Methods of Saving © 2010 Pearson Education, Inc. All rights reserved Chapter 13

Methods of Saving

© 2010 Pearson Education, Inc.All rights reserved

Chapter 13

Learning Objectives

• Explore the ways in which savings can earn interest

• Examine the different types of bank accounts that can aid in saving

• Describe retirement savings options

© 2010 Pearson Education, Inc. All rights reserved 0-2

Interest and Your Savings

• Banks are a great place to keep savings

• They offer safety and security

• Many types of banks offer interest on deposits

• Your money in your savings is making money and helping your savings grow


Interest Rates on Deposits

• Banks and similar financial institutions make money by borrowing and lending money

• They take in money from depositors

• They use that money to make loans, on which they charge interest


Interest Rates on Deposits

• The amount of interest the financial institution pay depends on several factors

• One factor is the length of time

• The longer you are willing to leave the money, the higher the rate

• Other factors that include: – the policies of the

financial institution

– the market rates of interest


Math for Personal Finance

• Candace put $1000 in a savings account that pays 2.4 percent in annual interest.

• How much interest will she earn during the year?



• Solution: $1000 x .025 = $25


Market Rates of Interest

• The Federal Reserve has a significant impact on the market rate of interest

• The Fed stimulates the economy or slows it down by manipulating the money supply

• The Fed influences the interest rate market when it sets the discount rate, or the interest rate it charges banks for loans


Liquidity

• Liquidity refers to how quickly you can convert something to cash without significant loss of value

• Interest rates offered for deposits differ depending on the level of liquidity the account offers

• Accounts that offer a high degree of liquidity usually offer the lowest interest rates

• Offering people quick access to their money limits their ability to make money on their money.


Check Your Financial IQ

• What is the relationship between liquidity and interest?



• In general, the greater the degree of liquidity, the lower the interest rate offered


Types of Bank Accounts

• Banks offer a wide range of different accounts and services

• Each type has benefits and drawbacks

• Understand the basic features of the different types of accounts available


Checking and NOW Accounts

• Demand deposit is the money put into a checking account

• Basic checking accounts are the most liquid type of bank account

• You can access your money instantly by writing a check or using an ATM

• The liquidity of a checking account helps explain why traditional checking accounts do not pay interest


Checking and NOW Accounts

• Negotiable order of withdrawal (NOW) accounts function like a checking account, but do pay interest

• You can write drafts (checks) on NOW accounts

• Most NOW accounts require you to maintain a minimum monthly balance, or pay higher interest rates


Interest Bearing Savings Accounts

• Savings accounts are accounts that you can withdraw money at any time, but do not provide check-writing services

• Savings accounts pay a little higher rate of interest on deposits than NOW accounts

• These accounts are still very liquid in that you can withdraw money at any time

• People often use a savings account to save money for specific purposes


Certificates of Deposits (CDs)

• Certificate of deposit (CD) is essentially a contract between an individual and the financial institution that specifies some length of time that the individual will leave a certain amount of money deposited at the particular bank

• Certificates of deposits are a financial product offered by many financial institutions

• CDs specify a minimum amount invested and have a specific maturity date

• Common CD maturities are one month, three months, six months, one year, three years, and five years


Certificates of Deposits (CDs)

• CDs offer a higher interest rate than savings accounts

• You can access your money prior to maturity, but will pay a penalty for early withdrawal

• Consider CDs only when you know that you will not need the money until after the CD matures



• Brooke bought a one year $5,000 CD that pays 4 percent interest annually

• How much will she have at the end of the year (assuming all the interest earned is added at year’s end)?



• Solution: $5,000 x 1.04 = $5,2000


Money Market Deposit Account (MMDA)

• Money market deposit accounts require you to maintain a minimum balance, have no maturity date, pay interest, and offer limited check-writing privileges

• Money market deposit accounts have some of the features of checking accounts and some of savings accounts

• Most MMDAs impose fees if your balance falls below the minimum or if you write more checks than allowed


Money Market Deposit Account (MMDA)

• MMDAs provide only very limited check-writing privileges and pay a higher rate of interest

• Many people use both a NOW account and MMDA account for their typical monthly expenditures

• Take a look at Figure 13.1 to see various money market investments and their advantages and disadvantages


Figure 13.1


About Credit Unions

• Credit unions differ from other depository financial institutions due to their nonprofit status

• A credit union does not exist to earn money for investors, but to serve its members

• Its members are the people who deposit money in the institution

• Credit unions often pay higher interest rates on deposits than an ordinary bank


APY and Comparing Savings Options

• Compound interest refers to the way that interest added to an account earns interest

• It might be necessary to compare savings options that have different compounding frequencies

• Compounding frequency is how often the bank puts interest you have earned into your account

• More frequent compounding is better given the same interest rate


APY and Comparing Savings Options

• Annual percentage yield (APY) is the interest rate that takes the compounding frequency into account

• APY tells you what your account will really earn on an annual basis once compounding is taken into consideration

• Always use APY as a tool to evaluate savings options that have different compounding frequencies

• Banks must make the APY available to you



• In general, how do people manage to achieve a higher rate of interest in their bank accounts?



• By choosing options that limit liquidity—for example. NOW accounts versus checking accounts or CDs versus savings accounts


Retirement Savings Options

• Saving for retirement is critical

• If you start saving now, you can accumulate a lot more than if you waited for a few more years

• Take a look at the next 2 figures so see how much difference a few years in savings can make


Figure 13.2


Figure 13.3


Individual Retirement Accounts (IRAs)

• Individual retirement accounts (IRAs) are a type of savings account created by the government to encourage people to save for retirement

• The government offers certain tax benefits that allow investors of an IRA to reduce their income taxes

• They also put limits on when you can use IRA funds to make sure people only use then for retirement


IRAs

• All IRAs can include a range of different types of investments

• There are two main types of IRAs:– Traditional IRAs – Roth IRAs

• They differ in the type of tax benefit they provide


IRAs

• Traditional IRAs allow people to make tax deductible contributions, and all earnings are tax deferred

• Tax deductible means that if you are eligible and contribute, say $3000 in a given year, you can deduct $3000 from your taxable income and pay no federal tax on that amount

• Traditional IRAs are tax deductible and tax deferred

• This feature allows you to reduce your income taxes for the year you made the contribution


IRAs

• Tax deferred means that the account’s earnings, such as from interest, are not taxed until they are withdrawn after retirement

• Tax deferral helps you in two ways

• A tax-deferred account grows in value more quickly than one earning the same rate but in which earnings are taxed

• When you do withdraw monies, it may be at a lower tax rate because you will be retired


IRAs

• The tax-deferred benefit of traditional IRAs is available to everyone

• Certain higher-income individuals are not allowed to deduct contributions from their taxes

• There are limits on how much a person can contribute to a traditional IRA


IRAs

• Roth IRA contributions are not tax deductible, but the earnings from an eligible account are never taxed, even after withdrawal

• The Roth IRA has the same contribution limits as the traditional IRA

• Eligibility to contribute to a Roth IRA phases out at high levels of income

• Roth IRAs have their own rules for how the money is distributed at retirement


IRAs

• Which type of IRA is right for you?

• There are various online tools that can help you make the choice that best meets your needs

• See Figure 13.4 for an example of one of these tools


Figure 13.4


IRAs

• Self-employed people may be eligible for a Simplified Employee Plan IRA (SEP-IRA).

• These function much like traditional IRAs, but they have their own contribution limits


Employer-Sponsored Retirement Plans

• Employer-sponsored retirement plans are set up by the employer, and the employer will generally make some contributions to the plan on your behalf

• Many full time working people have an employer-sponsored retirement plan

• These plans are designed to help you save for retirement

• Employers are not bound to offer such plans



• Employer sponsored plans come in two main forms: – the defined-benefit plan

– the defined-contribution plan

• There are many variations within each of these categories

• But, in both cases, you do not pay taxes on the contributions or the earnings until you retire and begin making withdrawals



• Defined-benefit plans guarantee you a specific amount of income when you retire

• Pension plans is when employers make contributions to the plan on the employee’s behalf

• The benefit of defined-benefit plans is often based on the number of years worked and the average salary earned during peak earning years

• Money from pension plans goes into a large fund

• Professional managers then invest and manage the fund



• Vesting is the process of earning eligibility for an employer benefit

• When an eligible person retires, he or she receives the agreed-to benefit from the fund

• Defined-benefit plans are less common than in the past

• People are living longer creating more financial risk for employers providing these plans



• Defined-contribution plans is when the employer contributes to the employee’s retirement account but does not guarantee a specific retirement benefit

• Defined-contribution plans offer the employee some control over where contributions are invested

• These plans limit the employer's liability to the individual

• When an individual’s funds are gone, the employer has no other obligation to that individual



• 401(k) and 403(b) plans allow employees to make contributions into their own accounts, which may feature an a range of investment options

• For-profit companies can establish 401(k) plans for their employees

• Nonprofit and charitable institutions can offer employees a similar type of plan, called a 403(b)



• The money employees contribute to these plans reduces their taxable income and therefore lowers the taxes withheld from their checks

• The money would be taken from your pay before your tax was withheld

• When you take money from your 401(k) at retirement, you pay income taxes on it



• Many employers offer employer matching on plan contributions

• 401(k) and other defined-contribution plans often offer choices about how much to contribute

• It is important to contribute to these, especially when employee contributions are matched up to some level by employers



• Barton’s employer has a 401k plan where they match $.50 of every $1 he contributes up to $3,000

• How much will the total contributions into his 401k be this year if he contributes $3000?



• Solution: His employer will contribute an additional $3,000 x $.50 = $1,500 so his total contributions will be $3,000 + $1,500 = $4500.


Annuities

• Annuities are a type of financial product that guarantees annual payments to the owner for a fixed period of time or for a person's lifetime

• Annuities generally require a minimum investment

• The amount invested grows tax free

• It will not be taxed until disbursed to the investor/retiree


Annuities

• Fixed annuity is when the return and ultimate payment is a guaranteed amount

• Variable annuity is when the return and ultimate payment depend on the performance of the investments

• Annuities come in two forms: fixed and variable

• Most annuities have high fees associated with the initial sale

• Annuities also have fees, known as surrender charges, for early withdrawal



• What role do employers play in the retirement savings of many people?



• The offer retirement benefits as a way of attracting good employees


Summary

• Banks offer safety and security and, in most cases, a chance to earn interest

• Banks offer a wide range of different accounts and services

• It is important to understand the basic features of different types of accounts for saving money


Summary

• Popular short-term saving accounts include checking accounts, NOW accounts, savings accounts, CDs, and MMDAs

• Checking accounts and NOW accounts offer the most liquidity, but also the lowest rates


Summary

• Retirement should be a key savings goal

• Individual retirement accounts come in several forms and help promote retirement savings by offering some valuable tax advantages

• Employers often offer retirement savings plans (defined-benefit plans or defined-contribution plans)


Summary

• Many employers encourage employees to contribute to 401(k) or 403(b) plans

• Self-employed people may be able to set up a Simplified Employee Plan IRA (SEP-IRA)

• Annuities are also commonly used for retirement savings


Key Terms and Vocabulary

• 401(k)/403(b) plan• Annual percentage yield (APY)• Annuity• Certificate of deposit (CD)• Compound interest• Defined-benefit plan• Defined-contribution plan• Demand deposit• Employer-sponsored retirement

plan• Fixed annuity• Individual retirement account

(IRA)

• Liquidity• Money market deposit

account• Pension plan• Roth IRA• Savings account• SEP-IRA• Tax deductible• Tax deferred• Traditional IRA• Variable annuity• Vesting


Websites

• www.piggybankpage.co.uk

• www.bankofamerica.com

• Cgi.money.cnn.com

• www.bankofamerica.com

• www.irs.gov

• www.lfg.com

• www.finance.cch.com


Documents

Methods of Saving © 2010 Pearson Education, Inc. All rights reserved Chapter 13