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Chapter 21 - Taxes, Inflation, and Investment Strategy
CHAPTER 21
TAXES, INFLATION, AND INVESTMENT STRATEGY
2. The owner will suffer from adverse selection. The owner will attract cargo that
would normally cost more than the flat fee being charged.
3. Passive investors who are not sophisticated and looking for reduced fees. These
4. The social security annuity is paid out for the balance of your life, regardless of
how long you live. The amount is determined based on the calculation of a
5. The progressive tax code sharpens the importance of taxes during the retirement
years. High tax rates during retirement reduce the effectiveness of a tax shelter. In
6. With a savings rate of 16%, the retirement annuity would be $205,060 (compared
to $192,244 with the 15% savings rate).
Chapter 21 - Taxes, Inflation, and Investment Strategy
Retirement Years Income Growth Savings Rate ROR
Age Income Saving Cumulative Savings Consumption
30 50,000 8,000 8,000 42,000
7. With a savings rate of 16%, the retirement annuity will be $52,979 (vs. $49,668).
The growth in the real retirement annuity (6.67%) is the same as with the case of
no inflation.
Spreadsheet 21.2: Adjusted for Change in Savings Rate
Retirement Years Income Growth Rate of Inflation Savings Rate ROR rROR
Age Income Deflator Saving Cumulative Savings rConsumption
30 50,000 1.00 8,000 8,000 42,000
8. The objective is to obtain a real retirement annuity of $49,668, as in Spreadsheet
21.2. In Spreadsheet 21.3: Backloading the Real Savings Plan, select Data/Solver
from the menu bar. Set the objective value of Real Annuity to 49,668; Assign the
25 0.07 0.03 0.083 0.06 0.0291
Age Income Deflator Saving Cumulative Savings rConsumption
30 50,000 1.00 4,145 4,145 45,855
9. Because of the exemption from taxable income, only part of income is subject to
tax, while a change in ROR affects all savings.
10. In the original Spreadsheet 21.5, real consumption during retirement is $60,789.
A 1% increase in the rate of inflation will reduce real consumption during
retirement to $15,780.
A 1% increase in the flat-tax rate reduces real consumption during retirement to
Chapter 21 - Taxes, Inflation, and Investment Strategy
Spreadsheet 21.5: Adjusted for Higher Rate of Inflation
Retirement Years Income Growth Rate of Inflation Exemption Now Tax Rate Saving Rate ROR rROR
25 0.07 0.04 15000 0.25 0.15 0.06 0.0192
Age Income Deflator Exemption Taxes Savings
Cumulative
Savings
rConsumption
30 50,000 1.00 15,000 5,016 9,922 9,922 35,063
31 53,500 1.04 15,600 5,518 10,309 20,826 36,224
RETIREMENT
Age Nom Withdraw Deflator Exemption Taxes Fund left rConsumption
66 65,827 4.10 61,559 1,067 1,255,966 15,780
70 77,008 4.80 72,015 1,248 1,268,594 15,780
11. In Spreadsheet 21.6, the real retirement annuity is $37,059.
A 1% increase in the lowest tax bracket reduces the real retirement annuity to $36,815.
A 1% increase in the highest tax bracket reduces the real retirement annuity to
Chapter 21 - Taxes, Inflation, and Investment Strategy
Retirement Years Income Growth Rate of Inflation Exemption Now Tax Rates in Saving Rate ROR rROR
Age Income Deflator Exemption Taxes Savings
Cumulative
Savings
rConsumption
30 50,000 1.00 10,000 8,400 6,240 6,240 35,360
31 53,500 1.03 10,300 9,151 6,652 13,267 36,599
35 70,128 1.16 11,593 13,061 8,560 50,802 41,842
Example of adjustment
Retirement Years Income Growth Rate of Inflation
Exemption Now
Tax Rates in Saving Rate ROR rROR
25 0.07 0.03 10000 Table 21.1 0.15 0.06 0.0291
Age Income Deflator Exemption Taxes Savings
Cumulative
Savings
rConsumption
30 50,000 1.00 10,000 8,000 6,300 6,300 35,700
31 53,500 1.03 10,300 8,716 6,718 13,396 36,958
12. The real retirement annuity in Spreadsheet 21.7 is $83,380.
A decrease of 2% in the ROR reduces the real retirement annuity to $50,900.
An increase of 2% in the ROR increases the real retirement annuity to $137,819.
Retirement Years Income Growth Rate of Inflation Exemption Now Tax Rates in Saving Rate ROR rROR
25 0.07 0.03 10000 Table 21.1 0.15 0.04 0.0097
Age Income Deflator Exemption Taxes Savings
Cumulative
Savings
rConsumption
30 50,000 1.00 10,000 5,140 9,160 9,160 35,700
31 53,500 1.03 10,300 5,553 9,880 19,406 36,958
35 70,128 1.16 11,593 7,480 13,654 73,648 42,262
Chapter 21 - Taxes, Inflation, and Investment Strategy
Retirement Years Income Growth Rate of Inflation Exemption Now Tax Rates in Saving Rate ROR rROR
Age Income Deflator Exemption Taxes Savings
Cumulative
Savings
rConsumption
30 50,000 1.00 10,000 5,140 9,160 9,160 35,700
31 53,500 1.03 10,300 5,553 9,880 19,773 36,958
13. The real retirement annuity in Spreadsheet 21.8 is $ 49,153.
A 1% increase in ROR increases the real retirement annuity to $63,529.
A 1% decrease in the rate of inflation increases the real retirement annuity to $119,258.
Retirement Years Income Growth Rate of Inflation Exemption Now Tax Rates in Saving Rate ROR rROR
Age Income Deflator Exemption Taxes Savings Cumulative Savings rConsumption
30 50,000 1.00 10,000 8,000 6,300 6,300 35,700
31 53,500 1.03 10,300 8,640 6,793 13,534 36,958
35 70,128 1.16 11,593 11,764 9,370 54,231 42,262
Chapter 21 - Taxes, Inflation, and Investment Strategy
Retirement Years Income Growth Rate of Inflation Exemption Now Tax Rates in Saving Rate ROR rROR
Age Income Deflator Exemption Taxes Savings Cumulative Savings rConsumption
30 50,000 1.00 10,000 8,000 6,300 6,300 35,700
31 53,500 1.02 10,200 8,660 7,143 13,821 36,958
14. When deferring taxes to the last year of retirement, you must set money aside
every year in order to accumulate a fund sufficient to pay the capital gains tax in a
lump sum. To leave consumption fixed in real terms, a fixed real amount is set
aside each year.
Chapter 21 - Taxes, Inflation, and Investment Strategy
Retirement
Years
Income
Growth
Rate of
Inflation
Exemption
Now
Tax Rates in Saving Rate ROR rROR
25 0.07 0.03 10000 Table 21.1 0.15 0.06 0.0291
Age Income Deflator Exemption Taxes Savings
Cumulative Savings
rConsumption
30 50,000 1.00 10,000 8,000 6,300 6,300 35,700
35 70,128 1.16 11,593 11,764 9,370 52,995 42,262
45 137,952 1.56 15,580 28,922 19,707 278,528 57,333
15. Answers will vary.
16. The present value of labor income is $ 2,010,917 (at the rate of the applicable
ROR). The present value of college tuition is $167,741. This is equal to:
($167,741/$2,010,917) = 8.34% of the present value of labor income. When
Chapter 21 - Taxes, Inflation, and Investment Strategy
Retirement Years
Income Growth Rate of Inflation Savings Rate ROR rROR Extra-Cons
Age Income Deflator Saving Cumulative Savings rConsumption Expenditures
30 50,000 1.00 7,500 7,500 42,500 0
31 53,500 1.03 8,025 15,975 44,150 0
35 70,128 1.16 10,519 61,658 51,419 0
45 137,952 1.56 20,693 308,859 75,264 0
48 168,997 1.70 25,349 375,099 84,378 68,097
Retirement Years Income Growth Rate of Inflation Savings Rate ROR rROR Extra-Cons
25 0.07 0.03 0.15 0.06 0.0291 40,400
Age Income Deflator Saving Cumulative Savings rConsumption Expenditures
30 50,000 1.00 7,500 7,500 42,500 0
31 53,500 1.03 8,025 15,975 44,150 0
35 70,128 1.16 10,519 61,658 51,419 0
17. Adverse selection is a concept that is generally associated with insurance; however,
in a broader sense, adverse selection is a potential issue in any contract where one
party has more complete information about the transaction than the other. In
insurance, the insured has more information about one’s own health (e.g., in life
insurance and health insurance) or, in general, the risk of loss (e.g., one’s driving
19. In general, moral hazard is a term associated with insurance contracts and with
government programs that essentially function as insurance. When an individual
or a business entity insures against loss of property due to fire, theft or other
hazard, the insured may have a tendency to take greater risks than one would in
