1. 21 Taxes, Inflation, and Investment Strategy Bodie, Kane, and Marcus
Essentials of Investments, 9th Edition

2. 21.1 Saving for the Long Run Basic Considerations in Developing Plan
Time until retirement
Life expectancy
Rate of return
Allocation of income to savings
Retirement annuity
Stream of level cash flows available for consumption during retirement

3. Spreadsheet 21.1 Savings Plan

4. 21.2 Accounting for Inflation
Inflation erodes real value of purchasing power
Real consumption = Nominal consumption/ Price Deflator
What is the real rate of return if inflation = 6% and nominal ROR is 6% annually?

5. 21.2 Accounting for 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?

6. Accounting for Inflation
Overcoming inflation requires either higher savings or higher ROR on investment or both
Because taxes are paid out of nominal returns, inflation further reduces after-tax ROR

7. Spreadsheet 21.2 Real Retirement Plan

8. Spreadsheet 21.3 Backloading Real Savings Plan

9. 21.2 Accounting for Inflation
Another Problem with Inflation
Inflation continues after retirement
Level annuity equals declining standard of living
Purchasing power of the $192,244 at age 65:
Purchasing power of the $192,244 at age 90:

10. 21.3 Accounting for Taxes Flat Tax
Taxes all income above exemption at fixed rate
Taxes further reduce retirement benefits available
Overcoming taxes’ impact requires larger allocations to savings or higher returns on investments

11. Spreadsheet 21.4 Saving with Simple Tax Code

12. 21.4 Economics of Tax Shelters
Potential Benefits
Postponing payment of tax
Additional earnings on investment of postponed payments
Effectiveness of Shelter
Depends on investment performance, how tax rates change

13. Spreadsheet 21.5 Saving with Flat Tax and IRA

14. Spreadsheet 21.6 Saving with Progressive Tax

15. Spreadsheet 21.7 Benchmark Tax Shelter with Progressive Tax Code

16. 21.5 Menu of Tax Shelters Tax-Sheltered Accounts
Individual Retirement Accounts (IRAs)
Currently allow investors to contribute up to $5,000/year to retirement account
Individuals 50/older may contribute another $1,000/year
10% tax penalty for withdrawal of funds prior to age 59½
Must begin withdrawals by age 70½

17. 21.5 Menu of Tax Shelters Types of IRAs Traditional Roth
Contributions may be tax deductible; earnings tax deferred until withdrawn
Roth
Contributions not tax deductible; earnings on account not taxed when withdrawn

18. Spreadsheet 21.8 Roth IRA with Progressive Tax

19. Table 21.2 Traditional versus Roth IRA under Progressive Tax Code

20. 21.5 Menu of Tax Shelters Defined Benefit Plans
Employer promises to pay defined benefit to employees when they retire
Typically percentage of salary based on years of service
Employer must fund pension obligation
Pension Benefit Guaranty Corporation (PBGC) guarantees pension benefits in event of corporate bankruptcy

21. 21.5 Menu of Tax Shelters Defined Contribution Plans
401k and 403b Plans are examples
Employee and employer contribute set amounts to investment plan; employee’s retirement benefit depends on investment performance
Employees typically given choice of mutual funds managed by fund family
Because of employer contributions these are attractive to employees

22. Spreadsheet 21.9 Saving with No-Dividend Stocks under Progressive Tax

23. Table 21.3 Investing Roth Plan Contributions in Stocks and Bonds
*Since the retirement annuity is similar in both plans, taxes on this annuity are ignored.

24. Table 21.4 Investing in Traditional Plans
*Since the retirement annuity is similar in both plans, taxes on this annuity are ignored.

25. 21.6 Social Security
Federal pension plan established to provide minimum retirement benefits to all workers
Unfunded, although in surplus on current-year basis; projected to go into red around 2016
You pay 6.2% of income to SS, plus 1.45% toward Medicare; employer matches contribution
SS is means of redistributing income; in dollar terms, taxes are regressive

26. 21.6 Social Security What You Earn
You pay in every working year but only top 35 years of earnings and contributions count for determining benefits
Lifetime real annuity paid in full if you retire at age 67; reduced amount if you retire earlier (62) or larger benefit if you retire later (70)

27. 21.6 Social Security What You Earn Four steps to calculate benefits
The series of your taxed annual earnings is compiled
Indexing factor series
All past earnings converted to today’s dollars using average wage index (AWI)
Average Indexed Monthly Earnings (AIME)
35 highest annual indexed contributions summed and then divided by (35 x 12) = 420

28. 21.6 Social Security What You Earn Four steps to calculate benefits
Primary insurance amount (PIA)
Annuity value received each year
Income replacement rate is percentage of working income received in retirement; substantially higher for low-income individuals
Benefits may be taxed if household income > $32,000

29. Table 21.5 Calculation of Retirement Annuity of Representative Retirees if 2012, Age 66
a Income is above the maximum taxable, and income replacement cannot be calculated.
b 2008 PIA parameters (bend points) are used is the year of eligibility, that is, the year in which the retiree attains age 62.
c COLA adjustment for years 2008–2011: 5.8%, 0.0%, 0.0%, 3.6%.
d Internal rate of return.

30. 21.7–10 Additional Considerations
Financing Child’s Education
Same procedure as funding retirement
Rent-or-Buy Decision
No equity created by renting
Equity is safeguard for tough times
Don’t try to buy too much house
Houses are illiquid investments whose value does not always increase

31. 21.7–10 Additional Considerations
Uncertain Longevity
Life annuity versus fixed-term annuity
Payment received on life annuity reduced due to adverse selection

32. 21.7-10 Additional Considerations
Marriage, bequests and intergenerational transfers
Marriage increases motivation for saving for old age
Dependents increase need to save
Desire for bequests increases need to save
75% of intergenerational transfers are involuntary (due to earlier than planned demise or under-spending in retirement)