Quiz 14: Planning for Retirement

Business

a. The amount accumulated by Ms. JS at the age of 65 if she invests $ 3,000 per annum at 8% can be determined by using the future value of annuity at 8% for 40 years. The future value of annuity factor is 259.06. The amount accumulated by JS would be as follows- img b. For Mr. MG the investment period would be 30 years. The future value of annuity factor of for 30 years at 8% would 113.28 and the calculation would be as follows- img Based on the above calculations it is clear that starting early for retirement savings is important. Ms. JS started early and invested for 40 years whereas Mr. MG invested for 30 years. Although the difference in investment period between the two has been only 10 years the difference in the accumulated amount is approximately 100% of what Mr. MG would have and what Ms. JS would save.

The 401(k) is the most common pension plan and allows employees to divert a part of the salary to the pension savings. The contribution made by the employees are tax free and the also allows tax free accumulation of the contribution. Tax is payable on at the time of withdrawal. The employer is required to contribution a certain percentage of the employee's contribution which may be up to 50%. The employee can contribute up to a specified limit ($ 17,000 in 2012) based on his discretion and does not depend on his salary. The plan also has vesting period during which on leaving the job on the employee contribution with nominal interest rate would be available. The contribution plan by the employee also allows tax benefits as in 401(k). The employer under such plans makes contributions equal to that of the employee. Vesting period requirements apply to these plans as well. The employee can however contribute based only on a certain percentage of his salary as in the given case where the employee can only invest 10% of his salary

a. The amount accumulated in IRA can be determined by using the future value of annuity at 10% for 25 years. The future value of annuity factor is 98.35. The amount accumulated would be as follows- img The amount accumulation will not be affected by the type of account opened but taxes will be deducted on the amounts withdrawn from traditional IRA account thereby reducing the amount available on withdrawal. No tax is deducted on withdrawal from Roth IRA. b. The annual and total tax savings under traditional and Roth IRA is the same and there is no difference between the two options. The calculation of the tax savings are as follows- img c. Tax is payable under traditional IRA on the earnings on withdrawal. The same is calculated as below- img No tax is payable on earnings on withdrawal under the Roth IRA. The tax payable under the traditional IRA on withdrawal is significantly higher than the tax saved on the contribution during the 25 years. The significant finding from the above calculation is that the tax saved through contribution is lower than the tax payable on withdrawal under the IRA. Hence there is not tax savings under traditional IRA. d. Based on the calculation it is advisable that Roth IRA should be selected over the traditional IRA as the tax benefit attributable is higher. As no tax is payable on withdrawal under the Roth IRA, the net impact is a tax savings. An increase in contribution to $ 7000 will not have an impact as the earnings would also proportionately increase and thereby the tax payable on withdrawal. Hence the increase in tax savings would get negated tax payable on withdrawal.