize the essence of each. WHAT DO YOU RECOMMEND NOW? Now that you have read the chapter on managing income taxes, what advice can you offer Timothy and Amber in the case at the beginning of the chapter regarding: 1. Using tax credits to help pay for Tom's college expenses? 2. Determining how much money Amber will realize if she sells the stocks, assuming she pays federal income taxes at the 25 percent rate? 3. Buying a home? 4. Increasing contributions to their employer-sponsored retirement plans? 5. Establishing a sideline business for Tom's jewelry operation? BIG PICTURE SUMMARY OF LEARNING OBJECTIYES L01 Explain the nature of progressive income taxes and the marginal tax rate The federal personal income tax is a progressive tax because the tax rate increases as a taxpayer's taxable income increases. The marginal tax rate is applied to your last dollar of earnings. Your effective marginal tax rate is probably 40 percent. L02 Differentiate among the eight steps involved in calculating your federal income taxes There are eight steps in calculating your income taxes. Certain types of income may be excluded. Regulations permit you to subtract adjustments to income, exemptions, deductions, and tax credits before determining your final tax liability. L03 Use appropriate strategies to avoid overpayment of income taxes You can reduce your tax liability by following certain tax avoidance strategies, such as putting your money in tax-sheltered investments, reducing taxable income via your employer, and investing pretax money for tax-deferred compounding. Other strategies are to postpone income, accelerate deductions, take all your legal deductions, and buy and manage a real estate investment. LET'S TALK ABOUT IT 1. During Slow Economic Times. Congress reduced taxes on middle- and low-income taxpayers with the expectation that they will spend most of that money and help create more economic growth. Was this idea good or not, and why? 2. Filing a Tax Return. Many college students choose not to file a federal income tax return, assuming that the income taxes withheld by employers “probably” will cover their tax liability. Is such an assumption correct? What are the negatives of this practice if the employers withheld too much in income taxes? What are the negatives if the employers did not withhold enough in income taxes? Will any tax credits be lost? 3. Fairness of Capital Gains. Long-term capital gains are taxed at a rate of 20, 15 or 5 percent, or zero (0). What is your opinion on the fairness of these lower capital gains tax rates as compared with the marginal rates applied to income earned from employment that range as high as 39.6 percent? 4. Reporting Cash Income. Some college students earn money that is paid to them in cash and then do not include this as income when they file their tax returns. What are the pros and cons of this practice? 5. Sideline Business. Identify one possible sideline business that you might engage in to reduce your income tax liability. 6. Tax Credits. Name three tax credits that a college student might take advantage of while still in school or during the first few years after graduation. 7. Reduce Tax Liability. Identify five strategies to reduce income tax liability that you may take advantage of in the future. 8. Taxable Income or Exclusions? Review the list of exclusions on pages 112 and 113 and select 3 you think ought to be classified as taxable income rather than exclusions. 9. Eliminate Tax Credits. Review the list of tax credits on pages 119 and 121 and select 2 you think ought to be eliminated, and explain your reasoning. 10. Strategies to Reduce Income Taxes. Review the list of strategies to reduce your income taxes on pages 125 through 133 and select 2 you think you might use in the future, and explain your reasoning. DO THE MATH 1. Calculate Tax Liability. What would be the tax liability for a single taxpayer who has a gross income of $39,700? (Hint: Use Table 4-2, and don't forget to first subtract the value of a standard deduction and one exemption.) 2. Marginal Tax Rate. What would be the marginal tax rate for a single person who has a taxable income of (a) $40,210, (b) $47,800, (c) $56,100, and (d) $90,230? (Hint: Use Table 4-2.) 3. Determine Tax Liability. Find the tax liabilities based on the taxable income of the following people: (a) married couple, $74,125; (b) married couple, $53,077; (c) single person, $27,880; (d) single person, $59,000. (Hint: Use Table 4-3.) DO IT IN CLASS PAGE 118 4. Use Tax Rate Schedule. Benjamin Addai determined the following tax information: gross salary, $60,000; interest earned, $90; IRA contribution, $1000; personal exemption, $3950; and itemized deductions, $5900. Calculate Benjamin's taxable income and tax liability filing single. (Hint: Use Table 4-2.) DO IT IN CLASS PAGE 114 5. Use Tax Rate Schedule. Samual Clark determined the following tax information: salary, $144,000; interest earned, $2000; qualified retirement plan contribution, $7000; personal exemption, $3950; itemized deductions, $10,000. Filing single, calculate Samual's taxable income and tax liability. (Hint: Use Table 4-2.) DO IT IN CLASS PAGE 114 6. Review Figure 4-1 on page 107 and comment on the logic of how different segments of Victoria's income is taxed. DO IT IN CLASS PAGE 107 FINANCIAL PLANNING CASES CASE 1 The Johnsons Calculate Their Income Taxes Several years have gone by since Harry and Belinda graduated from college and started their working careers. They both earn good salaries. They believe that they are paying too much in federal income taxes. The Johnsons' total income last year included Harry's salary of $63,000 and Belinda's salary of $84,000. She contributed $3000 to her 401 (k) for retirement. She earned $400 in interest on savings and checking and $3000 interest income from the trust that is taxed in the same way as interest income from checking and savings accounts. Harry contributed $3000 into a traditional IRA. (a) What is the Johnsons' reportable gross income on their joint tax return? (b) What is their adjusted gross income? (c) What is the total value of their exemptions? (d) How much is the standard deduction for the Johnsons? (e) The Johnsons are buying a home that has monthly mortgage payments of $3000, or $36,000 a year. Of this amount, $32,800 goes for interest and real estate property taxes. The couple has a $14,000 in other itemized deductions. Using these numbers and Table 4-2, calculate their taxable income and tax liability. (f) Assuming they had a combined $22,000 in federal income taxes withheld, how much of a refund will the Johnsons receive? (g) What is their marginal tax rate? (h) List three additional ways that the Johnsons might reduce their tax liability next year. CASE 2 Victor and Maria Reduce Their Income Tax Liability The year before last, Victor earned $51,000 from his retail management position, and Maria began working full-time and earned $45,000 as a medical technician. After they took the standard deduction and claimed four exemptions (themselves plus their two children), their federal income tax liability was about $12,000. After hearing from friends that they were paying too much in taxes, the couple vowed to try to never again pay that much. Therefore, the Hernandezes embarked on a yearlong effort to reduce their income tax liability. This year they tracked all of their possible itemized deductions, and both made contributions to qualified retirement plans at their places of employment. DO IT IN CLASS PAGE 114 (a) Calculate the Hernandezes' income tax liability for this year as a joint return (using Table 4-2) given the following information: gross salary income (Victor, $56,000; Maria, $51,000); state income tax refund ($400); interest on checking and savings accounts ($250); holiday bonus from Maria's employer ($375); contributions to qualified retirement accounts ($5500); itemized deductions (real estate taxes, $2600; mortgage interest, $6300; charitable contributions, $2500); and exemptions for themselves and their two children ($3950 each). (b) List five additional strategies that Victor and Maria might consider for next year's tax planning to reduce next year's tax liability. CASE 3 Julia Price Thinks About Reducing Her Income Taxes Julia does well financially because she earns a good salary as an engineer, is somewhat frugal, and is making the maximum contribution to her employer-sponsored retirement plan. After reading about ways to decrease her income tax liability, she has some thoughts. Buying a home is an option, but Julia is worried about the changing prices of housing. As an accomplished sculptural artist, she is thinking about creating a sideline business to sell some of her work and convert some everyday expenses into business expenses. She is considering taking a tax-deductible job-hunting trip and then stretching the trip into a vacation. Also on her possibilities list is to start a master's degree program in engineering to enhance her skills. Finally, Julia figures she could contribute $200 a month to a Roth IRA account. Offer your opinions about her thinking. CASE 4 A New Family Calculates Income and Tax Liability Jerri Nichols and her two children, Austin and Alexandra, moved into the home of her new husband, Samuel Glenner, in Ames, Iowa. Jerri is employed as a librarian, and her husband sells cars. The Glenner family income consists of the following: $40,000 from Jerri's salary; $42,000 from Samuel's salary; $10,000 in life insurance proceeds from a deceased aunt; $140 in interest from savings; $4380 in alimony from Jerri's ex-husband; $14,200 in child support from her ex-husband; $500 cash as a Christmas gift from Samuel's parents; and a $1600 tuition-and-books scholarship Jerri received to go to college part time last year. (a) What is the total of the Glenner reportable gross income? (b) After they put $5600 into qualified retirement plan accounts last year, what is their adjusted gross income? (c) How many exemptions can the family claim, and how much is the total value allowed the household? (d) How much is the allowable standard deduction for the household? (e) Their itemized deductions are $13,100, so should they itemize or take the standard deduction? (f) What is their taxable income for a joint return? (g) What is their final federal income tax liability, and what is their marginal tax rate? (Hint: Use Table 4-2.) (h) If Jerri's and Samuel's employers withheld $18,000 for income taxes, does the couple owe money to the government or do they get a refund? How much? CASE 5 Taxable Versus Tax-Exempt Bonds Dario Flores, radio station manager in Franklin County, New Jersey, is in the 25 percent federal marginal tax bracket and pays an additional 5 percent in income taxes to the state of New Jersey. Dario currently has more than $20,000 invested in corporate bonds bought at various times that are earning differing amounts of taxable interest: $10,000 in ABC earning 5.9 percent; $5000 in DEF earning 5.5 percent; $3000 in GHI earning 5.8 percent; and $2000 in JKL earning 5.4 percent. What is the after-tax return of each investment? To calculate your answers, use the after-tax yield formula (or the reversed formula) on page 129, or the Garman/Forgue companion website. DO IT IN CLASS PAGE 129 CASE 6 Taxable Versus Nontaxable Income Identify each of the following items as either part of taxable income or an exclusion, adjustment, or an allowable itemized deduction from taxable income for Brian Collins and Morgan Smithfield, a married couple from San Diego: DO IT IN CLASS PAGES 112 AND 116 (a) Brian earns $45,000 per year. (b) Brian receives a $1000 bonus from his employer. (c) Morgan receives $40,000 in commissions from his work. (d) Morgan receives $300 in monthly child support from his ex-wife. (e) Brian pays $200 each month in alimony. (f) Brian contributes $2000 to his retirement account. (g) Morgan inherits a car from his aunt that has a fair market value of $3000. (h) Morgan sells the car and donates $1500 to his aunt's church. (i) Brian receives a $5000 gift from his mother. BE YOUR OWN PERSONAL FINANCIAL MANAGER 1. keep Track of Your Sources of Income. Complete Worksheet 19: My Sources of Taxable Income from “My Personal Financial Planner” to record all of your various income sources throughout the tax year so that you will not forget to report them to the Internal Revenue Service. Record the names of the income sources in the spaces provided. Record the amounts in the appropriate spaces. 2. Estimate Your Income Tax Liability. Complete Worksheet 20: Estimate Your Income Tax Liability from “My Personal Financial Planner” to determine an estimate of your income tax liability (for either last year or next year). 3. Should You File an Income Tax Return to Obtain a Refund? Complete Worksheet 21: Determining Whether I Should File for a Refund from “My Personal Financial Planner.” Even if you are not required to file a return perhaps because you did not earn enough money, you should file if you have a refund coming—that is, if you had more taxes withheld from your paychecks than you ultimately owed. Follow the steps to make the determination. 4. Strategies to Reduce Your Income Tax Liability. Complete Worksheet 22: Strategies to Reduce My Income Tax Liability from “My Personal Financial Planner.” There are several ways to reduce your income tax liability. For each strategy that might be of interest, make checkmarks to identify what characteristics you like about each and which strategies you might follow during your tax-paying life. ON THE NET Go to the Web pages indicated to complete these exercises. 1. IRS Publication 17. Go to the Internal Revenue Service website address www.irs.gov/publications/p17/. There you will find the IRS's entire Publication 17 online. This is the government's detailed explanation of all aspects of federal income taxes where you can look up almost any possible tax question. Summarize your observations about this publication. 2. Estimate Your Tax Refund. Visit the website for BankRate.com (www.bankrate.com/calculators/tax-planning/1040 -form-tax-calculator.aspx)to estimate your tax refund. Fill in a few numbers and get an answer. 3. Estimate Your Income Taxes. Enter your filing status, income, deductions and credits and the calculator at Dinkytown (www.dinkytown.net/java/Tax1040.xhtml) and based on your inputs (filing status, income, deductions, and credits) and projected withholdings for the year, it can estimate your tax refund or amount you may owe the IRS next year. 4. Check Taxes in Your State to Determine Your Effective Tax Rate. Visit Bankrate.com's website www.bankrate .com/finance/taxes/check-taxes-in-your-state.aspx. There you will find a map of states. Click to find your state income tax, if applicable. What is your combined federal and state marginal tax rate? Add in another 7.65 percent for Social Security and Medicare taxes to determine your effective marginal tax rate. ACTION INYOLYEMENT PROJECTS 1. Telephone the Internal Revenue Service. Dial 1 (800) TAX-3676 (or 1 (800) 829–3676) to pose a question for an IRS spokesperson. Think of a question before you call. Perhaps it has to deal with whether or not you qualify for a specific tax credit, can deduct expenses for a sideline business, or can make Roth IRA contributions. Write a summary of your findings. 2. Tax Reform Proposals. Type “tax reform” into your browser and skim read what you find of interest on three websites. Write a summary of your findings and include your views of what reform(s) you might prefer. 3. Who Pays Income Taxes? Type “income taxes, who pays” into your browser and skim read what you find of interest on three websites. For starters, you will discover that close to half of Americans do not pay any federal income taxes at all and that the top 1 percent of earners pay close to 40 percent of all personal income tax revenues. Write a summary of your findings, and cite your sources. 4. Tax Bills Lowest Since 1950s. Read the FactCheck.org article on taxes in the United States at factcheck.org/2012/07/tax-facts-lowest-rates-in-30-years/. In addition, search the Web for a more recent report on the same topic and write a summary of your findings. 5. Corporate and Individual Tax Rates Around the World. Comparing taxes on individuals and businesses around the world is extremely challenging. Some countries have a value-added tax paid by consumers. Others provide free health care to citizens, while people in some countries have to pay health care premiums. Review the table provided by Worldwide-Taxes.com at www.worldwide-tax.com/#partthree, and write a brief summary of your impressions. 6. Corporate Tax Avoidance. Read the article on the Center for American Progress (www.americanprogress.org/issues/2012/02/corporate_profits.xhtml) to discover how many billions the large multinational corporations in the United States do or do not pay in income taxes in this country. Write a summary of your findings. visit the Garman/Forgue companion website at www.cengagebrain.com. * The history of the latest year when the highest federal marginal tax rates in the United States was applied to taxable income is as follows: 1953 (92%); 1980 (70%); 1986 (50%); 2000 (39.6%); and 2012 (35%). * The 6.2 percent Social Security tax is applied to wages up to $117,000. ** The Medicare tax is applied to all wages regardless of amount. *** “Higher-income” taxpayers earning $200,000+, about 4.7 million returns, which is 3.2 percent of all returns, also must pay two additional Medicare taxes: A 3.8 percent surtax on net investment income and a 0.9 percent Medicare contributions tax on self-employment earnings. Those earning $400,000+ also pay a 20 percent rate on all long-term capital gains. **** Check income tax rates in various states at www.bankrate.com/taxes.aspx * If you or your spouse is age 65 or older, medical expenses exceeding 7.5 percent of AGI may be claimed. 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.