Question

Problem 1: What is the Best Way to Save for Retirement?

Derek Ha will save $5,000 p.a. every year for 10 years. At the end of the 10 years he will convert his savings to an ordinary annuity that pays an equal amount at the end of each year for the next 10 years. The annuity interest rate is 4% p.a. His marginal tax rate during the first 10 years will be 40%. His marginal tax rate during the 10 years when he is receiving the annuity will be 25%. He has three possible plans for the account he saves the money in.

PLAN 3

He deposits the $5,000 into an unregistered (taxable) account and invests it in a portfolio of common shares that pay no dividends. The value of the shares grows at 6% p.a. for 10 years. At the end of 10 years he sells all the shares and pays the tax owing, at a marginal tax rate of 40%. Then he buys the 10 year annuity. You would pay tax only on the interest portion of each payment during the 10 years. Chapter 18 shows you how to do this most efficiently, using a prescribed annuity.

Required

What is the annual amount of the annuity after-tax under each of the three plans?

What does this tell you about the best way to save for retirement and why?

Answer 1

Year	Investment	Cumulative Investment	ROI @ 6%
1	0	5000	300
2	5000	10300	618
3	5000	15918	955
4	5000	21873	1312
5	5000	28185	1691
6	5000	34877	2093
7	5000	41969	2518
8	5000	49487	2969
9	5000	57457	3447
10	5000	65904	3954
11	0	69858	0
Total Investments & return	50000	19858
Less: Tax rate @ 40%		7943
Balance available	50000	11915

Year	Balance Available	ROI @ 4%	Tax @ 25%	Withdrawal
	61915
1	56522	2477	619	7250
2	50968	2261	565	7250
3	45247	2039	510	7250
4	39355	1810	452	7250
5	33285	1574	394	7250
6	27034	1331	333	7250
7	20595	1081	270	7250
8	13963	824	206	7250
9	7131	559	140	7250
10	95	285	71	7250

As per above calculation, Derek Ha can withdraw $7250 annuity amount annually.

If Derek Ha doesn't want to take any risks then this is the best way to save for retirement. If he is ready to take some risks, then he can invest in mutual funds having equity and debt plan.