Financial Planning Time Value of Money

In early March 1996, Amborose Studebaker is discussing with his economist friend, Phyllis Comer, various ways to enable Studebaker to accumulate additional money in 20 years Studebaker reaches the age of 60.

BACKGROUND

A local financial planner, R.G.D. Morton, had suggested that Studebacker, a nationally known historian, borrow the equity accumulated in his home and invest it plus $30,000 of excess cash in a single-premium life insurance policy. This appeared to be quite an attractive investment until Comer pointed out a number of problems with this strategy and said that more money could be accumulated in a variety of ways.

Studebaker, desirous of acting in a prudent manner with his savings, was obviously upset at his failure to detect the flaws in Mortons presentation. Comer noted, however, that Morton had uncovered two extremely important facts. First, Studebaker had an obvious need for some type of safe, long-term, tax-sheltered investment, and second, he had excess yearly income in addition to the money market fund that could be placed in such an investment, a review of Studebaker.s situation confirmed the following.

First, Studebakers life insurance situation was adequate.

Second, it was extremely unlikely that the $30,000 of excess cash in the money market fund would be needed.

Third, Studebaker, due to royalties from a best-selling college textbook, could afford tO gave his annual income reduced by 3,052 after-tax dollars. And finally, any funds accumulated in 20 years would be used for a possible early retirement or to defray the education expenses of a newborn child.

THE CURRENT MEETING

Comer realizes that Studebaker is interested in specific investment suggestions but thinks it is the best to begin by explaining the gain from the tax-free accumulation of interest. The excess $30,000 in the money market earns 5 percent per year compounded monthly, which converts to a 5.12 percent annualized return.since interest is taxable as it is earned each year, however, the money is only growing at a 3.58 percent annual rate since Stubaker is in the 30 percent tax bracket. This means that 60,623 after-tax dollars will be accumulated after 20 years. If this money could grow tax free then there would be 81,438 before-tax dollars and 66,007 dollars after taxes at the end of the same period. This is an increase of nearly 10 percent. Comer then points out that some investments have even more advantages and gives Studebaker a handout on the various ways that investment could be taxed.

Two Tax-deferred Investments: The SPA and the TDA

The discussion next focuses on two investments vehicles for which Studebaker is eligible. One is a single-premium, tax-deferred annuity (SPA); the other is a tax-deferred annuity (TDA). The first investment requires Studebaker to invest after tax dollars, and taxes on any accumulated interest are due only when funds are withdrawn. The TDA has even more advantages. An individual can invest before tax dollars and the money grows tax-free. When the funds are withdrawn, taxes are due on the full accumulation value. This investment is only available to individuals employed at certain nonprofit institutions; it must be done as a part of a payroll deduction; and there is a limit on the amount per year that can be done invested. This limit is relatively generous and in Studebakers case would be $12,000 per year.

Both the TDA and the SPA would pay a higher return than the money market. Comer then explains that there are numerous companies offering single-premium, tax -deferred annuities, and Studebabker is free to choose whichever one he wants. Core does, however, highly recommend Mahac, Inc. Mahac pays a competitive return of 7 percent and imposed no penalty if the funds are withdrawn after two years. The options with the tax-deferred annuity are more limited, however. Comer reminds Studebaker that the money can be placed in a TDA only as a part of payroll deduction and only with a company that has obtained the approval of Studebakers university.

Northern Annuities and Modern Investments

At present only two companies have university approval to offer their TDAs on campus. One firm, Northern Annuities, pays a 7 percent return and imposed no Penalties on any withdrawals after 1 year. The other firm, Modern Investments, currently pays 8% but imposes a substantial penalty if the funds are withdrawn before the investor reaches the age 55. Studebaker wonders if Modern Investments isn't the more appropriate company for his situation considering that offers the higher yield, and I shouldn't need this money prior to age 60, which suggests the withdrawal penalty is irrelevant,. The problem, Comer explains, Is that you may want to withdraw the money to invest somewhere else. Just because Modern Investments offers the higher return today doesn't mean it will in the future. Studebaker is quick to see the point. By imposing substantial withdrawal penalties, Modern Investment essentially locks an investor in until age 55 and could, if it wishes, reduce the yield below competitive rates. Fortunately there is a floor to any rate drop. Modern Investments does a lot of penalty-free withdrawal if it pays, at any time, the rates below 5% per year. In addition, the Firm guarantees the 8 percent rate for at least 10 years.

Three investment scenarios

Come then says she will compare three possible strategies starting with the as is Scenario. This involves leaving the $30,000 in the money market and investing Studebaker success 3,052 after-tax dollars each year in the money market. Though she is certain that this is not the way to go, Comer feels it will serve as a useful benchmark.The second strategy involves placing the $30,000 into an SPA and then putting Studebakers excess yearly income into a TDA. Third is more subtle. This eventually involves putting everything into a TDA. The trick is how to move the $30,000 into the TDA. Comer recommends that Studebaker increase the yearly amount in the TDA to the legal maximum of $12,000. This, of course, would mean that Studebakers remaining income would be insufficient to cover his yearly expenses. To cover this shortfall, therefore, Comer recommends using the funds in the money market until they run out and then reducing the amount placed in the TDA.

Studebaker next asks about the risk of each strategy. Comer says the default risk of all the investment is infinitesimal since all involved very safe investments in the companies are rated A+ by A.M. Best Company. The liquidity risk is the chance that Studebaker will need some, if not all, of his money but will not be able to get it without incurring a large penalty. Federal law allows penalty-free withdrawals on each investment after the owner reaches the age 59 , income taxes would have to be paid on any liquidated amount that had previously gone untaxed. (The untaxed amount would be the accumulated interest with SPA and the entire amount in a TDA.) Before this age the law allows withdrawals for any purpose on the SPA but with a 10% penalty in addition to the income tax due. The TDA is more restrictive. Under present text laws withdrawals before age 59 , or only allowed in the event of (1) death; (2) disability; (3) separation from service (as a professor); and (4) hardship. In all cases taxes would be due on any funds removed from the TDA, though the IRS does allow tax-free transfers from one TDA to another. Comer also pointed out that the IRS has not rigorously defined what constitutes a hardship. In short, she says, if you choose a TDA you are pretty much locked in until age 59 1/2 the way the present tax laws read, unless you want to move funds from one TDA to another.

Before doing the analysis comer decides that it is quite reasonable to assume that (1) any money placed in the SPA will earn 7% over the 20-year time horizon; (2) Northern Annuities (a TDA option) will also pay 7%; and (3) Modern Investments, the other TDA option, will pay 8 percent for the first 10 years (the guaranteed time) and 5 percent for the last 10. Under these conditions Comer would assume that any money placed with Modern Investments would grow at 8 percent during years 1 to 10 and 5 percent in years 11 to 15. Studebaker would then have reached age 55 and could move these funds without penalty to Northern Annuities. Thus, Studebakers money would earn 7 percent during years 16 to 20.

Question

Instructions

1. Provide enough detail on calculations and assumptions to allow the instructor to understand how the answer was calculated.
2. Write in complete sentences for questions that request explanations (i.e. complete sentences are not needed if the answer is a number)
3. Provide answers on an electronic medium that is separate from this page.

3a)If 30,000 after-tax dollars are invested at 7 percent in a single premium tax-deffered annuity, how many after-tax dollars will be accumulated in 20 years?

(b)Studebaker can afford to have his annual income reduced by 3,052 after-tax dollars. How much is this before taxes? If these before-tax dollars are invested each year at 7 percent, how many after-tax dollars will be accumulated in 20 years?

(c) Redo part (b) assuming 8 percent is earned during years 1 to 10, 5 percent during years 11 to 15, and 7 percent in years 16 to 20

4

a) Studebaker is eligible to put 12,000 before-tax dollars each year into a tax deffered annuity (TDA). In order to invest in a TDA, However, he must have his spendable income of $3,052 each year without disrupting his lifestyle. One investment option is to increase the amount placed into a TDA each year to the legal maximum of $12,000 and move funds from the money market to cover the resulting shortfall in studebakers spendable income. How much money will he need to transfert each year form the money market (round your answer to the next highest year)

4. (b) Assume Studebaker will earn a 4% after-tax annual return in the money market. For how many years can he contribute the maximum amount to the TDA and cover any shortfall in the spendable income with the funds from the money market? (Round your answer to the next highest year.)

(c) How many after-tax dollars will be accumulated in 20 years if the legal maximum is placed in the TDA as long as possible and a 7-percent annual return is earned? (Keep in mind that Studebaker would reduce the amount invested in the TDA when the funds in the money market are exhausted.)

(d) Redo your answer part (c) assuming 8 percent is earned during the years 1 to 10, 5 percent years 11 to 15, and 7 percent in year 16 to 20.

5. Based on your previous calculations and other information in the case, what do you recommend? Justify your answers.

For all three situations assume the investor:

Exhibit 1.

1. Has 4,000 before-tax to invest.
2. Is in the 40-percent tax bracket (combines federal and state).
3. Can earn 10-percent annual Terhune before taxes.
4. \will remain in the 40-percent bracket.

We will compare the amount of after-tax dollars accumulated in 10 years under different tax situations.

Situation One After-tax dollars are invested and taxes must be pays year on any interest earned. Under our assumptions $2,400 is invested and will grow at a rate of 6-percent per annum.No taxes will be due at the end of 10 years and the amount of the after-tax dollars Accumulated will equal

P10= 2,400 (1.06) ^10 = $4,298

Situation Two after tax dollars are invested, but taxes on the interest can be deferred for 10 years. Under our assumptions, $2400 is invested and will grow at a rate of 10 percent per annum. The amount of investment after 10 years will be

P10= 2,400(1.1) ^10 = $6,225

This is now, however, the amount of after-tax dollars available since the investor owes taxes on the accumulated interest of $3,825 parentheses ($6225 -$2400), taxes due are $1,530 ($3825.40). Does, 4,695 after-tax dollars ($6225 -$1530) will be accumulated, this is a 9.2% increase over the first situation.

Situation three before tax dollars are invested, and the taxes on the interest can be deferred for 10 years. Thus, all taxes can be postponed For 10 years. Under our instructions, $4000 is invested and will grow at a rate of 10% per annum. The amount of investment after 10 years will be

P10= 4,000 (1.1) ^10=$10,375

This is not, however, equal the after-tax dollars available says the investor who is the taxes on the amount. The taxes are due to $4150 ($10,375 x .40). Does, 6225 after dollar tax ($10,375 -$4150) will be accumulated. This is an increase of 45% compared to the first situation and 33% compared to the second.