In: Finance
Stephen Watkins
4.Stephen plans to retire in twenty years at age sixty seven, at which time he will be in the 24 percent marginal income tax bracket. He is considering the purchase of a $200,000 face value whole life policy. The annual premium is $4,000. Alternatively, he is thinking that he could buy a twenty-year $200,000 face value term policy for $500 per year.
a.If he implements a buy term and uses ‘the invest the difference’ strategy, and can earn 8 percent annually in a Roth IRA (assume he saves annually for twenty years), how much will be in his account when the term policy expires?
b.If Stephen were to die at age sixty eight (one year after the term policy expires and he has stopped saving), which strategy (buy the cash value policy or buy the term policy and invest the difference) is the better choice if he continues to save in a Roth IRA?
c.If instead Stephen were to purchase a twenty five-year term policy for $500 per year in premiums, and he were to die at age seventy three (one year after the term policy expires and he has stopped saving), which strategy (buy the cash value policy or buy the term policy and invest the difference) is the better choice if he continues to save in a Roth IRA?
d.Would your answers change if Stephen used a traditional IRA?
Stephen was recently diagnosed with cancer. He underwent treatment and was found to be healthy and cancer free. However, Stephen worries that in the future he might have a reoccurrence, which could affect his chances of obtaining life insurance. If his budget is constrained and he can only afford a twenty-year term policy, what feature(s) or policy rider(s) should he purchase to enable him to continue coverage in the future even if the cancer returns?
this is the entire question
a. Whole life policy worth $200,000 and pemium $4000 for 20 years
Term policy of $200000 and premium of $500 and Invest the difference = $4000 - $500 = $3500 in Roth IRA which a return of 8%, all tax free.
At the end of the term, the investment of difference ($3500) in ROTH IRA can be calculated using the FV function in excel
Here, rate = 8%,
Term or NPER = 20,
PV = 0,
Investments =PMT = - $3500 (Cash outflow)
Type is 1
Thus FV = FV(8%, 20,-3500,0,1) = $172,980.23 (Value of Investment in Roth IRA)
B.
While his policy expires, he wouldnt be investing in Roth IRA, but his investment would still accrue interest
In the 21 st year, the value of Roth IRA investment would be = $172980.23 X (1+8%) = $ 186,818.64
However the whole life policy would have paid $200,000 at death.
The buy in cash policy (Whole life policy), which would pay $200000 is better than "Invest the difference" policy which would accumulate $186,818.64
C.
Buy the Cash value policy would pay $200000 at death.
If stephen chooses a 25 yr term policy and invest the difference for 20 years in Roth IRA, the value of investment at the year end 26 (one year after term policy expires) is the Future value of investments done till year 20 and grown at 8% thereafter
Here, we will use excel functiuon FV or same can be applied in financial calculator
Rate = 8%
NPER = 6 (6 years after 20 years)
Investments = PMT = 0 (No investment after year 20)
PV = Present value of investments at year 20 = $172,980.23 (This investment would continue to earn returns at 8%)
Type =1
Future Value = FV(8%,6,0,172980.23,1) = $274,497.89
Therefore invest the difference in Roth IRA is a better choice
D.
In an traditional IRA, the capital gain is taxed
Thus in previous case, the FV value of investment was $274497.89
The investments are $3500 x 20 = $70,000
Capital Gain = $274497.89 - $70000 = $204497.89
Now this gain would be taxed at 24% = 24% x $204497.89 = $49079.49
The real value of investment would be $274497.89 - $49079.49 = $ 225418.39
The decision would still be same, Invest in the difference