Chapter 21

Taxes, Inflation, and Investment Strategy

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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21.1 Saving for the Long Run

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Basic Considerations in Developing a Plan

• The major goal is retirement planning.• Time until retirement

– When do you plan to retire?– When can you collect Social Security?

• Life expectancy – How long will you live after you retire?

• Rate of return– How much risk are you willing to take?

• Allocation of income to savings– How much are you saving for retirement?

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Finding Your Retirement Annuity

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21.2 Accounting For Inflation

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Planning with Inflation• Inflation reduces the real value of the retirement benefit by eroding

the purchasing power of the dollars earned.– Real consumption = Nominal consumption / Price Deflator

– Suppose inflation = 3% per year and the nominal rate of return is 6%. What is the real rate of return?

return nominalROR

inflationi return; realr

;i1

)iROR(r

ROR

ROR

%91.203.1

)03.06(.rROR

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Planning with Inflation• The investor in the example is 30 years old.

What is the size of the price deflator with 3% inflation at age 35?

• By age 65?

16.103.1)i1( 5n

81.203.1 35

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Interest Rates, Inflation, and Real Interest Rates, 1926-2008

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Planning with Inflation• To overcome inflation requires either

higher savings or higher rates of return on investment or both

• Because taxes are paid out of nominal returns, inflation reduces the after tax rate of return even further.

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A Real Retirement Plan

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Another Problem with Inflation

• Inflation continues after retirement.• If you have a level annuity during retirement you will

have a declining standard of living:• Purchasing power of the $192,244 at age 65 is:

• Purchasing power of the $192,244 at age 90 is:

630,32$8916.5

1244,192$

03.1

1244,192$

60

320,68$8138.2

1244,192$

03.1

1244,192$

35

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The Solution?• Should an investor take on more risk to offset inflation? What are

the effects of increasing the riskiness of your retirement portfolio?• Real returns based on historical averages

• As you approach retirement what should you do with the risk level of your portfolio?– Is this easy to do?

• The best solution is simply to save more and start early.

InvestmentAverage Real

Return

Stocks 9%

Government bonds 2.6%

Treasury bills 0.7%

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21.3 Accounting For Taxes

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Planning with Taxes• Taxes further reduces the retirement benefits available

• To overcome the impact of taxes requires larger allocations to savings or higher returns on investments

• As mentioned, inflation combined with taxes further reduces the benefits available

• Flat versus graduated tax rates

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Saving With a Simple Tax Code

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The Effect of Double Taxation• Investors pay income taxes and pay taxes on some of their savings.• We can use the numbers in Spreadsheet 21.4 to illustrate the effect

on the overall tax rate:

Income (1) Lifetime labor income $7,445,673 Total exemptions during working years

$949,139

(2) Lifetime Taxable labor income

6,496,534

TaxesDuring labor years 1,884,163During retirement 203,199(3) Lifetime taxes 2,087,362

Lifetime average tax rate = (3) / (1) 28%Lifetime tax rate on taxable income = (3)/ (2) 32%

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21.4 The Economics of Tax Shelters

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Tax Shelters• Means of postponing taxes as long as possible

• Potential benefits of shelters– Postponing payment of tax,– Additional earnings on the investment of postponed

tax payments

• Effectiveness of the shelter– Depends on investment performance and how tax

rates change.

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Savings with a Flat Tax and an IRA Style Tax Shelter

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Savings With a Progressive Tax Rate

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IRA with a Progressive Tax Code

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21.5 A Menu of Tax Shelters

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Tax Sheltered Accounts• Individual Retirement Accounts (IRAs)

– Created by the Tax Reform Act of 1986, currently allow investors to contribute up to $5,000 per year to a retirement account.

• Individuals age 50 and older may contribute another $1,000 per year,

• 10% tax penalty for withdrawal of funds prior to age 59 ½,

• Must begin withdrawals by age 70 ½.

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Types of IRAs• Traditional IRAs

– Contributions to traditional IRAs are tax deductible, the earnings are tax deferred until withdrawn.

• Roth IRAs– Contributions to Roth IRAs are not tax

deductible but earnings on the account are not taxed when withdrawn.

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Spreadsheet 21.8 Roth IRA with Progressive Tax Code

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Table 21.2 Traditional vs. Roth IRA Tax Shelters Under a Progressive Tax Code

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Defined Benefit Plans

• Defined Benefit Plans– Employer promises to pay a defined or known

benefit to employees when they retire.• Typically a percentage of salary based on years of

service.• The employer must fund the pension obligation.• Pension Benefit Guaranty Corporation (PBGC)

guarantees pension benefits in the event of corporate bankruptcy, but often get an inferior pension plan if administered by the PBGC.

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Defined Contribution Plans

• Defined Contribution Plans• 401k and 403b Plans are examples

– Employee and employer contribute set amounts to an investment plan. The employee’s retirement benefit depends on the investment performance.

– Employees are typically given a choice of mutual funds managed by a fund family such as Vanguard or Fidelity.

– Because of the employer contributions you want to take advantage of these plans.

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Table 21.3 Investing Roth IRA Contributions into Stock and Bonds

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Table 21.4 Investing Traditional IRA or 401k Contributions in Stocks and Bonds

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21.6 Social Security

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Social Security (SS)• Federal pension plan established to provide minimum

retirement benefits to all workers.– It is unfunded although it is in surplus on a current

year basis, projected to go in the red around 2016,– You pay 6.2% of your income to SS, plus 1.45%

toward Medicare; your employer matches your contribution,

– SS is a means of redistributing income. In dollar terms taxes are regressive and low income workers receive a relatively larger share of preretirement income upon retirement.

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SS, What You Earn• You pay in every working year but only top

35 years of earnings & contributions count for determining benefits.

• Lifetime real annuity paid in full if you retire at age 67, you receive a reduced amount if you retire earlier (62) or your receive a larger benefit if you retire later (70)

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SS, What You EarnFour steps to calculate your benefits:1.The series of your taxed annual earnings is compiled

2. Indexing Factor Series– All past earnings are converted to today’s dollars

using the Average Wage Index (AWI)

3.Average Indexed Monthly Earnings (AIME)– The 35 highest annual indexed contributions are

summed and then divided by (35 x 12) = 420. This number is the AIME

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SS, What You EarnFour steps to calculate your benefits:4.Primary Insurance Amount (PIA)

– The annuity value received each year,– The income replacement rate is the

percentage of the working income received in retirement,

– Income replacement rate is substantially higher for low income individuals,

– Benefits may be taxed if household income > $32,000.

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SS Annuities if You Were to Retire in 2009 at Age 66

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Additional Considerations• 21.7 Children’s Education and Large Purchases

• 21.8 Home Ownership: The Rent-verus-Buy Decision

• 21.9 Uncertain Longevity and Other Contingencies

• 21.10 Matrimony, Bequest, and Intergenerational Transfers

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Additional Considerations in Planning

• Financing a child’s education– Same procedure as funding retirement

• Rent or buy decision– You gain no equity in renting,– Equity is a safeguard for tough times,– Don’t try to buy too much house,– Houses are illiquid investments whose value

does not always increase.

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Additional Considerations in Planning

• Uncertain longevity– Life annuity versus fixed term annuity– Payment received on a life annuity is reduced due to

adverse selection.• Marriage, bequests and intergenerational transfers

– Marriage increases motivation for saving for old age– Dependents increase need to save– Desire for bequests increase need to save– 75% of intergenerational transfers are involuntary

(due to earlier than planned demise or under spending in retirement).