- Unit 1: Basic Building Blocks of Successful Financial Management
- Unit 2: Investing Basics
- Unit 3: Finding Money to Invest
- Unit 4: Ownership Investments
- Unit 5: Fixed-Income Investing
- Unit 6: Mutual Fund Investing
- Unit 7: Tax-Deferred Investments
- Unit 8: Investing Small Dollar Amounts
- Unit 9: Getting Help: Investing Resources
- Unit 10: Selecting Financial Professionals
- Unit 11: Investment Fraud
Tax-Deferred Investments Review Questions & Answers
1.What is the difference between tax-exempt and tax-deferred investments?
Tax-exempt investments produce earnings that are income tax-free. For example, Series EE and I Savings Bonds are exempt from state and local (if applicable) income taxation. Furthermore, payment of the federal taxes on the earnings can be deferred, or postponed, until the bonds are sold. As noted in this unit, earnings on municipal bonds are exempt from federal income tax, and, under certain circumstances, may be state and local tax exempt.
With tax-deferred investments, income taxes on the earnings are deferred until the investment is sold. You are able to keep money invested, and earning more, than if you had to pay taxes in the year of the earnings. Consequently, tax-deferred investments grow faster than taxable investments earning the same rate of return. Aside from selected investment products, such as Series EE and I bonds, most investments do not offer the benefit of tax deferral unless the investment products are purchased within a retirement plan.
2. What are the advantages of investing in retirement accounts?
Investing in retirement accounts offers the possibility of matching contributions from the employer. But aside from this “free money,” two significant advantages of retirement investing include:
- Contributions with pre-tax dollars to a tax deferred retirement account reduce your current year income tax liability. In other words, dollars that would have gone to the government in tax payments are instead paid to your retirement account. The percentage of the retirement contribution saved is determined by an investor’s marginal tax rate (currently 10%, 15%, 25%, 28%, 33%, and 35%, as a result of the 2003 tax law).
- Earnings in a tax-deferred account grow faster than a “regular account” or one that is not tax deferred. In other words, earnings can remain in the account to yield additional earnings, instead of being withdrawn to pay taxes.
3.Under what conditions can tax-deferred investments be withdrawn without the typical penalty of 10% of the amount withdrawn?
If the funds are withdrawn before age 59½, tax-deferred retirement accounts typically assess a 10% penalty for early withdrawal of funds, in addition to state and federal taxes. Some exceptions apply, including:
- withdrawal of up to $10,000 for the purchase of a first home;
- withdrawal to pay qualified education expenses;
- withdrawal to pay certain medical expenses;
- distribution through equal payments over the life expectancy of the owner for at least 5 years or until age 59½, whichever comes later; or
- death or disability of the owner.
4.Name the three categories of tax-deferred retirement plans. How do they differ?
Three major categories of retirement plans are available to an individual, including:
- employer-sponsored plans,
- plans for self-employed persons, and
- individual retirement accounts (IRAs).
An individual may have the option to participate in plans in all three categories contingent upon his or her employment situation. Even a spouse without access to an employer-sponsored retirement plan has the option to establish an IRA. Teenagers or college students with earned income can also use an IRA to start saving for retirement.
5.Briefly describe 401(k), 403(b), and Section 457 plans. How might the employer match vary for each plan? How are maximum contribution limits for each changing?
Three widely available employer-sponsored, salary-reduction plans for tax-deferred retirement savings include the following:
- 401(k) plans: Offered through for-profit companies with over 25 employees. Employer may contribute a match or a percentage of a worker’s contribution. 401(k) plans often allow borrowing of up to 50% of the funds.
- 403(b) plans: Offered through non-profit, or tax-exempt, organizations such as research or education facilities or charitable organizations. Employer matching contributions are not often available. 403(b) plans may allow borrowing of funds.
- Section 457 plans: Offered through state and local governments and other tax-exempt organizations. Employer matching contributions are rarely available.
To encourage retirement savings, maximum contribution limits for each of these plans are at a maximum of $15,500 in 2008. An additional $5,000 maximum catch-up contribution is allowed for workers age 50 and over who wish to contribute additional amounts to their plan ($20,500 total).
6.What do Keogh, Simplified Employee Pension (SEP), SEP- IRA, and Savings Incentive Match Plan for Employees (SIMPLE) plans have in common?
Keogh, SEP, and SIMPLE plans share common characteristics including:
- Eligibility: Available to individuals who are self-employed or employees of small businesses.
- Tax consequences: All three are salary-reduction tax-deferred plans that reduce current year tax liability and avoid taxation on the earnings until the time of withdrawal.
- Limitations on contributions: Limitations on contributions vary with the type of plan.
7.What factors might you consider when choosing between a defined-contribution Keogh plan and a defined-benefit Keogh plan?
Self-employed or small business owners should consider the following when choosing the type of Keogh plan:
- Contribution maximum: The maximum allowable contribution to a defined-contribution Keogh is 100% of compensation or an annual limit amount, with future periodic adjustments for inflation (Note: the 2008 maximum contribution is $46,000). In contrast, a defined-benefit Keogh allows for greater contribution amounts that are not based on earnings.
- Contribution flexibility: The money-purchase defined-contribution plan offers the least contribution flexibility. With this plan, the same percentage of earnings chosen must be contributed every year. Both of the other defined-contribution plans offer year-to-year flexibility in choosing the contribution amount as long as it does not exceed the annual maximum. Defined-benefit Keoghs offer similar flexibility in the amount contributed annually.
- Ease or complexity of establishing and maintaining the account: Keogh plans are established through a bank, mutual fund, or other financial institution that will provide a prototype plan consistent with the Internal Revenue Service (IRS) Code. Because an actuary must oversee a defined-benefit plan, it is the more complicated and costly to establish and operate.
8.What are the advantages and disadvantages of a SEP or SEP-IRA?
A Simplified Employee Pension (SEP) or SEP-IRA plan offers the following advantages to a self-employed individual or employer who establishes SEP-IRAs for his/her employees:
- Contributions are excluded from current year taxable income.
- Contributions (based on earned income and an annual maximum) can exceed the maximum allowable contribution to an IRA.
- Plans are simple to set up with less paperwork and reporting requirements than a Keogh.
- Employer contributions are tax deductible to the employer, another tax incentive.
A SEP or SEP-IRA plan offers the following disadvantage to the self-employed individual or the employer who establishes SEP-IRAs for his/her employees:
- Contribution maximums are less than for a Keogh plan.
The following features can be viewed as advantages or disadvantages, whether viewed from the perspective of the employer or the employee:
- Employers must contribute the same percentage of earnings to an employee SEP-IRA as they do to their own account.
- Contributions do not have to be made every year.
9.Describe a SIMPLE plan.
Businesses that employ 100 or fewer employees may establish a Savings Incentive Match Plan for Employees, or SIMPLE plan, to cover the business owner(s) and employees. Features of a SIMPLE plan include:
- Employees must earn at least $5,000 annually to participate.
- Employee contributions are excluded from the current year taxable income.
- Employer contributions are limited to 3% of the employee’s compensation, but are tax deductible to the business, another tax incentive.
- Employer cannot sponsor another retirement plan.
- Maximum contribution limits apply, currently $10,500 in 2008 with a $2,500 catch-up contribution for workers age 50+.
- Employee owns the account even after termination of employment.
- Plan requires low administrative costs and responsibilities.
10.Explain the differences between a tax-deductible and non-deductible traditional IRA. What is the major benefit regardless of contribution year tax deductibility?
To establish and claim a traditional IRA contribution as an adjustment to income for the current tax year, an individual must (1) not have access to a retirement plan at work OR (2) must meet the annual adjusted gross income (AGI) guidelines for his/her income tax filing status (e.g., single; joint; head of household; or married, filing separately). In addition, part of the contribution may be tax-deductible if AGI falls within the phase-out range for the taxpayer. Once income exceeds the maximum amount of the phase-out range, the contribution to the IRA is not tax-deductible and is referred to as a “non-deductible” traditional IRA.
Regardless of whether a traditional IRA is fully tax deductible, partially tax-deductible, or non-deductible, the earnings on the account grow tax-deferred until withdrawal upon retirement. This can be a significant advantage over saving the same amount in a fully taxable account. Additionally, taxes on all, or a portion of, the amount of current-year income contributed to the IRA are deferred until retirement if the guidelines are met for a fully or partially tax-deductible IRA.
11.Compare and contrast a traditional IRA and the Roth IRA on the following: tax consequences in the contribution year, tax consequences during the withdrawal years after age 59½, withdrawals and minimum distribution requirements (usually referred to as RMDs), and contribution amount.
When comparing traditional and Roth IRAs, consider the following:
- Tax consequences in the contribution year: Both the traditional and Roth IRAs are funded with “after-tax dollars,” or dollars earned and taxed through employment. Contingent upon a taxpayer’s access to a plan at work, income tax filing status, and adjusted gross income (AGI), a traditional IRA contribution may be fully or partially tax-deductible. This, in effect, reduces the income taxes paid in the year of the contribution. A Roth IRA has no tax implications in the contribution year.
- Tax consequences during the withdrawal years after age 59½: Withdrawals of contributions and earnings from a traditional IRA are taxable and treated as ordinary income, assuming the contributions were tax-deductible. If not, only the earnings are taxable. Withdrawals from a Roth IRA are not taxable, assuming the account has been established for more than 5 years and the owner is age 59½ or older.
- Withdrawals and minimum distribution requirements (usually referred to as RMDs): Withdrawals from a traditional IRA must begin no later than April 1 of the year after the year that a taxpayer turns 70½ and are subject to minimum distribution rules (RMDs). Withdrawals from a Roth IRA are not subject to the minimum distribution rules.
- Contribution amount: Contribution limits are the same for traditional and Roth IRAs. Annual limits are $5,000 in 2008, with subsequent inflationary adjustments in $500 increments. Catch-up provisions (a maximum of $1,000 in 2008) allow workers age 50 and over to increase their contributions.
12.List the features of the Coverdell Education Savings Account (ESA).
The Coverdell Education Savings Account (ESA) offers the advantage of tax-deferred growth for funds designated for education. Effective in 2002, these funds can be used for qualified educational expenses for elementary, secondary, or higher education. Other changes effective in 2002 increased the annual contribution to $2,000 and allowed accumulations to continue after a child reaches age 18.
Other features include:
- Contributions are not deductible in the current tax year. In other words, there are no tax savings for the donor in the year of the contribution.
- Withdrawals are tax-free assuming the funds are used solely for the beneficiary’s qualified education expenses.
- Any earnings withdrawn, but not used for education expenses, are included in the gross income of the beneficiary and are subject to income taxation and a 10% penalty tax.
- Unused balances can be rolled over before the beneficiary reaches age 30 to another ESA to benefit a younger member of the beneficiary’s family. A rollover of account balances is penalty-free and tax-free.
- Income restrictions on eligibility to make contributions apply but the maximum income levels and phase out range increased in 2002.
13.Explain an annuity, an immediate annuity, and a deferred annuity. What are the tax consequences of an annuity purchase?
An annuity is a contract between an individual and an insurance company to provide tax-deferred growth on a lump sum, or series of deposits, to be paid to the individual and his/her beneficiary. If an individual dies during the accumulation phase, or before receiving any payments, his or her beneficiary is guaranteed to receive the amount of the original investment. A fixed annuity pays a specified interest rate, while the return on a variable annuity is contingent on the performance of the investment products (stocks, bonds, money market mutual funds) purchased within the annuity contract.
As implied, an immediate annuity pays a lifetime income starting at the time of purchase. A deferred annuity accumulates funds for the future. A number of payout options are available.
Annuity purchases do not affect the current year tax situation of an investor. However, funds grow tax-deferred, and taxes are paid on the earnings when the money is withdrawn at retirement. A 10% penalty is assessed on earnings that are withdrawn before age 59½.
14.What consumer caveats, or warnings, should you consider before purchasing an annuity?
When considering an annuity purchase, do your homework and comparison-shopping. Be sure to consider the following caveats.
- Purchase from a quality insurance company with a record of paying consistently above average returns. To compare products, check the Annuity and Life Insurance Shopper or Best’s Retirement Income Guide to determine the companies that pay the five highest monthly incomes per $1,000 invested.
- Study an annuity contracts to determine the cost structure, characteristics, and rate of return, which vary by company and annuity contract.
- Decrease the risk by buying from two or more companies or buying in different years.
- Recognize that buying an annuity is a long-term commitment (e.g., 15-20 years). Moving the money may be difficult and surrendering or selling the annuity can be expensive.
- Consider the tax consequences, particularly of available tax-exempt or employer-matched retirement savings options, when buying an annuity.