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Executive Retirement Benefits. Purpose of Retirement Benefits Income replacement at retirement Maintain standard of living at retirement Need about 80% of pre-retirement income from all sources Some of retirement income is not taxed such as Soc. Sec. & income from Roth IRAs

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Executive Retirement Benefits

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Executive Retirement Benefits

Purpose of Retirement Benefits

  • Income replacement at retirement

  • Maintain standard of living at retirement

  • Need about 80% of pre-retirement income from all sources

  • Some of retirement income is not taxed such as Soc. Sec. & income from Roth IRAs

  • Use as asset to create wealth, borrow, or form estate to leave to your heirs (children, spouse, charity).

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Sources of Retirement Income

When you Decide to Retire you want a 3-legged stool of resources to generate retirement income

1. Social Security (10 percent or less for executives)

2. Retirement Benefits (50-60 percent) - most significant source of retirement income:

  • pensions (defined benefit plan)

  • retirement benefits (defined contribution plan)

    3. Personal Savings (30-40 percent)

  • home equity

  • personal investments in stocks, bonds, vacation property

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Retirement Benefits: Defined Benefit Plans

Features of Defined Benefit (DB) Plans

  • Retirement benefit is known in advance based on a formula

  • Traditional retirement plan used by large firms

  • Employer assumes all the financial risk and makes contributions while managing them

  • Formula based on two variables:

    1. Average Salary for last 5 years (year prior to retirement)

    2. Number of years of service (may need 20 or more yrs.)

  • Examples: pensions, cash balance plans

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Retirement Benefits: Defined Contribution Plans

Features of Defined Contribution (DC) Plans

  • Employer contributions to plan are known

  • But…amount of retirement income when employee retires is unknown.

  • Employee shares risk with employer

  • Employee takes active role in managing investment contributions - and also can keep all of the upside investment gains (not the case with DB plans).

  • Examples: 401(k) Plan, IRAs, SEP

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401(k) Plans

Plan Characteristics

  • Refers to sec. 401(k) of IRC - 1981

  • Fastest growing retirement plan

  • Contribution limit: 15% salary up to $10,000 per year

  • Employer matches: 25% to 100% in most firms

  • Plan contributions not taxed and accumulations tax deferred

  • Distributions taken out after age 59 1/2; tax penalty of 20% for early withdrawal, except emergency

  • Loans of up to $50 K possible; repay @9% interest

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401(k) Plan: Compare to taxed investment

401(k) Investment Taxed Investment

before taxes $1000 $1000

after taxes (28%) $1000 $720

‘er match (75%) $750 00

fund gain (20%) $350 $144

taxed gains (28%) 00 $40

net gain $350 $104

Total after 1 year $2100 $824

ROI (1 year) 110% 14%

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401(k) Plan Tips

  • Start your 401(k) plan immediately, to take advantage of “miracle” of compound interest

    • some companies now have automatic enrollments

  • If 20 or more years from retirement, invest aggressively in stocks

  • If employer match is paid in company stock, sell some of the stock when vested so there is diversification of assets and reduced exposure to risk.

  • When changing jobs, roll over money into new employer’s 401(k) if > $5K, if < $5K roll into an IRA - there are tax penalties for cashing out early.

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Characteristics of best 401(k) Plans

  • Diverse Investment Choices

    • at least 8 investment options to choose from

    • employees are able to change fund allocations

  • Asset Diversification

    • stocks and bonds

    • large and small cap stocks

    • domestic and international stocks

    • index and sector funds

  • Limited Employer Stock Holdings

    • less than 10% of portfolio

    • limited employer stock when matching

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Important Considerations for 401(k) plans

  • Invest at least up to the maximum employer match - don’t leave free money on the table

  • Avoid loans

    • loss of compounding is costly

    • make loan only for an emergency

  • Prevent allocation drift

    • reallocate contributions periodically to maintain investment within risk comfort zone

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IRA Plans: Traditional IRA

Plan Characteristics

  • There are both personal and employer-sponsored IRAs

  • Contribution limit: $2,000 per person and $4,000 if joint with spouse

  • Used by self-employed or entrepreneurs without company retirement plan or may those who have put maximum in company plan.

  • Plan contributions not taxed and accumulations tax deferred

  • Full pre-tax benefit limit: $30K (single), $50K (joint) AGI

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IRA Plans: Traditional IRA

Advantages of Traditional IRAs

  • Immediate tax savings and accumulations tax deferred

  • A person with AGI above $40K ($60K for joint filers) can start an IRA with tax deferred interest benefits, but without tax savings on contributions.

  • More investment choices than 401(k) plans.

    Disadvantages of Traditional IRAs

  • Distributions are taxed - high income people get hit

  • Must make min. distributions by age 70 1/2

  • Early withdraw (< 59 1/2) incurs tax penalty

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IRA Plans: Roth IRA

Characteristics of Roth IRAs

  • Amount of Contributions same as other IRAs

  • Contributions are made with after tax money

  • Accumulations are not taxed

  • Distributions are not taxed

  • Attractive investment for people who have put maximum in 401(k) plan

  • At retirement non-taxed distributions allow retiree to have tax diversification from other retirement income that is taxed - so a lower income tax bracket is possible.

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IRA Plans: Roth IRA

Advantages of Roth IRAs

  • Singles who earn up to $95K get full benefits and up to $110K partial ($150K & $160K for joint).

  • Can continue making contributions after age 70 1/2 which is not possible with traditional IRA

  • Not required to take min. distributions age 70 1/2

  • Can convert traditional to a Roth IRA

  • Past 59 1/2 take lump sum distributions w/o tax

    Disadvantages of Roth IRAs

  • Contributions are taxed - may not be beneficial if expect to be in low tax bracket at retirement.

  • 5 year holding period requirement

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Simplified Employee Pensions (SEPs)

Plan Characteristics

  • An individual retirement account or individual retirement annuity for an employee to which the employer makes tax-deductible contributions.

  • For self-employed or employees of small business without a retirement plan.

  • Similar tax rules as IRA with no tax on contributions, tax deferred accumulations and taxed on distributions after age 59 1/2

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Simplified Employee Pensions (SEPs)

Plan Characteristics

  • The employer’s contribution limit for an employee is the lesser of 15% of employee’s annual salary or $30,000.

  • Employee may contribute an additional $2,000 to a personal IRA while participant in an SEP.

  • SEP distributions taxed similar to IRA rules.

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Simplified Employee Pensions (SEPs)

SEP Advantages

  • Minimal amount of record keeping to start and maintain the plan. Less need for lawyers, etc.

  • Employer can be flexible in providing contributions, compared to qualified pensions.

  • Employees choose own investments in SEP.

    SEP Disadvantages

  • More employees such as part-time must participate than qualified pension plans.

  • Employees must be fully vested at all time, which is not the case with qualified pensions.

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