CHAPTER 13

Basic Structure of Retirement Income

INTRODUCTION

Argument for planning early for retirement is compelling

Nationwide Financials Survey (2011): Americans are becoming increasingly concerned about retirement as the economic downturn stymied income growth and wreaked havoc on investments.

Wells Fargo Retirement Survey (2010): 72 percent of middle-class Americans between the ages of 25 and 69 expect to work through their retirement.

Gallop Poll (2011): The poll reveals that 66 percent of Americans ranked not having enough money for retirement as their top financial concern.

Wells Fargo-Harris Survey (2010): Survey reveals a disturbing gap between savings needs and savings rates.

This gloomy picture dims further by recognizing that pensions and Social Security might not provide sufficient cushion for retirement

Planning for retirement involves four steps:

Estimate pre-retirement expenses

Determine desired standard of living based on (1) monthly/annual retirement expenses needed

Estimate total expected income during retirement from all sources, including government-sponsored plans, corporate & personal retirement plans, personal savings, and employment

Take appropriate steps now if expected income falls short of expected expenditure needs

Key sources of retirement income:

Government Sponsored Plans

Corporate Retirement Plans

Personal Retirement Plans

Personal Investment

Employment During Retirement

PLANNING FOR RETIREMENT

RETIREMENT PLANS: SOCIAL SECURITY

Types of Benefits

Retirement

Normal retirement age 67 if born after 1960

If work longer benefits raised

Minimum retirement age is 62

Lowers benefits (permanent)

Benefits extend to spouse and children (max 50%)

Survivors Benefits

Children and spouse amount based on credits

Disability

Based on inability to work (long-term)

Has an impairment that will last at least 12 months or result in death

Could last for a lifetime

Private usually only lasts until retirement age

Medicare (Health insurance program)

Part A - hospital and nursing care

Part B – medical insurance (premium)

Part C – Medicare advantage (choose heath plans)

Part D – Drug plan

CORPORATE RETIREMENT PLANS

GENERAL DISCUSSION

These plans, known as qualified plans, provide excellent means of accumulating wealth on a tax-deferred basis.

Corporate retirement plans offer tax advantages both to employer and employee.

Terms

HCE = highly compensated

NHCE non-highly compensated

SPECIFIC REQUIREMENTS

PARTICIPATION REQUIREMENTS

21 years old and 1 years employment must be covered

If have immediate vesting 2 years employment may be required

COVERAGE REQUIREMENTS

Ratio Percentage Test

Cover a percentage of NHCE is at least 70% of the HCE covered

Average Benefits Test

Must benefit NHCE as a percentage of compensation compared to the HCE

Minimum Participation Test

Only for defined benefit plans

Outlines how many people must participate

VESTING REQUIREMENTS

How long must you work until company contributions belong to the employee

Full vesting at end of 5 or graduated (20% per year)

Immediate vesting can also be provided

FUNDING REQUIREMENTS

Rules set to determine how much and when company is required to place funds in the plan

PLAN INVESTMENT RULES

Federal guidelines indicate that investments should be sufficiently :

Liquid; Diversified; and conservative w/o undue risk

Major Categories of Qualified Plans:

Defined Contribution Plans

Employee contribution usually a percentage

Limits for different plans

Employer contribution also a percentage of compensation

Rules applied if an employee terminates before vested

Defined Benefit Plans

Amount contributed based on forecasts of future benefits to be paid out, current balances, and investment returns

Target Benefit Plans: a hybrid of a money purchase (form of defined contribution) and defined benefit plans

Money Purchase Pension Plan

Employer contribution

Percentage or flat amount

Maximum contribution 100% of income or50,000 (2012)

Plans gains and losses allocated to participants

Forfeitures may be reallocated

Investments determined by trustee of the plan

Simple Retirement Plan

100 or fewer employees

Looks like a 401k plan (max 12,000) (2013)

No discrimination rules problems if

Employer matches up to 3 percent

Or makes non-matching 2 percent contributions

Simplified Employee Pension (SEP) Plan

Employers make contributions into IRA

Very little paperwork

Contribution must be made according to the formula maximum 51,000 or 25% if lower

IRA rules followed except for the contribution limits

Can still have individual IRA outside the work plan

Profit Sharing Plan

Formula determines contribution

Can still make contributions if no profit

Limited to 25% of compensation to ALL eligible employees

Vesting rules apply

If employee leaves before vesting; the company’s contribution to the leaving employee’s plan can be

1) used to reduce future contributions

2) split between the remaining employees

401(k) Plan

Company and employee contributions

17,500 employee contribution (5,500 catch-up if over 50)

Company can match but total combined contribution cannot exceed 45,000

Individual 401k plans are available for self-employed without employees

403B plans are very similar except a non-profit company

Stock Bonus Plan

Profit sharing except employer’s contribution can be stock or cash

Thrift plan

Hybrid of profit sharing and stock bonus plan

ESOP

Invests primarily in company stock

15 KEY QUESTIONS

Defined Benefit Plans

A qualified employee pension plan that guarantees specified benefit level at retirement

Reward long-term employees with larger retirement benefits

First establishes the benefit employer wants employee to receive upon retirement, then contributions are set at the level necessary to achieve targeted benefits

Formula consists of either a flat dollar amount or a flat percentage of earnings

Defined Benefit Plans include:

Fixed benefit plans in which all employees receive the same benefits

Flat benefit plans where benefit is % of salary

Unit benefit plans in which benefit depends on income (optional) and time of service

Age-Weighted Profit Sharing Plans

Offer some of the best features of profit sharing and defined benefits plans

Are cheaper than traditional defined benefit plans

Are subject to less rigorous IRS regulatory requirements than those for defined benefit plans

Age-Weighted Profit Sharing Plan must meet all the requirements of a regular profit sharing plan:

1. Maximum deduction is 25% (2007)of covered payroll

2. Each year employer maintains discretion over making contributions to the plan

3. Maximum individual allocation for any one participant is $50,000 (2012) or 100% of salary, whichever is less

4. Top heavy plans must satisfy the 3% top-heavy minimum requirement for all non-key employees

5. Forfeitures from non-vested accounts are allowed to be reallocated, or they may be used to reduce future contributions

6. Investment earnings are allocated to participant accounts

Age-Weighted Profit Sharing Plans

PERSONAL RETIREMENT PLANS

INDIVIDUAL RETIREMENT ACCOUNT (IRA)

Deductible versus Nondeductible Contributions

Before tax

Get tax deferral of earnings

Investment principal can be taken after certain rules met

After-tax contributions

Tax deferral

All withdrawals taxed

Contributions

5,500 (indexed to inflation), or gross income

1,000 catch up if over 50

Types of IRAs

Traditional IRA

Taxable withdrawals

Tax deductible

Roth IRA

Withdrawals not taxed

After-tax contribution

Rollover versus Transfer

Converting an account such as a 401k from a previous employer

Technically rollover goes through investor

Transfers are the prudent method of moving the assets

DEDUCTIBILITY OF IRA

IRA: Before versus After-Tax Contribution

This represents the taxes paid in the beginning. An opportunity cost. However, the actual dollars invested would be the same. The end balances would be the same.