Retirement and Estate Planning Summary

Chapter 14 Starting Early: Retirement and Estate Planning

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Chapter Learning Objectives

  • LO 14.1: Analyze your current assets and liabilities for retirement and estimate your retirement living costs.

  • LO 14.2: Determine your planned retirement income and develop a balanced budget based on your retirement income.

  • LO 14.3: Analyze the personal and legal aspects of estate planning.

  • LO 14.4: Distinguish among various types of wills and trusts.

Planning for Retirement: Start Early (LO 14.1)

  • Why is it important now?

  • Myths about retirement:
      - You have plenty of time to start saving for retirement.
      - Saving just a little bit won’t help.
      - You’ll spend less money when you retire.
      - My retirement will only last 15 years.
      - You can depend on Social Security and a company pension to pay your basic living expenses.
      - Your pension benefits will increase to keep pace with inflation.
      - Your employer’s health insurance plan and Medicare will cover all your medical expenses when you retire.

Saving Smart for Retirement

  • Even a little goes a long way:
      - Start Now: Time is critical.
      - Start small if necessary.
      - Use automatic deductions from your payroll.
      - Save regularly.
      - Be realistic about returns.
      - If you change jobs, keep your old retirement account or roll it over to the new one.
      - Don’t touch your savings early, unless absolutely necessary.

The Importance of Starting Early

Example: The Time Value of Money

  • Start at age 25:
      - Invest $127 per month at 11% APR for 40 years.
      - Total savings: $1,092,216.

  • Start at age 50:
      - Invest $2,244 per month at 11% APR for 15 years.
      - Total savings: $1,020,362.

Conducting a Financial Analysis

Net Worth Calculation

  • Formula: Assets - Liabilities = Net Worth
      - Ideally, net worth should increase each year.

  • Housing:
      - If owned, probably your biggest single asset.
      - If large equity, a reverse mortgage could provide additional retirement income.
      - Option to sell your home, buy a less expensive one, and invest the difference.

Life Insurance

  • Consider reducing coverage as you near retirement when children are self-sufficient.

  • Potentially increase income by lowering premiums.

Other Investments

  • After retirement, consider changing your objective from growth to income.

Estimating Retirement Living Expenses

Changes in Spending Patterns

  • Spending patterns and lifestyles will likely change. Some expenses may decrease:
      - 401(k) retirement fund contributions.
      - Work-related expenses (gas, meals).
      - Clothing expenses (more casual, fewer needs).
      - Housing expenses may cease if the house is paid off.
      - Federal income taxes could be lower.

Potentially Increasing Expenses

  • Some expenses may increase:
      - Life and health insurance costs, unless coverage is ongoing through the employer.
      - Medical expenses increase with advancing age.
      - Expenses for leisure activities could rise.
      - Gifts and contributions may also become more significant.

  • Inflation: Will increase the amount needed to cover expenses over retirement.

Your Retirement Income (LO 14.2)

Major Sources of Retirement Income

  • Four major sources:
      - Employer Pension Plans
      - Public Pension Plans
      - Personal Retirement Plans
      - Annuities

Employer Pension Plans

  • A pension plan funded, at least in part, by an employer.
      - Contributions and earnings remain tax-deferred until withdrawal in retirement.
      - Private employer pension plans vary.

Types of Pension Plans

  • Defined-Contribution Plan:
      - Individual account for each participant, includes profit-sharing, money purchase, Keogh, or 401(k).
      - Contributions might include a set percentage of earnings or stock purchases.
      - 401(k) Plan:
        - Salary-reduction plan where employer contributes non-taxable amounts.
        - Employee contributions are tax-deferred.
        - Funds invested in stocks, bonds, and mutual funds with possible employer matching.
        - Vesting period defines employee rights to benefits upon leaving the company before retirement.

  • Defined-Benefit Plan:
      - Employer pays a specified amount monthly upon retirement based on pre-retirement salary and years of service.
      - Investment decisions made by the employer.

Portability of Plans

  • Portability allows carrying benefits from one employer’s pension plan to another upon job changes.

  • ERISA (Employee Retirement Income Security Act of 1974):
      - Sets minimum standards for pension plans.
      - Federal insurance protections for defined-payment plans.

Public Pension Plans

Social Security

  • Established by the U.S. government in 1935.
      - Most widely used source of retirement income covering about 97% of U.S. workers.
      - Intended as a part of retirement income, not the sole source.
      - Check the Earnings and Benefit statement for accuracy.

Social Security Eligibility

  • Full retirement benefits at age 70 (depends on year of birth); 62 for reduced benefits.

  • Benefits based on earnings must meet criteria for credits.

Other Public Pension Plans

  • Federal government pensions for special employees (federal workers, railroad employees) not covered by Social Security.

  • The Veterans Administration offering survivor pensions, disability pensions for eligible veterans, state and local government retirement plans.

Personal Retirement Accounts

Individual Retirement Accounts (IRAs)

  • Traditional IRA:
      - Contribution limit of $5,500 (or $6,500 if over 50) since 2014.
      - Contributions may be tax-deductible; interest accumulates tax-free until withdrawal (taxable).

  • Roth IRA:
      - Contributions not tax-deductible; distributions are tax-free after age specified.
      - Same contribution limits as traditional IRA, with AGI thresholds for eligibility.

  • Simplified Employee Pension (SEP):
      - Employer-funded IRA allowing annual contributions up to $50,000.
      - Contributions fully tax-deductible for the employee.

  • Spousal IRA:
      - Contributions for a non-working spouse in a joint return ($5,500 or $6,500).

  • Rollover IRA:
      - Traditional IRA for transferring taxable distributions from retirement plans.

  • Education IRA (Coverdell):
      - Up to $2,000 per year for children under 18 with tax-free distributions for education expenses.
      - Contributions not tax-deductible.

IRA Withdrawals

  • Withdrawal methods include all at once, installments, or annuity placements.

Keogh Plans

  • Designed for self-employed individuals with annual tax-deductible contributions limits.

Types of IRAs

  • Various features exist for standard IRAs, Roth IRAs, SEP IRAs, and Spousal IRAs, including tax-deferred interest, contribution limits, and eligibility for tax deductions.

Annuities

  • Annuities provide guaranteed income for life, purchased from IRA or company pensions as supplemental retirement income.

  • Payment types include single or periodic payments.

  • Immediate Annuity: Payments begin immediately.

  • Deferred Annuity: Payments start at a future date.

Living on Your Retirement Income

  • Estimate a retirement budget and ensure funds are adequate. If not:
      - Verify income entitlements.
      - Convert assets to cash or income sources.
      - Balance spending vs. saving.
      - Consider working during retirement and carefully managing withdrawals from savings.

Estate Planning (LO 14.3)

Overview

  • Your estate: Everything you own.

  • Estate Planning: Detailed plan for administration and disposition of property during life and after death.

  • Shifts focus from accumulating wealth to distributing it wisely as one ages.

Legal Documents in Estate Planning

  • Typical estate plans include:
      - Wills
      - Birth, marriage, divorce, and legal name change documents
      - Military records, Social Security documents, insurance policies
      - Transfer records of joint accounts, safe-deposit records, automobile registrations, stock/bond titles

Legal Aspects of Estate Planning (LO 14.4)

Wills

  • A legal declaration of a person's wishes concerning property disposition after death.

  • Recommended to have an attorney draft your will to avoid complications.

  • If you die without a valid will (intestate), the state controls asset distribution, ignoring personal wishes.

  • Cost for a standard will ranges between $300 to $400.

Types of Wills

  • Simple Will: Leaves everything to your spouse. Suitable for small estates.

  • Traditional Marital Share Will: Distributes adjusted gross estate half to spouse and half to heirs, may be held in a trust.

  • Exemption Trust Will: Passes assets to spouse except for an amount equal to the exemption, which goes into a trust.

  • Stated Amount Will: Allows passing an amount to the spouse that meets family financial needs.

  • Wills and Probate:
      - Probate court validates wills and ensures debts are settled. Processes can be expensive, prolonged, and public.

Will Formats

  • Holographic Will: Entirely handwritten; may not be recognized in some states.

  • Formal Will: Prepared with attorney assistance, requires signature and two non-beneficiary witnesses.

  • Statutory Will: Preprinted form obtained from lawyers or stores; could include unsuitable provisions.

Writing Your Will

  • Executor: Person responsible for executing will provisions who manages property, pays debts, and distributes the estate.

  • Guardian: Person elected to provide care for children and manage their estates.

  • Reasons to Alter or Rewrite: Move to different state, changes in property, relationship status changes, or changes in heirs.

  • Codicil: Document modifying provisions in an existing will; avoid written changes directly on the will.

Living Will

  • Document expressing the intention for life to end under terminal illness conditions.

  • “Do Not Resuscitate” (DNR) provisions can be included.

  • Most lawyers handle living will paperwork at no cost in conjunction with estate planning.

  • Partnership for Caring: Offers crisis information for end-of-life issues.

Social Media Will

  • Steps to handle your profile posthumously:
      - Review privacy policies and terms of conditions.
      - Specify profile handling instructions.
      - Provide online executor with necessary documents, including password and usernames, and claim to a death certificate.

Power of Attorney

  • Legal document authorizing someone to act on one’s behalf if incapacitated.

Letter of Last Instruction

  • Non-legally binding document providing heirs with important instructions and information post-death, including:
      - Funeral preferences, notifications, asset locations, debts, and Social Security numbers.

Trusts

  • Legal arrangement whereby a trustee holds assets for beneficiaries’ benefit.

  • Benefits of Trusts:
      - Reduce estate taxes, avoid probate, free management responsibilities, secure income for survivors, assure property use as desired after death.

Types of Trusts

  • Revocable Trust: Can be changed during life; avoids lengthy probate but doesn't shield from taxes.

  • Irrevocable Trust: Unchangeable terms; used for tax reduction and avoiding probate.

  • Credit-Shelter Trust: Lets surviving spouses avoid federal taxes on specific asset amounts with limits up to $10.98 million (2017).

  • Disclaimer Trust: For couples anticipating asset growth, allowing one spouse to disclaim portions to a trust for tax protection.

  • Living Trust: Active during life, providing benefits, ensuring privacy, and reducing disputes among heirs.

  • Testamentary Trust: Established by a will, often helps inexperienced beneficiaries manage wealth.

Taxes and Estate Planning

Estate Taxes

  • Federal tax on property value at death based on fair market value.

  • Exemption limit of $5.49 million (2017); payment due within 9 months post-death.

Trust and Estate Taxes

  • Estates and some trusts must file tax returns; quarterly estimated taxes may apply.

Inheritance and Gift Taxes

  • Inheritance Tax: State tax on property passed through wills (4% to 10% average).

  • Gift Tax: Tax on gifts exceeding $14,000 from one individual in a single year, imposed by state and federal governments.

Chapter Summary

  • LO 14.1: Assess and estimate retirement living costs; ensure assets cover expenses.

  • LO 14.2: Identify retirement income sources, including pension and personal plans.

  • LO 14.3: Personal aspects of estate planning depend on marital status, ensure estates are organized.

  • LO 14.4: Differentiate wills and trusts; understand estate tax implications.

Additional Calculations

  • Savings Calculation for Age 25:
    N = 480 months, I/Y = 0.9167 (11%/12); PMT = -127; PV = 0; Future Value (FVCPT) = $1,092,216.

  • Savings Calculation for Age 50:
    N = 180 months, I/Y = 0.9167; PMT = -2,244; PV = 0; Future Value (FVCPT) = $1,020,362.