Chapter 21 – Taxes, Inflation, and Investment Strategy
CHAPTER TWENTY ONE
TAXES, INFLATION, AND INVESTMENT STRATEGY
CHAPTER OVERVIEW
CHAPTER OUTLINE
**Topics 1 through 6 of this chapter are written around a series of spreadsheets so the
discussed the inputs and outputs beneath the appropriate spreadsheet.
1. Saving for the Long Run
PPT 21-2 through PPT 21-3
The development of the basic retirement plan involves identification of the time until retirement,
the allocation of the percentage allocation to saving, the life expectancy following retirement and
65. According to the spreadsheet there will be $2.5 million in the retirement fund at age 65,
yielding an annuity of $192,444 per year for 25 years. This works out to the same real
2. Accounting for Inflation
PPT 21-4 through PPT 21-9
Inflation reduces the purchasing power of the savings accumulation. Real and nominal
consumption can be related as follows: Real consumption = Nominal consumption / Price
At age 65 =
21–2
16.103.1)i1( 5n
Both of these numbers are in the spreadsheet. These deflators are used to convert the nominal
purchasing power in year t to starting date (age 30) dollars.
Historically inflation has been much higher than in recent time periods. From the 1990s on the
Federal Reserve has managed the money supply to limit inflation. Nevertheless much higher rates
needed (and more risk) or a greater percentage of income must be allocated to savings.
Spreadsheet 21.2 A Real Retirement Plan
The inputs are the same as before with inflation of 3% added. rConsumption is real consumption. Thus
the $192,244 nominal annuity buys only $49,668 in real purchasing power (the same purchasing
power as age 30). This will give the investor the same spending power as they had at age 34.
riskiness of the retirement portfolio? Increasing the risk increases the expected return, but also the
probability of not having enough to live on when the investor retires. As one gets older,
increasing the risk to make up for years in which one did not save is really rolling the dice. Nor is
it is not easy to reduce the risk level as you retire. It is particularly difficult if one has some bad
years of earnings. Does one want to sell at the market bottom to realign one’s portfolio? There
simply with the following example:
Suppose an investor begins investing $1,000 per year at age 30 and earns 10%. He stops
investing at retirement. The future value of his retirement fund at age 65 is $271,024 ignoring
taxes. Suppose another investor invested $1,000 per year for 10 years starting at age 20 and then
stopped adding any additional funds. This portfolio will have a future value at age 65 (with 10%
21–3
81.203.1 35
Chapter 21 – Taxes, Inflation, and Investment Strategy
Stocks 9%
Government bonds 2.6%
3. Accounting for Taxes
PPT 21-10 through PPT 21-11
Taxes are a cash outflow from the funds that are available to meet the retirement needs. To
achieve the same retirement benefit, a larger percentage allocation to savings or higher rates of
return on investment is required. Inflation combined with taxes has a compounding impact
3%, saving a lot of their income, 15% and a tax rate of 25%. Note that the tax rate should
(roughly) be the sum of federal, state and local income taxes.
At this point one must recognize that one will probably have to take some risk in a portfolio to
generate a large enough expected return. SEC studies have shown that most people under invest
in equities but stocks are probably their best bet (among liquid assets) at earning sufficiently high
Total exemptions during working years $949,139
(2) Lifetime Taxable labor income 6,496,534
Taxes
During labor years 1,884,163
During retirement 203,199
Chapter 21 – Taxes, Inflation, and Investment Strategy
As a result the average tax rate is elevated above the marginal tax rate of 25%.
4. The Economics of Tax Shelters
PPT 21-12 through PPT 21-15
Tax shelters are means of postponing taxes as long as possible. One can’t get rid of taxes, one can
only postpone them. The discussion on tax shelters contains general discussion of the benefits of
rate paid during retirement.
Spreadsheet 21.7, IRA with a Progressive Tax Code
The real annuity is increased considerably in this case; it is now up to $83,380. This is better than
with a flat tax rate for the reasons noted above.
5. A Menu of Tax Shelters
PPT 21-16 through PPT 21-24
Individual Retirement Accounts (IRAs) were created by the Tax Reform Act of 1986. Current
rules 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. There is a 10% tax penalty for withdrawal
value at the same rate or more).
There are two types of IRAs. With traditional IRAs contributions are tax deductible and the
earnings are tax deferred until withdrawn. With a Roth IRA contributions are not tax deductible
but earnings on the account are not taxed when withdrawn.
Spreadsheet 21.8 Roth IRA with Progressive Tax Code
21–5
contributions that come with a traditional IRA in order to gain the tax free withdrawals upon
retirement that the Roth IRA provides.
Table 21.2 Traditional vs. Roth IRA Tax Shelters under a Progressive Tax Code
This table summarizes the differences between traditional and Roth IRAs. Note that although the
Roth IRA results in less taxes paid over the lifetime and a lower average tax rate, the traditional
each individual to see which type is better. This usually has to be decided on a case by case basis.
With defined benefit (DB) plans the employer promises to pay a defined or known benefit to
employees when they retire. The benefit is typically a percentage of salary based on years of
service. The employer must fund the pension obligation by setting aside a certain amount of funds
in a pension trust. Many of these funds are managed by life insurance firms (listed under separate
medical coverage in the event of bankruptcy and takeovers. The PBGC is very underfunded and a
few large bankruptcies would force a government bailout of “Penny Benny” as it is called.
Defined contribution (DC) plans include 401k and 403b plans. The employee and the employer
contribute set (defined) amounts to an investment plan. The employee’s retirement benefit
depends on the investment performance. Employees are typically given a choice of mutual funds
of the tax code. 401k plans are used in the for–profit sector and 403b plans are for non-profits, but
they are very similar to one another in function and regulations.
Table 21.3 Investing Roth IRA Contributions into Stock and Bonds
Some investors make the mistake of putting stocks in their IRA and buy bonds outside their IRA.
The interest income on bonds is taxed each year and is taxed at the ordinary income rate. Much
6. Social Security
PPT 21-25 through PPT 21-29
Social Security (SS) is a federal pension plan established to provide minimum retirement benefits
to all workers. Technically it is the Old Age and Survivors Disability Fund. It is unfunded
later (as late as 70). The retirement ages will be going up to help for younger people to reduce
the fiscal problems of the plan.
There are four steps required to calculate an individual’s benefits:
1. The series of the 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. If an individual works less than 35 years their AIME may
be low because the number is still divided by 420.
4. Primary Insurance Amount (PIA): The PIA is the amount the individual receives each year.
No exact formula is provided for this calculation. The income replacement rate is the
7. Additional Considerations
PPT 21-30 through PPT 21-32
The text identifies and very briefly describes how specific considerations such as funding a child’s
college education, should be built into the financial plan. Financing a child’s education involves
Excel Applications
The best method to cover the material in this chapter involves the integrated use of the models
that are available on the web. The impact that each of the factors has on performance can be
demonstrated in class. The power point presentation gives an overall framework to the discussion