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FI 413 Study Guide - Final Guide: Tax Advantage, Efficient Frontier

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School
MSU
Department
Finance
Course
FI 413
Professor
Johner

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Document Summary

Taxes and cost of investing fed income tax rates of up to 35 percent. Long term capital gains are taxed up to 20 percent. Iras, rother iras, and 401 (k) all are tax free. Ira an investors annual contribution to an ira is tax-deductible if the investors income does not exceed a certain level. Tax is deferred until the money is withdrawn and at current income. Roth ira not tax deductible but allows dividend, interest and capital gains on the investments to compound on a tax-exempt basis. If the investor is at least 591/2 and has invest for at least 5 years he may withdraw money on a tax-free basis. May be matched by employer: time value of money. Time and the value of money are inversely related. Spending money today and receiving cash payments in the future. Compounding the process of going from today"s value, or pv, to some expected but unknown future value.

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Related Questions

A Roth IRA enables an individual to invest after-tax dollars during the accumulation phase of a retirement plan. The money is then income tax free when it is withdrawn during retirement. A tax-deductible IRA, on the other hand, provides an up-front tax deduction for the annual contribution, but it then requires income taxes to be paid on all future distributions. A basic assumption as to which plan is more beneficial concerns the current value income tax rates versus their projected rates in the future. Suppose that you plan to invest $4,000 at the end of each year for 30 years. Your current income tax rate now is 28%, so $4,000*(1-0.28) = $2,880 can be invested this year into the Roth IRA. However, the full $4,000 per year can be invested into a tax-deductible IRA. Money invested under either plan will be deposited into a mutual fund earning 8% per year. (A) Develop a spreadsheet to determine which IRA will be the better investment. (B) Assuming you will turn 65 in 30 years, examine your projected income and tax rate and develop an investment and retirement withdrawal strategy.

Mary and Harry Reser, 57 and 62, are looking ahead to retirement early next year. They are thinking about heading south to a cheaper and warmer state but haven't made a firm decision. Harry is the sole breadwinner and earns $64,543, plus an additional $8,169 from investments.

The Reser's two main concerns are longevity and taxes. "We want to take income from investments with the least amount of tax liability and make the money we have accrued last as long as we do," notes Harry. He also noted a concern about taking money out of tax-deferred plans in the correct manner to avoid IRS penalties.

The Reser's can be considered "millionaires next door," with an impressive net worth of $1,065,951. They have absolutely no debt and the following assets: $32,000 in a 2% bank passbook account, $347,365 in telephone stock; $224,901 in Harry's 401(k); $31,000 in an annuity; $202,685 in mutual funds; $23,000 in whole life insurance; their $190,000 home; and $15,000 of personal property.

No information was provided as to the type of mutual funds or the 401(k)'s asset allocation (i.e., the percentage of the account in different types of assets like stocks and bonds). Harry contributes 15% of his salary to the 401(k) and appears to have been doing this for many years. Neither spouse has an individual retirement account (IRA), however.

The Resers estimate that their monthly expenses total $1,500. The are concerned about the future cost of health care and note that, in retirement, "the biggest expense not in our current budget will be medical insurance." Currently, Harry shares part of the cost of health coverage with his employer but this coverage will end after he retires. His employer also provides short-term disability coverage and matches his 401(k) contribution up to the first 8% of pay.

The Reser's car and home have $500,000 and $300,000 of liability coverage, respectively. They do not own an umbrella liability policy. The Resers are thinking of tapping their $23,000 of life insurance cash value. "We do not feel that we need life insurance any longer," says Harry, "and will most likely cash them in."

Taxes were mentioned several times as a major concern. The Reser's taxable income is $50,543. If their adjusted gross income in retirement exceeds $44,000, 85% of their Social Security benefits will be taxed. Tax on Social Security is figured on what is known as "preliminary adjusted gross income." This figure includes all earnings, pensions, dividends and interest from investments, including tax-free municipal bonds, and half of a person's Social Security benefit.

The Resers do not have wills. They have no children and it is unclear who their heirs are.

1. Discuss the strengths and weaknesses of the Rese family's financial situation.

Their strength is their net worth of $1,065,951, their job contribute 8% of their 401k, they invest for the future and they have no debt.

Their weakness is that they can be penalize by the IRS, they have no kids so there’s no will and they have no future health insurance.

2. Comments about Reser family's cash flow.

4. Calculate the savings required to reach Reser family’s financial goals.

5. Recommend 3 to 5 action steps to improve Rese family's financial.

6. Recommended financial products such as bank accounts, insurance policies, and mutual funds for Rese’s family.

1. Briefly summarize the key point of the article, but DO NOT include any direct text from the article (i.e., don't quote or copy from the article), tell me in YOUR OWN words. This should be brief.

2. Explain how your article is connected to business

3. Explain what other businesses, or your employer, could learn from the key point(s) in this article.

Americans Keep Crushing It With Their 401(k)s

The stock market is fueling all-time highs in retirement account balances, with the average IRA breaking into the six figures.

It’s happened again: Retirement savings account balances have hit all-time highs. A string of record 401(k) and IRA account totals now stretches across three consecutive quarters, according to second-quarter data from Fidelity Investments. The data covers 22,155 companies and 15.1 million 401(k) plan participants, as well as 8.8 million IRA accounts. The performance reflects the impressive display of endurance training by a stock market that just keeps on running, as well as increased employee and employer contributions to retirement accounts. The average 401(k) account balance stands at $97,700 as of June 30. That’s a 9.6 percent gain from the $89,100 average of a year ago, and a big leap from the $73,300 average of five years ago. Average IRA totals, meanwhile, rose to $100,200 from $89,600 a year ago and $73,100 in 2012. For the 12 months ending June 30, market gains accounted for 72 percent of the rise in retirement account balances at Fidelity. Over that same period, the Standard & Poor’s 500 had a total return of 17.9 percent. Employees put a record average of $5,850 into their 401(k)s over the past 12 months, a 4 percent increase from a year ago. Ninety-five percent of active employees contribute to their 401(k)s, and many defer enough of their pre-tax salary to get the average company match, which is 4.5 percent. But about 21 percent of employees can’t, or aren’t, contributing enough to get the full match. Many are likely to have been auto-enrolled into their 401(k) at a salary deferral rate of 3 percent, and left it there. The bit of good news is that many savers don’t have that far to go before getting the full match—53 percent are 1 or 2 percentage points away. Competing financial priorities may mean saving another 1 or 2 percent of salary isn’t feasible until a raise or bonus comes into play. But if extra cash flow exists, a relatively small increase in savings rates can make a big difference over a long career. One way companies are trying to get employees to save more is by rejiggering the company match, said Jeanne Thompson, a senior vice president at Fidelity. For example, instead of giving a 100 percent match on the first three percent of salary put into the plan, a company may match 50 percent of contributions up to 6 percent, so employees need to contribute 6 percent to get the full match. In addition to tracking accounts quarterly, Fidelity looks at workers with long histories in 401(k) accounts. Workers with 10 straight years in the same 401(k) also enjoyed a record quarter, with the average balance rising to $266,100. Ten years ago, the average was about a third of that amount, $78,800. Market action is responsible for 53 percent of the tripling in these 10-year plan participant balances since 2007, and the rest came from employee and employer contributions. The long run-up in stocks has Fidelity urging retirement savers to make sure they don’t have too much of their nest egg in equities. That’s not an issue for all generations of savers—two-thirds of millennials in Fidelity’s database are 100 percent invested in target-date funds (TDFs). (The funds automatically adjust asset allocations over time, based on your years to retirement; Fidelity assumes you’ll retire at age 67.) Millennial accounts hold 87.4 percent in stocks on average. That’s where they should be, according to the equity allocation in a Fidelity TDF for someone who wants to retire in about 30 years. The generation with the largest chunk of savers holding equity stakes at least 10 percentage points above Fidelity’s recommended allocation for their age is baby boomers, coming in at 26 percent. The average equity stake for boomers is 68.8 percent. For someone who wants to retire in 10 years—say a 55-year-old planning to retire in 2027—the recommendation is 64 percent in stocks. So the average equity stake isn’t far off, but there are some extremely equity-heavy portfolios out there. Boomers may also be very tech-heavy in their retirement portfolios, since they are less likely to be in widely diversified target-date funds than younger workers. Some of the most widely held mutual funds in 401(k) plans, including the $116.1 billion Fidelity Contrafund and the $39.3 billion Fidelity Growth Company, have large tech stakes and big chunks of assets concentrated in their top five holdings. Contrafund’s tech stake was just over 37 percent as of June 30, and the Growth Company held almost 40 percent in tech. The top five holdings in Contrafund make up 23.5 percent of the fund; it was 24 percent for Growth Company. It’s been a great strategy so far. The dilemma now, at least for boomers nearing retirement, is when and if to take some money off the equity table. “An element of caution needs to be built into a portfolio,” said Brian Singer, head of dynamic asset allocation strategies at William Blair and Co., “but the market is making it so expensive to put that caution into place.”