Personal Financial Planning homework

Business Finance

Harvard University

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Please complete the 8 homework questions attached as a word document. please explain all the work. I have attached two powerpoints for reference as well. if you need anything else, please

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Question 1 John established his first Roth IRA six years ago and has made a total participant contribution of $8,000 so far. Two years ago, he also converted his Traditional IRA assets ($6,000) to his Roth IRA (tax deduction was allowed when he contributed to his Traditional IRA and he has paid tax at the time of conversion). John is now 55 years old. (a). If John withdraws all the money (including contributions, conversions and earnings) from his account to pay for his son’s college tuition now, is it a qualified distribution and Why? Question 2 1. b) The balance in John’s Roth IRA is $18,500. If John withdraws $18,500 to pay for a vacation, what amount is subject to income tax and what amount is subject to earlydistribution penalty obligation? Amount subject to income tax $ Amount subject to early-distribution penalty obligation $ c) The balance in John’s Roth IRA is $18,500. If John withdraws $18,500 from his account to pay for his son’s college tuition, what amount is subject to income tax and what amount is subject to early distribution penalty obligation? Amount subject to income tax $ Amount subject to early-distribution penalty obligation $ Question 3 2. On January 1, Bowie, just reached age 42, has come to you for help in planning his retirement. He works for a bank, where he earned $80,000 annually at the end of last year. It is assumed that his salary will grow by 3% per year and it is paid at the end of each year. Bowie would like to retire when he reaches 62 (20 years from today). He has consistently earned 6% of his investments annually. Assuming he is expected to live 20 years after retirement and he has an expected wage replacement ratio of 80%. (a). What’s Bowie’s salary right before his retirement? (show your work to get partial credit) Question 4 (b). What is his first annual retirement need at a wage replacement ratio of 80%?(show your work to get partial credit) Question 5 (c). How much will Bowie need to accumulate as of the day he retires to adequately provide for his retirement lifestyle, assuming that he needs the retirement funding at the end of each year and there is no inflation for it. N= , PMT= , i= %,FV= , therefore, the amount Bowie needs to accumulate as of the day he retires is (keep two decimals) Question 6 (d). What’s the present value of the retirement needs as of today? (show your work to get partial credit). Question 7 (e). What’s the present value of his future earnings as of today? N= , PMT= , i= %(keep two decimals), FV= , therefore, the present value of his future earnings as of today is (keep two decimals) Question 8 (f). Based on the results in d) and e), what’s his saving rate? (show your work to get partial credit) Topic 7-Social Security FINANCE 589, Professor Ning Tang, Spring 2020 1 Agenda • • • What is Social Security Benefit? How to calculate the benefit? Social Security Funding FINANCE 589, Professor Ning Tang, Spring 2020 2 What is Social Security Benefit? FINANCE 589, Professor Ning Tang, Spring 2020 3 Social Security Benefit Social Security Benefits: • Retirement benefits • Disability benefits • Family benefits • Survivors’ benefits • Medicare • Supplemental Security Income (SSI) FINANCE 589, Professor Ning Tang, Spring 2020 4 FINANCE 589, Professor Ning Tang, Spring 2020 5 FINANCE 589, Professor Ning Tang, Spring 2020 6 FINANCE 589, Professor Ning Tang, Spring 2020 7 How Much Can You Get? FINANCE 589, Professor Ning Tang, Spring 2020 8 When Can You Collect the Benefit? Pay-as-you-go • Full Retirement Age: https://www.ssa.gov/planners/retire/retirechart.html • FINANCE 589, Professor Ning Tang, Spring 2020 9 Who Can Get Retired-Worker Benefit? •The basic unit for determining whether a worker is insured under the Social Security program: quarter of coverage (QC). •To be fully insured, a worker must have at least one work credit (quarter of coverage) for each year elapsed after age 21 (but no earlier than 1950) and before the year in which he or she attains age 62, becomes disabled, or dies. • The minimum number of QCs needed is 6. The maximum number needed is 40. Any year (all or part of a year) that was included in a period of disability is not included in determining the number of QCs you need. • An individual is said to be permanently insured if he or she has earned 40 QCs. FINANCE 589, Professor Ning Tang, Spring 2020 10 How Much Can You Get? • • • • Average Indexed Monthly Earnings (AIME) The highest 35 years Averaged to monthly Primary Insurance Amount (PIA) FINANCE 589, Professor Ning Tang, Spring 2020 11 Primary Insurance Amount (PIA) ($5785) ($960) • Skews benefits toward the low-income worker • PIA rise each year based on a cost of living adjustment (COLA) FINANCE 589, Professor Ning Tang, Spring 2020 12 Early or Late Retirement Options • Three basic reduction formulas: A. reduced by 5/9 of 1 percent (or 1/180) for each month of entitlement before full retirement age B. Wife's and husband's insurance benefits are reduced by 25/36 of 1 percent (or 1/144) for each month of entitlement before full retirement age. C. Retirement insurance benefits and spouse's benefits are reduced by 5/12 of 1 percent for each month of reduction in excess of 36 months. This applies to individuals whose full retirement age is after age 65. • Delayed Retirement Benefit Attain Age 65: Monthly percentage Yearly percentage 2008 or later 2/3 of 1% 8% FINANCE 589, Professor Ning Tang, Spring 2020 13 Social Security Funding FINANCE 589, Professor Ning Tang, Spring 2020 14 FINANCE 589, Professor Ning Tang, Spring 2020 15 FINANCE 589, Professor Ning Tang, Spring 2020 16 Solutions to Funding Problems • • • • • • • • Increase social security tax Decrease benefits and/or Decrease rate of growth in benefits Increase normal retirement age (for full PIA) to later age (now age 67) -- index to life expectancy Increase earliest retirement age -- index to life expectancy Reduce or eliminate spouses benefit Allow alternative plan such as modified national 401k Place a % of trust fund in equity securities FINANCE 589, Professor Ning Tang, Spring 2020 17 Topic 8 --Retirement Planning FINANCE 589, Professor Ning Tang, Spring 2020 1 Agenda 1. 2. 3. 4. Why do we need retirement planning? What are the main sources of retirement income? – Social security – Private pension and company-sponsored retirement plans – Personal savings and assets Retirement plans – Main types of retirement – Distribution from retirement plans – Regulatory considerations How much do we need for retirement? FINANCE 589, Professor Ning Tang, Spring 2020 2 1. Why Retirement Planning? FINANCE 589, Professor Ning Tang, Spring 2020 3 Why Retirement Planning? • Life-cycle hypothesis – The theory that people try to maximize but stabilize their consumption over their entire lifetime. – It predicts that young and old households will consume in excess of their income and that those in-between will save more→ we need to save for retirement Repay, Save $ De-Save Borrow 20 35 age 50 65 80 FINANCE 589, Professor Ning Tang, Spring 2020 95 4 Why Retirement Planning? (cont.) • To take advantage of the time value of money • People are spending more years (16-30) in retirement • A private pension and Social Security are often insufficient to cover the cost of living • Inflation may diminish the purchasing power of your retirement savings • …… FINANCE 589, Professor Ning Tang, Spring 2020 5 Source: Dalton, Gillice and Langdon, 2011. Fundamental of Financial Planning. FINANCE 589, Professor Ning Tang, Spring 2020 6 Longer Retirement Life Source: Centers for Control and Prevention, National Center for Health Statistics, National Vital Statistics System. FINANCE 589, Professor Ning Tang, Spring 2020 7 Insufficient Retirement Funding A typical middle income household needs $52,000 (after-tax) for retirement • A middle-income household , with wage earners currently aged 40-59, current annual income of $50,000-$100,000 $33,000 for retirement→37% shortfall • Workers aged 30-39, earning $50,000-$100,000 >50% shortfall • • 35 million household have NO retirement plan 34% of the workforce has no savings set aside specifically for retirement. FINANCE 589, Professor Ning Tang, Spring 2020 8 After the Financial Crisis… Retirement Confidence Survey Somewhart confident 24% 38% 23% Very confident Do not know 14% Not at all confident Not too confident 1% Source: Employee Benefit Research Institute, 2012 Retirement Confidence Survey FINANCE 589, Professor Ning Tang, Spring 2020 9 Why NOT Save for Retirement? • • • • • • • My expenses will decrease when I retire My retirement will only last 15 years Social security and my pension will pay for my basic living expenses My pension benefits will increase to keep pace with inflation My employers health insurance plan and Medicare will cover my medical expenses There’s plenty of time for me to start saving for retirement Saving just a little bit won’t help FINANCE 589, Professor Ning Tang, Spring 2020 10 2. Sources of Retirement Income FINANCE 589, Professor Ning Tang, Spring 2020 11 Sources of Retirement Income FINANCE 589, Professor Ning Tang, Spring 2020 12 Three Legged Stool • • • Social security – Most widely used source of retirement income, covering almost 97% of U.S. workers – Meant to be part of your retirement income, but not the sole source Private Pension and Employer-sponsored Retirement Plans – 61% of workers aged 16+ worked for an employer or union that sponsors a pension or retirement plan – 51% participated – Switch from DB to DC plans Personal Savings and Assets – Americans are not saving enough! FINANCE 589, Professor Ning Tang, Spring 2020 13 Current Earnings Worker Benefit % Worker with Same Age, Nonworking Spouse Total Benefit % Comment $13,100 59 89 $20,000 47 71 Low Income (WRR Good) $25,000 41 62 $30,000 38 57 $35,000 36 54 $50,000 31 47 $75,000 28 42 $100,000 24 36 $200,000 14 21 Middle Income (WRR Adequate) High Income (WRR Poor) Estimated based on single person at normal retirement age (2011); at same age, nonworking spouse would receive 50% of the benefits of the covered worker. Source: Dalton, Gillice and Langdon, 2011. Fundamental of Financial Planning. FINANCE 589, Professor Ning Tang, Spring 2020 14 Personal Savings Source: Bureau of Economic Analysis. FINANCE 589, Professor Ning Tang, Spring 2020 15 3. Retirement Plans FINANCE 589, Professor Ning Tang, Spring 2020 16 Types of Retirement Plans Qualified Plans • • • • • • • • • • • • • DC Defined benefit plans Cash balance plans Target benefit plans Money purchase plans DB(K) plans Profit-sharing plans (traditional) Stock bonus plans ESOPs 401(k) plans Thrift plans SIMPLE 401(k) Age based profit-sharing plans New comparability plans FINANCE 589, Professor Ning Tang, Spring 2020 DC Profit-sharing plans DB Pension plans Other taxadvantaged plans • SEPs • SARSEPs • Traditional IRAs • Roth IRAs • SIMPLE IRAs • 403(b) plans 17 Qualified vs. Tax-Advantaged Plans • Qualified plans – Must meet ERISA and Internal Revenue Code (IRC) requirements regarding coverage, funding, eligibility, vesting, reporting and disclosure and fiduciary requirement – Both employers and employees receive tax advantages – Protected from creditors by ERISA • Tax-advantaged plans – Have certain tax advantages (tax deferred) – Easier and less costly to administer – Not subject to the same federal reporting requirements as qualified plans – Not protected by ERISA non-alienation benefits • Trade off: tax advantage vs. compliance FINANCE 589, Professor Ning Tang, Spring 2020 18 Pension vs. Profit-Sharing Plans Characteristic Pension plan Profit-sharing plan Legal promise of the plan Paying a pension at retirement Deferral of compensation and taxation Are in-service withdrawals permitted? No* Yes (after two years) if plan document permits Is the plan subject to mandatory funding standards? Yes No Percent of plan assets available to be invested in employer securities 10% Up to 100% Must the plan provide qualified joint and survivor annuity and a qualified presurvivor annuity? Yes No * Under the Pension Protection Act of 2006. pension plans can provide for in-service 589, Professor Tang, Spring 2020 distributions to participants whoFINANCE are age 62 orNing older. 19 Defined Benefit (DB) vs. Defined Contribution (DC) Plans Characteristics What is the annual contribution limit? Defined benefit plan The greater of (1) the sum of the plan’s funding target, target normal cost, and a cushion amount over the value of the plan asset, or (2) the minimum required contribution for the plan Defined contribution plan • • • • Maximum contribution per participant: the lesser of (1) 100% of an employee’s compensation, or (2) $57,000 (2020) Employer deductions cannot exceed 25% of covered compensation Maximum employee elective deferral: $19,500 (2020) $6,500 catch-up contributions for those aged 50+ Who assumes the investment risk? Employer Employee Subject to PBGC coverage? Yes (except professional firms with <25 employees) No Does the plan have separate investment accounts? No, they are commingled Individual accounts Subject to benefit limits? The lesser of (1) $230,000 (2020), or (2) 100% of the average of the Ee’s three highest consecutive years compensative during the time of plan participation (considering the covered compensation limit) Other Provide a specific benefit the employee Lower administrative cost than DB plan based on pre-retirement salary or/and 589, Professor Ning Tang, Spring 2020 20 numberFINANCE of years of service Number of Pension Plans by Type of Plan, 19752010 Source: From 5500 Filings with the U.S. Department of Labor. FINANCE 589, Professor Ning Tang, Spring 2020 21 Number of Participants in Pension Plans by Type of Plan, 1975-2010 (in millions) Source: From 5500 Filings with the U.S. Department of Labor. FINANCE 589, Professor Ning Tang, Spring 2020 22 Pension Plan Assets by Type of Plan, 1975-2010 (in trillions) Source: From 5500 Filings with the U.S. Department of Labor. FINANCE 589, Professor Ning Tang, Spring 2020 23 401(k) Plans • • • Advantages: – Allow employees a degree of choice in the amount they wish to save under the plan and how they want to invest the money – Can be funded entirely through elective deferrals by employees, employer has no annual contribution commitment (some may match) – In-service withdrawals by employees for hardship are permitted – Loans also may be permitted – Minimal administrative expense Disadvantages – Account balances at retirement age may not provide adequate retirement savings – Employee bear the investment risk – Contribution limit Tax implications: – Employee elective deferrals are not currently taxable income to the employer – Earnings growth tax deferred until distribution – Employer contributions are deductible up to a limit of 25% of the total covered compensation of all employees covered under the plan FINANCE 589, Professor Ning Tang, Spring 2020 24 Tax-Advantaged Plan Example: IRAs FINANCE 589, Professor Ning Tang, Spring 2020 25 Regular (traditional) IRA • • • • • Accumulate tax free until you start taking it out Withdrawals prior to age 59 ½ are subject to a 10% tax in addition to the ordinary income tax Must begin to withdraw funds by age 72 (RMD) Contribution limit: - Lesser of individual’s earned income or $6,000 - $1,000 catch-up for those who aged 50+ - No contribution in or after age 72 except in the case of a rollover IRA or Roth IRA (No more restrictions now!) - No contribution phase-out Deduction phase-outs : • Not an active participant • Active participant FINANCE 589, Professor Ning Tang, Spring 2020 26 Roth IRA • • • • • Contributions are not tax deductible, but earnings accumulate tax free, distributions tax free Qualified distributions must satisfy both of the following tests – After a five-taxable-year period – Satisfy one of the following ▪ On or after age 59 ½ ▪ Death ▪ Disability ▪ First time home purchase (lifetime cap $10,000) Contribution phase-outs Contribution limit: lesser or individual’s earned income or $6,000 ($1,000 catch up) – Contributions can be made after age 72 – No RMD during the owner’s life Roth conversion – You believe tax rates will be higher in the future – You believe your taxable income is lower this year – You wish to take advantage of estate planning benefits of a Roth FINANCE 589, Professor Ning Tang, Spring 2020 27 Distribution from Qualified Plans and IRAs FINANCE 589, Professor Ning Tang, Spring 2020 28 Distribution Options • • • • • Annuities Lump-sum distribution Rollovers In-service withdrawals Non-repaid loans FINANCE 589, Professor Ning Tang, Spring 2020 29 FINANCE 589, Professor Ning Tang, Spring 2020 30 Early Distribution Penalty • • Distributions taken from qualified plans, 403(b) plans, IRAs before age 59 ½ are subject to 10% early distribution penalty Exceptions for qualified plans, 403(b) plans and IRAs: – – – – – • Exceptions for qualified plans and 403(b) plans – – – • Attainment of age 59½ Death Disability Substantially equal periodic payments Medical expenses exceeding 10% of AGI Separated from service after attainment of age 55 (not for IRA) Made after separation from service after attainment of age 55 Made to qualifying family member under a QDRO Exceptions for IRAs – – – Made for higher education costs Made for acquisition costs of a first-time home buyer, up to a $10,000 lifetime limit Made for health insurance premiums for unemployed individuals FINANCE 589, Professor Ning Tang, Spring 2020 31 How Are Nonqualified Distributions from Roth IRA Taxed? FINANCE 589, Professor Ning Tang, Spring 2020 32 4. How Much Do We Need for Retirement? FINANCE 589, Professor Ning Tang, Spring 2020 33 Determinant Factors • • • • • • • Remaining work life expectancy (RWLE) Retirement life expectancy (RLE) Savings (amount, rate, time) Investment considerations Annual income needs Wage replacement ratio (WRR) Inflation, investment returns, and sources of retirement income FINANCE 589, Professor Ning Tang, Spring 2020 34 Investment Considerations • Risk tolerance • Asset allocation-before and after retirement Tax advantaged and taxable accounts • FINANCE 589, Professor Ning Tang, Spring 2020 35 Computation of Needs Types of Retirement Planning Methods • Deterministic • Stochastic FINANCE 589, Professor Ning Tang, Spring 2020 36 Method 1--Deterministic (Present Value) Analysis Estimate Retirement Now Estimate Death Estimate inflation & tax rate Estimate discount Rate (Rate of return on retirement Assets PV Today PV at Retirement of net needs FINANCE 589, Professor Ning Tang, Spring 2020 37 Steps in Calculating Retirement Needs (Deterministic) 1) 2) 3) 4) 5) 6) 7) Enumerate assumptions and other input Forecast needs for each retirement year, reduce them by expected social security and defined benefit payments Find PV of Needs at retirement and now Find PV of Income (now) Reduce #3 by Current savings and current value of defined contribution plans find % to save if #6 is unreasonably high reduce needs and recalculate FINANCE 589, Professor Ning Tang, Spring 2020 38 Source: Dalton, Gillice and Langdon, 2011. Fundamental of Financial Planning. FINANCE 589, Professor Ning Tang, Spring 2020 39 Dealing with Unpredictable Variab ...
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