Chapter-22B-notes

Chapter-22B-notes - Finance 3700 Financial Markets and...

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Finance 3700 Financial Markets and Institutions Fall 2007 Lecture Notes CHAPTER 22 (Part 2): Pension Funds © Sven Thommesen
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2 Retirement savings and pension funds This section should be read in conjunction with my lecture notes called “Topic: pensions.” Personal savings We all need to secure for ourselves the necessary economic resources to maintain our standard of living for our “golden years” between retirement from work and the ultimate retirement. One way to do that is to save out of your (after-tax) income while you work, so that you have a nest egg to draw on later. The money you save may be invested in any number of possible financial instruments or assets, which vary in maturity, yield, liquidity, and riskiness. Typically, you will pay income taxes on any interest or dividend payments you receive, as well as capital gains taxes if you sell an investment for more than what you paid for it. (The question of how much to save for your old age is covered in the Topic paper.) Individual tax advantaged (“qualified”) savings plans The government (state and federal), in an effort to encourage people to save for their own old age (given that Social Security will soon be broke – see below), have enacted laws that provide various tax advantages to specific types of savings plans. (But Congress always gives up lost tax revenues very grudgingly!) The advantages you get in terms of after-tax yield from using a particular kind of savings plan depends of how the tax savings are given: Best case: pre-tax contributions, tax free distributions. Such a plan does not exist. Next: pre-tax contributions, taxable distributions. [Examples: pensions, 401(k) plans, IRA’s.] You get two benefits: o You may pay lower taxes, if we assume you are in a lower income tax bracket after you retire than before; o You get to pay your taxes much later, reducing the NPV of the tax burden. Next: after-tax contributions, but distributions are not taxed. [Roth IRA’s, life insurance, annuities.]
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3 Next: after-tax contributions, and only the yield (growth) part of distributions is taxed. [ ? ] Next: after-tax contributions, and distributions are taxed. [This is the same as putting your money in the bank.] Worst case: putting your after-tax money in a shoe box under the bed, where the money earns no interest. NOTE that you typically give up flexibility in exchange for the favored tax treatment: while the “worst case” scenario gives you the lowest overall yield, it does allow you to spend your money any time you wish. Money contributed to qualified savings plans may only be spent in accordance with IRS rules, e.g. if you spend it before you turn 59 ½ you will pay huge tax penalties. Some tax-advantaged savings plans are:
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This note was uploaded on 04/20/2008 for the course FINC 3700 taught by Professor Thommesen during the Spring '08 term at Auburn University.

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Chapter-22B-notes - Finance 3700 Financial Markets and...

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