Chapter 21
Taxes,
Inflation, and
Investment
Strategy
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
21.1 Saving for the Long
Run
21-2
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?
21-3
Finding Your Retirement
Annuity
21-4
21.2 Accounting For
Inflation
21-5
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
(ROR  i)
;
1 i
 real return; i  inflation
rROR 
rROR
rROR 
(. 06  .03)
 2.91%
1  .03
ROR  nominal return
– Suppose inflation = 3% per year and the nominal rate of return is
6%. What is the real rate of return?
21-6
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?
(1 i)n  1.035  1.16
1.0335  2.81
• By age 65?
21-7
Interest Rates, Inflation, and Real
Interest Rates, 1926-2008
21-8
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.
21-9
A Real Retirement Plan
21-10
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:
1
1
$192,244 
 $192,244 
 $68,320
35
1.03
2.8138
• Purchasing power of the $192,244 at age 90 is:
1
1
$192,244 
 $192,244 
 $32,630
60
1.03
5.8916
21-11
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
Investment
Stocks
Government
bonds
Treasury bills
Average Real
Return
9%
2.6%
0.7%
• 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.
21-12
21.3 Accounting For Taxes
21-13
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
21-14
Saving With a Simple Tax Code
21-15
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
Total
exemptions
during
working years
(2) Lifetime Taxable labor
income
Taxes
During labor years
During retirement
(3) Lifetime taxes
$7,445,673
$949,139
6,496,534
1,884,163
203,199
Lifetime average tax rate = (3) / (1)
Lifetime tax rate on taxable income = (3)/ (2)
2,087,362
28%
32%
21-16
21.4 The Economics of Tax
Shelters
21-17
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.
21-18
Savings with a Flat Tax and an IRA Style
Tax Shelter
21-19
Savings With a Progressive Tax Rate
21-20
IRA with a Progressive Tax Code
21-21
21.5 A Menu of Tax Shelters
21-22
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.
21-23
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.
21-24
Spreadsheet 21.8 Roth IRA
with Progressive Tax Code
21-25
Table 21.2 Traditional vs. Roth IRA Tax
Shelters Under a Progressive Tax Code
21-26
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.
21-27
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.
21-28
Table 21.3 Investing Roth IRA
Contributions into Stock and Bonds
21-29
Table 21.4 Investing Traditional IRA
or 401k Contributions in Stocks and Bonds
21-30
21.6 Social Security
21-31
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.
21-32
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)
21-33
SS, What You Earn
Four 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
21-34
SS, What You Earn
Four 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.
21-35
SS Annuities if You Were to Retire
in 2009 at Age 66
21-36
Additional Considerations
• 21.7 Children’s Education and Large
Purchases
• 21.8 Home Ownership: The Rent-verusBuy Decision
• 21.9 Uncertain Longevity and Other
Contingencies
• 21.10 Matrimony, Bequest, and
Intergenerational Transfers
21-37
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.
21-38
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).
21-39