#1 (3 points) Janet is 5 years from retirement and is about to receive a $5,000 bonus from her work. She wants to save it for retirement and can either save it in a regular saving account or put it into her IRA (a retirement account). With an IRA you earn interest first and then pay taxes when you take your money out. So with the IRA she wouldnt pay any taxes on her bonus until 5 years later when she withdraws the money (plus the interest earned). If she receives it now and puts it into a traditional account she has to pay taxes on the original $5,000 right when she receives it. Additionally, the interest you earn from a regular saving account will also be taxed each year. This is not true for an IRA. But, with a regular account, if you earn, say 10% interest, then a 20% tax means you pay 20% 10% = 2% in additional taxes on your interest. Therefore your annual interest rate is only 8% (= 10% - 2%) instead of the pre-tax 10% return.

a)Assume both an IRA and her saving account would earn 7% interest. Also assume she would pay 30% in taxes in either case. After 5 years, would she have more with an IRA and paying taxes later or a regular account and paying taxes now? (Note: to calculate how much is left after taxes, multiply the amount by 20% to get the taxes paid and then subtract that from the original. So, $1.00 * 0.20 = $0.20 paid in taxes and $0.80 left over. For the saving account, youll also need to compute an after-tax annual interest rate as shown above.)

b) Would you expect the availability of IRAs to increase the amount that households save? Dis- cuss in light of (1) the response of the saving to changes in the real (after tax) interest rate and (2) psychological theories of saving. Note that IRAs contain penalties if you remove your saving early.