Chapter 21 – Taxes, Inflation, and Investment Strategy
CHAPTER TWENTY ONE
TAXES, INFLATION, AND INVESTMENT STRATEGY
CHAPTER OVERVIEW
This chapter presents material on developing a framework for retirement planning. The chapter
is built around a set of Excel models that can be used to plan for retirement. The first model
ignores inflation and taxes and subsequent models add the effects of inflation, a flat tax rate and
a progressive tax rate. This method allows students to see the effects on the retirement portfolio
LEARNING OBJECTIVES
After studying this chapter the student should have an understanding of the basic elements
required to build a financial plan and how taxes and inflation will affect retirement income.
Students should be able to describe the basic types of tax sheltered retirement accounts and how
CHAPTER OUTLINE
**Topics 1 through 6 of this chapter are written around a series of spreadsheets so the
Instructor’s Manual follows the same format. I have labeled each spreadsheet and
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
the expected rate of return. These key factors become the base of the plan. The first step in the
Chapter 21 – Taxes, Inflation, and Investment Strategy
Spreadsheet 21.1: The Savings Plan
Specific Inputs: Retirement years = 25, income growth rate =7% (which is way too high for
many people); income at age 30 = $50,000, the rate of savings (% of income) which is very high
at 15%, and the rate or return on investment (ror) which is low at 6% for a retirement portfolio.
The spreadsheet converts the payments into the retirement fund into a level 25 year annuity at
2. Accounting for Inflation
Chapter 21 – Taxes, Inflation, and Investment Strategy
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
Deflator. A simple example can be used to illustrate the point. Suppose inflation = 3% per year
and the nominal rate of return is 6%. What is the real rate of return?
Inflation turns the 6% nominal return into a 2.91% real return. This is before taxes are
considered. Since taxes are paid out of nominal earnings, the combine effect of inflation and
taxes results in even greater reductions than may be expected in real after tax rates of return.
The investor in the example is 30 years old. The size of the price deflator with 3% inflation at
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 than the 3% used in the example are possible and probably even likely after the recovery
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
Chapter 21 – Taxes, Inflation, and Investment Strategy
Should an investor take on more risk to offset inflation? What are the effects of increasing the
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
Real returns based on historical averages
Investment
Average Real
Return
Because we have had a long period of low inflation people forget how regressive the effects of
inflation really are. It erodes investment returns and drives up the cost of necessities which
reduces the standard of living of low income individuals, the group that can least afford it.
3. Accounting for Taxes
PPT 21-10 through PPT 21-11
Chapter 21 – Taxes, Inflation, and Investment Strategy
Spreadsheet 21.4, Saving With a Simple Tax Code
The effects of inflation and taxes together really have major impacts on the ability to meet
investment goals. In this case the real retirement annuity is $37,882 with very modest inflation
of 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.
Investors pay income taxes and pay taxes on unsheltered savings. One can use the numbers in
Spreadsheet 21.4 to illustrate the effect on the overall tax rate:
$7,445,673
$949,139
6,496,534
1,884,163
203,199
2,087,362
Lifetime average tax rate = (3) / (1)
28%
Lifetime tax rate on taxable income = (3)/ (2)
32%
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
Chapter 21 – Taxes, Inflation, and Investment Strategy
Tax shelters are means of postponing taxes as long as possible. One can’t get rid of taxes, one
Spreadsheet 21.5 Savings with a Flat Tax and IRA Style Tax Shelter
This spreadsheet redoes sheet 21.4 with the tax shelter. It still uses a flat tax rate. All funds in
Spreadsheet 21.6 Savings with a Progressive Tax Rate
We have seen that taxes on income during the working years reduce the future value of the
investments dramatically. A progressive tax code magnifies this effect because retirement tax
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
Chapter 21 – Taxes, Inflation, and Investment Strategy
Spreadsheet 21.8 Roth IRA with Progressive Tax Code
The effectiveness of the Roth IRA as a tax shelter is independent of tax rates during retirement.
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 IRA offers a substantially higher retirement annuity. The higher tax rates on the
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 account business). A fully funded pension plan is one where the firm has set aside the
full present value of expected future payments. Many plans are only partially funded. The
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.
6. Social Security
PPT 21-24 through PPT 21-28
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 although it is in surplus on a current year basis, but it is projected to go in the red
around 2016.
U.S. citizens pay 6.2% of their income to SS, plus 1.45% toward Medicare and their employer
matches their contribution.
1
SS is a means of redistributing income. In dollar terms taxes are
regressive, rising with income but low income workers receive a relatively larger share of
preretirement income upon retirement than higher income workers.
There are four steps required to calculate an individual’s benefits:
1. The series of the taxed annual earnings is compiled
3. Average Indexed Monthly Earnings (AIME)
The 35 highest annual indexed contributions are summed and then divided by (35 x 12) =
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 percentage of the working income received in retirement. The income replacement
1
Actually you would pay the 7.65% taxes on the first $106,800 of your income in 2009. On your paycheck this will be in the
FICA section. Note that between the employee and the employer 12.4% is being paid in to fund SS.
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 the same procedure as funding retirement. One gains no equity in renting, and equity is
a safeguard for tough times. Too many people try to buy too much house and this can limit their
ability to save as well as stress their relationships. Houses are illiquid investments whose value
does not always increase.
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