BM410: Investments
Personal Investing 3:
Taxes, Inflation, and
Investment Strategy
Objectives
A. Review the Investment Hourglass
B. Understand the factors in developing
a retirement plan
C. Understand Social Security
2
A. Review the Investment Hourglass
 Remember the investment hourglass
• It is a way of helping remember that
investing is a means to help us achieve our
goals—it is not an end in itself
• And since our goals should be based on
our values, our investments should reflect
those values
3
Before you Invest: The Hourglass Top
1. Have your priorities in order and are “square” with the Lord
2. Have adequate life and health insurance
3. Be out of credit card and
consumer debt
4. Know your personal goals, budget,
and have an investment plan
If you can answer these affirmatively,
you are ready to invest!
4
The Hourglass Bottom (continued)
Retirement Assets
Taxable Assets
4. Opportunistic: Individual Stocks and Sector Funds
3. Diversify: Broaden and Deepen your Asset Classes
2. Core: Broad Market Exposure: Core Mutual Funds
1. Basics: Emergency Fund and Food Storage
5
B. Factors in
Developing a Retirement Plan
 What are the critical factors in developing a
retirement plan?
• 1. Inflation
• 2. Tax rate
• 3. Rate of return
• 4. Time until retirement
• 5. Allocation to savings
• 6. Life expectancy
6
1. Inflation
 What is the impact of inflation
• Inflation reduces the retirement benefit.
• It can substantially reduce the purchasing
power of future cash inflows
 How do you handle inflation?
• To overcome inflation requires greater
allocation to savings or higher rates of
return on investment.
 What is the formula for calculating real
returns?
• Real Return = (1 + r(n))/(1+r(infl.))-1
7
2. Taxes
 What is the impact of taxes?
• Taxes further reduces the retirement benefits
available
• Different investment vehicles are taxed differently
• Utilize the vehicles that maximize after-tax
return
 How do you handle taxes?
• Use larger allocations to savings or higher returns
on investments
• Invest tax-efficiently
8
3. Rate of Return
• What is the impact of the rate of return?
• The higher the rate of return, the:
• Faster you will achieve your goals, or
• Less you will need to save each month to
achieve your goals
• Use wisdom in your forecasts
• This rate should be consistent with your asset
allocation and the return requirement from your
Investment Plan
9
4. Time Until Retirement
 Why is time until retirement important?
• This is the amount of time that your money
can be working for you
• Start earlier rather than later, or you will
have to save significantly more to reach
your goals.
10
5. Allocation to Savings
(i.e. savings percent)
 Why is your allocation to savings important?
• You cannot save what you do not have
• Set your goals now, and follow through
• This allocation should increase as you get
older
• But it should never be below a specific
percentage (I recommend your minimum
to be 10%)
11
6. Life Expectancy
 Why is life expectancy important?
• It determines how long you will need funds
in retirement
• You do not want your money to be gone
before you are
• Plan for a long life, and if it is shorter, there
are more funds for your kid’s inheritance
12
Putting it All Together:
A Retirement Planning Worksheet
 How do we bring it all together?
• We have developed a Retirement Planning
Spreadsheet to help with this activity (see
RP-1 Retirement Planning Worksheet)
• We have also developed another spreadsheet
to help you see where you are on your road
to achieve your financial goals (see RP-2
Retirement Planning Ratio Forecasts)
13
Applications #1
You are 25 and will graduate with a degree in Business
this year. You expect to retire in 30 years, and believe
you can ear 8% on your investments until retirement.
You expect inflation to average 2% until retirement.
You expect to be in retirement for 25 years, and will
earn 7% during retirement and inflation will stay at
2%. You estimate your tax rate in retirement at 30%.
You estimate that you will need $75,000 in after-tax
dollars to retire comfortably, and that social security
will provide $25,000 per year. How much must you
save each year to achieve your goals?
14
Applications #2
You are 45 years old, married, with three kids.
You have $175,000 in savings, and your
remaining balance on your home mortgage and
other debt is $250,000. Your annual salary is
$70,000 per year. Is there any way of
determining if you are on-track for retirement
or not? How are you doing?
15
Source: WSJ, 23Mar05, p. D1.
16
17
Measuring Up
Age
30
35
40
45
50
55
60
65
Savingsto-Income
0.1
0.9
1.8
3.0
4.5
6.5
8.9
12.0
Debt-toIncome
1.70
1.50
1.25
1.00
0.75
0.50
0.20
0.00
This chart is from Doman Farrell, LLC as quoted in: Jonathan Clements, “Ugly
Math: How Soaring Housing Costs are Jeopardizing Retirement Savings,” Wall
Street Journal, 23Mar05, p. D1.
The Relationship between
Savings and Debt
 What does this framework tell us?
• It gives a reality check in today’s overheated
spending frenzy
• It shows the relationship between savings
and debt and how we need to manage both
• It encourages us to reduce debt at the same
time you increase savings
19
Assumptions of the Model
 Assumptions
• 1. Investors will earn 5% more than
inflation
• What do you think?
• 2. Investors will save about 12% of pre-tax
income every year from age 30 to 65
• What do you think?
• 3. Investors will withdraw 5% of portfolio
value each year
• What do you think?
20
Overall View
 Assumptions
• 1.
•
• 2.
•
Earn 5% over inflation?
You may have a hard time achieving that return
Save 12% of pre-tax income
That is a challenge for most people (but not
students of this class)
• 3. Withdraw 5% of portfolio value each year
• This is probably OK
 Overall, these guidelines are likely to be too soft.
They should probably be made more stringent!!!
21
Application #2 Answers
 Calculations
Current
Salary
Savings
Debt
• Age 45 $70,000 $175,000 $250,000
 Ratios
Current Recommended
• Savings ratio 2.5 ($175/70) > 3.0
• Debt ratio
3.6 ($250/70) < 1.0
 Overall recommendations
• They have too little savings and too much
debt. They either need to begin saving
more, or selling assets to reduce their debt!
22
Teaching Tool in Process
 One of the ways we are working on this
problem, is through Teaching Tool 25 –
Retirement Planning Forecasts Ratio. While it
is in preliminary form, it may be useful given
different financial situations and goals.
23
Application #3
 You are a menace to society, single and make $65,000
per year. Your company has a 401(k) plan that matches
50 percent of your contributions up to 3 percent of your
salary. You determine that you can save 15% of your
salary, and will put 10% or $6,500 away year for
retirement, with the other 5% for other goals. Which
investment vehicles you should use and why? How
much will you ultimately save, including company
match and tax savings? Assume your are in the 25%
federal and 7% state marginal tax rates.
24
Review the Priority of Money
(for investing and retirement)
 What is the priority of money?
• The priority of money is a process of
understanding which types of investment
vehicles will help you achieve your goals the
fastest
 Why should we learn it?
• Investment vehicles have different benefits, i.e.,
due to matching (free money), tax avoidance, tax
deferral, or just tax-efficient and wise investing.
• The wise use of correct investment vehicles will
help you reach your goals faster
25
Priority of Money (continued)
 What is the difference between investment
vehicles and financial or investment assets?
• The investment vehicle is the tax-law defined
framework that has specific tax advantages, i.e.,
401k, 403b, Individual Retirement Account (IRA),
SEP IRA, etc.
• The financial assets are the securities that are
invested in by the vehicles, i.e., stocks, bonds,
mutual funds, REITs, MMMFs, CDs, etc.
26
Priority of Money (continued)
Current Investment Vehicles:
Plan
Tax-def. Tax-elim. Max Amount For Employees of:
401-k
Y
$14,000
Businesses w/plans
403-b
Y
14,000
Non-profit, tax-exempt
457
Y
14,000
State/municipalities
SEP IRA
Y
42,000
Small businesses
SIMPLE IRA Y
10,000
Small businesses
IRA
Y
4,000
Individuals
Roth IRA
Y
4,000
Individuals
Education IRA
Y
2,000
Individual Education
529 Plans
Y
315,000 p.c. Individual Education
27
Priority of Money (continued)
 What is the priority of money?
1. Free money
• Money that is made available by your company,
generally on a matching basis, to encourage
greater participation in company sponsored
retirement plans, i.e., 401k, Keogh and other
matching plans
 What are the risks?
• You must stay at the company a certain number
of years to become fully vested, i.e., to be able
to take full ownership of these funds
28
Priority of Money (continued)
2. Tax-advantaged money
2.a. Tax Eliminated money
 This money allows the elimination of all future
taxes
• This money can be used at retirement (or
education) without penalty or taxes (i.e., Roth
IRA), and the Education IRA, 529 Funds, and
Series EE/I bonds for education)
 What are the risks?
• You must be 59½ to take distributions
• Money from 529 Funds and government bonds
must be used for qualified educational expenses
to be tax-free
29
Priority of Money (continued)
2.b. Tax-deferred money
 This money defers taxes until retirement
• This is money that has specific tax
advantages, particularly the ability to be
invested before-tax, with principle and
earnings taxed only at retirement (IRA, SEP
IRA, 401k, 403b, etc.)
What are the risks?
• You must be 59½ to take distributions
• Distributions before retirement require a
10% penalty and the funds are taxed at
ordinary income tax rates
30
• This money changes
capital gains to ordinary
Priority of Money (continued)
3. Tax-efficient and wise investments
• This is money that is invested tax-efficiently and
wisely, consistent with the investment principles
discussed earlier
 What are the risks?
• Earnings are taxed consistent with the assets
invested in
• You need to take into account the tax and
transaction cost implications of whatever you invest
in
31
Priority of Money (continued)
Remember, investment earnings from assets not
in retirement vehicles are not all created equal.
 1. Know the impact of taxes on your returns
• This includes the tax rates on all distributions,
capital gains, dividends, and interest.
• After-tax return = Before-Tax * (1 – Marginal
Tax Rate). The marginal rate includes federal
and state
32
Priority of Money (continued)
2. Look to Capital Gains
Replace ordinary income with capital gains
• Capital gains are taxed at 15%, whereas earnings
from interest and short-term capital gains (from
assets held less than 12 months) are taxed at
ordinary income rates
 How is this done?
• Get earnings as long-term capital gains.
• Invest with a buy and hold strategy, don’t trade in
taxable accounts, and hold assets as long as
possible.
• Minimize transactions costs and defer earnings to
the future. Pay as little in taxes now as possible
33
Priority of Money (continued)
3. Defer earnings to the future
• With some types of earnings, you are not taxed until
you take the money out at retirement. Defer as
much as you can to the future.
 How is this done?
• Utilize as much as possible retirement vehicles
where the objectives are consistent with your goals
and Personal Financial Plan.
34
Priority of Money (continued)
4. Minimize turnover and distributions
• Minimize turnover. Turnover leads to higher
transactions costs and taxes
• Minimize distributions from mutual funds. Mutual
funds are required by law to distribute most of their
realized capital gains and interest annually to the
shareholders in the fund, which are taxed at the
shareholder level (even though they did not sell
shares)
 How is this done?
• Utilize a buy and hold strategy
• Invest in mutual funds that limit trading and
minimize distributions35
Priority of Money (continued)
5. Look to Stock Dividends
• Taxes on stock dividends are taxed at 15%, while
taxes on interest earnings on bond dividends are
taxed at the higher ordinary income rates of up to
35% federal and 10% state.
 How is this done?
• Include stocks or stock mutual funds in your
diversified portfolio.
• Compare the after-tax return on stocks with the
after-tax return on bonds
36
Priority of Money (continued)
6. Invest Tax Free
• If your tax rate is high, you can look to financial
assets which are tax-advantaged.
• U.S. government securities are free of state tax
• Municipal bonds are free of federal tax
• If municipal bonds are from your state of
residence, they may be state tax-free as well.
 How is this done?
• Compare the after-tax return on municipal bonds to
the after-tax return of corporate bonds
• Invest in the assets that give you the highest
after-tax return for 37
your specific asset class
Priority of Money (continued)
What is the impact of taxes on these two bond funds:
Mutual Funds
Fund A
Fund B
Beginning Net Asset Value $10.00
$10.00
Short-term distributions
.10
.90
Ending NAV
10.90
10.10
YTD Nominal returns
10% (.10+.90)/10 10% (.90+.10)/10
Turnover
10% (guess)
90% (guess)
Fed tax rate on ST distributions 35%
35%
Taxes paid (without selling) .035 (.10 * 35%) .315 (.90 * 35%)
After-tax return
9.65% (.90+.065)/10 6.85%
(.10+.585)/10
Loss from return due to taxes
.35%
3.15%
Although both have the same nominal return, fund B had a 29%
lower return due to taxes, even though both had the same
before-tax return
38
Priority of Money (continued)
 How do you prioritize vehicle choices?
• Some investment vehicles are higher on the priority
list than others, but they also have lower
contribution amounts (i.e., $4,000 for the Roth in
2005). What should you do?
• Use the highest priority money first, and then
next highest, etc. until you have utilized all your
available funds
39
Application #3 Answer
 First, look to free money
• If you will save 3 percent of your salary, or $1,950
per year, your company will match that with 50
percent of that amount, or $975.
• Note that this is tax-deferred money, or money
that has not been taxed yet. The maximum
contribution for 2005 in a 401(k) account is
$14,000
• Since your first priority of money is free money,
you should invest $1,950 here first.
• Note that there is also a tax saving here, as
investments reduce your adjusted gross income
40
Application #3 Answer
 Second, look to tax-advantaged money.
• A Roth IRA would likely be your second choice.
• A Roth IRA not only offers total elimination of future
taxes, it also has an additional benefit: should you
need funds in the future, you can withdraw the
principle without penalty as it has been taxed
• You can invest up to $4,000 in 2005 in a Roth or
Traditional IRA
• You invested $1,950 in your 401(k) plan and $4,000
in a Roth IRA
• What about the remaining $550?
41
Application #3 Answer
 Third, look to tax-deferred money.
• Invest the remaining $550 in your 401(k), even
though there is no additional match.
• Note that your goal was to invest $6,500 for
retirement. In reality, you:
• Invested $6,500 of your own money
• Got a free $975 match from the company
• And saved taxes on the $2,500 ($1,950 for the
match and $550 extra) in your 401k.
Multiplied times your Marginal Tax Rate of
32%, you saved $800 in taxes.
• Total Savings: $6,500 + $975 + $800 = $8,275
42
Implications for Portfolios
 Where should you put different types of financial
assets?
• Retirement Accounts: 401k, IRA’s, 529 Funds, etc.
• Financial assets in which you trade actively
• Taxable bonds, and high turnover funds
• You do not pay taxes until you take out funds
• Taxable Accounts: investment portfolios
• Stocks and mutual funds with a buy and hold
strategy
• Tax-free bonds and tax-efficient index funds
• You pay taxes on these funds each year
43
Questions
 Any questions on the priority of money and
how that should impact your portfolio?
44
C. Understand Social Security
• What is social security?
• It is a government sponsored retirement plan
• It was set up to keep individuals from retiring in
poverty
• It was never intended to be an individuals entire
retirement program—but a help to that program
• It is planned to cover 42% of retirement
• It was started in an environment were there were 17
contributors to every recipient
• It is moving to an environment where there are 2
contributors to every recipient
45
Social Security (continued)
 How much does an employee pay in Social Security
and Medicare Taxes?
• FICA tax rates
• Social security tax
6.20%
• Medicare tax
1.45%
• The employer pays
7.65%
• Maximum wage subject to SS tax is $90,000 in
2005
• No maximum wage for Medicare tax
46
Social Security (continued)
 What is the employer’s share of Social
Security and Medicare Taxes?
• Your employer matches dollar for dollar
If You Earn
You Pay
Employer Pays
$10,000
$765
$765
$20,000
$1,530
$1,530
$30,000
$2,295
$2,295
$40,000
$3,060
$3,060
$50,000
$3,825
$3,825
$60,000
$4,590
$4,590
$70,000
$5,355
$5,355
$80,000
$6,120
$6,120
$80,400
$6,151
$6,151
$90,000
$6,290
$6,290
Note: Medicare 1.45%47past $84,900
Social Security (continued)
 How is Social Security Funded?
• Social Security is a pass-through account
• FICA taxes being paid by today’s workers are
providing the money for benefit payments to
today’s retirees
• There is no investment or savings
component
• The assumption is that when you retire, there
will be enough others paying into the system to
pay for your benefits
• Interesting assumption!
48
Social Security (continued)
 Changes in Social Security Tax Rate
 Social Security Tax Rates
1937
1.0%
1954
2.0%
1960
3.0%
1971
4.7%
1984
5.8%
1990
6.2%
49
Social Security (continued)
 How much Self-Employment tax must a selfemployed person pay in 2005?
• A self-employed person pays both parts
• 12.4% on first $90,000 of net earnings (SS
tax)
• 2.9% on all taxable earnings (Medicare tax)
• Self-employed may deduct half of their SS taxes as
an adjustment to taxable income
50
Social Security (continued)
 If you have a job and a small business on the
side, what do you pay?
• No more than $90,000 of combined wages are
subject to FICA tax in 2005
• Additional wages are subject to Medicare tax
though
51
Social Security (continued)
 How does one qualify for benefits?
• To qualify for full benefits
• Quarters-of -coverage requirement
• The number of calendar quarters that you
earned required minimum amount
• For 2003 the quarter-of-coverage
minimum is $890 in earnings
• Need 40 quarters to qualify for full benefits (10
years)
• Earning beyond 40 quarters will not increase
benefits
52
Social Security (continued)
 How much will one get?
• Benefit amounts vary depending on:
• Number of years of earnings, average level of
earnings, an adjustment for inflation, and age at
retirement
• Nonworking spouses get benefits equal to 50% of
their working spouses benefit
• If both spouses worked, each is eligible for
benefits based on own earnings or based on 50%
of spouse’s benefit, whichever is greater
• The formula goal is to replace 42% of your average
earnings
53
Social Security (continued)
 How do I get a copy of my benefits?
• To get a copy of your Social Security Statement
benefits, go to www.ssa.gov/mystatement.
• Click on “Your Benefits” near the top, and then
click on “Request a Social Security Statement”
at the bottom of the page.
• Fill out your name, middle initial, last name,
social security number, birthday, and other
information that is requested.
• Click on “continue” to submit a request for your
Statement. You will receive your Statement in
3-4 weeks.
54
Social Security (continued)
 How about getting an estimate?
• As a preliminary estimate of benefits, go to
www.ssa.gov/mystatement.
• Click on “Need to Request a Social Security
Statement” in the top, and then click on “How
can I calculate my own benefit estimates” in the
middle of the page.
• Then click on “Benefits Planner” and “calculate
your retirement benefits based on different
retirement scenarios.” You can either fill out the
quick calculator “Quick Calculator” or the more
detailed “Online Calculator.”
• Click on the calculator desired, and then fill in
the information.
55
Social Security (continued)
 How does starting age affect benefits?
• You can start receiving benefits anytime after age
62, but benefits will be less than starting at your full
retirement age of 67 (for those born after 1959).
 What is my full retirement age?
• Birth Year
Full Retirement Age
• 1937
65
• 1943-1954
66
• 1960
67
56
Social Security (continued)
 What if I want to retire at 62 and I was born in
1960?
• Payments would be reduced by 5/9 percent for each
month prior to age 67 for the first 36 months and
5/12 percent for each month prior to that
• To retire at age 62 would be:
5/9 percent x 36 months = 20%
5/12 percent x 24 months = 10%
Total reduction in payments = 30%
• You may delay benefits after age 67 up to age 70
and receive credits amounting to 8 percent per year
for those born after 1943
57
Social Security (continued)
 What is the annual Social Security statement
and when does one get it?
• Must be 25 or older
• Statement arrives 3 months prior to birth date
• Statement shows:
• Quarter coverage credit
• How much you have paid
• Estimated benefit data
58
Social Security (continued)
 Where is Social Security now?
• The Social Security program is currently taking in
more than it is paying out
• It had income of $632bn in 2003 ($627bn in
2002). and paid out $470bn in 2003 ($454bn in
2002) in benefits to 47mn (46mn in 2002)
people
• Reserves are in government bonds (SS Trust Fund)
• Today there are 3.4 workers per recipient
59
From http://strengtheningsocialsecurity.gov/need_for_action.shtml, 21Mar05
From http://strengtheningsocialsecurity.gov/need_for_action.shtml, 21Mar05
60
From http://strengtheningsocialsecurity.gov/need_for_action.shtml, 21Mar05
From http://strengtheningsocialsecurity.gov/need_for_action.shtml, 21Mar05
61
Social Security (continued)
 Until 2014
• Benefits can be paid solely from tax revenues until
2014
 Until 2025
• From 2015-2025 SS will have to use the interest on
the bonds
 Beyond 2037
• From 2026-2037 the SS will have to redeem bonds
• At current projections social security funds will be
exhausted in 2042
• By year 2075 there will be 1.9 workers per
recipient
62
Social Security (continued)
 What about a worst-case scenario in 2042?
• Even if SS assets are exhausted in 2042, Social
Security calculates that from the regular inflow of
tax revenue alone it could pay about 73 percent of
benefits
 My recommendation?
• Don’t plan for much, but if it still is available, be
thankful
63
Social Security (continued)
 President Bush’s Plan
• Establish Personal Accounts (PA) which
would be totally voluntary. This is similar
to the existing Federal Employee Thrift
Savings Plan
• PA’s would be invested in a conservative mix of
stock and bond funds
• Those who earned an average of $35,000 over
their career would have $250,000 at retirement
• Savings would supplement the Social Security
benefits, or be passed to children
64
Review of Objectives
A. Do you understand the Investment
Hourglass
B. Do you understand the factors in
developing a retirement plan
C. Do you understand Social Security
65
For more information
Go to www.socialsecurity.gov for more
information
66