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Income - Head Matters


3. Employer Savings Plan

Now, let’s examine the effect on her future income.

Tina was pretty sure she’d like to invest in her retirement savings account, employer-match plan and wanted to estimate how much money she’d save for her retirement.  She’s now 30 years old and plans to retire at 65.  She knew that her earnings estimates would vary greatly based on the rate of return on her investments; that is, the “yield”, or return on an investment expressed as a percentage of its cost (e.g., $3 annual return divided by $24 price per share of stock= .125 or 12.5 percent rate of return).  In fact, there is no guarantee that there will be a return.  The stock market does not make guarantees.  Knowing this, her future earnings estimates include several rates of return.  Tina assumed the following and made a few calculations to project her savings:

  1. She would work for 35 years before retirement.
  2. Her annual salary would remain at $30,000.
  3. She would contribute $3,000 a year into her RETIREMENT SAVINGS ACCOUNT for 35 years.
  4. Her employer would maintain a 33% match on her contributions.
  5. Her calculations should be based on several interest rate assumptions since rates fluctuate over time.
  6. Interest is compounded daily, and she remains in the 15% tax bracket.

Tina’s savings after 35 years on the job:

    Without Match With Match 
 Total Invested $105,000   $105,000 $140,000 
 Interest Rate on Earnings    After-taxes Savings Account  After-taxes Savings Account 
 2%  $144,292 (after taxes)  $130,036 $173,381 
 3.1% (1925-2004 CPA inflation rate)  $173,536 (after taxes)  $167,075  $216,099
 9%  $514,925 (after taxes)  $599,568  $799,424
11.5% (1970-2004) S&P annual average) $847,619 (after taxes) $1,091,465 $1,455,276

Remember that Tina, like you, will have to pay that tax when she begins to withdraw from her tax-deferred plan.  The tax was just “deferred”, not forgiven.  One disadvantage of a tax-shelter is that you may pay a higher tax rate on the money when you withdraw it.

Some employer plans require you to work a certain amount of time to become fully vested in a plan.  Once you are vested you can keep the amount the employer put in.  If you don’t work the full amount of time, some of the money might be taken back.  You are always vested in the money you contributed from your paycheck.

It is important to note that Tina’s calculations could be refined by considering the effects of inflation on her savings, contributions and investments.  Here are some financial factors she failed to consider when creating her tables:

  1. She did not correct estimates of future earnings to adjust for inflation.  This is important because inflation as measured by the Consumer Price Index (CPI) is an estimate of fluctuations in the cost of consumer goods.  Rising costs means that a saver must earn more than the CPI on savings or she is not gaining money.
  2. She did not correct her contributions to her plan to adjust for inflation.  Tina should adjust her contributions to match the CPI.  If she doesn’t, she is in effect contributing less to savings than when she made her first year’s contribution.
  3. Future raises based on job experience and/or more training are not considered.
  4. Many employers are not as generous as Tina’s.  They often do not match at the 33% level, so be careful to include the actual level of contribution if you are using the calculator.

Let’s estimate the effect an employer-sponsored, tax-deferred, retirement-savings plan could have on your present and future income.
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