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

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

2 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

3 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 2010 Pearson Education, Inc. All rights reserved 0-3

4 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 2010 Pearson Education, Inc. All rights reserved 0-4

5 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 2010 Pearson Education, Inc. All rights reserved 0-5

6 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? 2010 Pearson Education, Inc. All rights reserved 0-6

7 Math for Personal Finance Solution: $1000 x.025 = $ Pearson Education, Inc. All rights reserved 0-7

8 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 2010 Pearson Education, Inc. All rights reserved 0-8

9 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 Pearson Education, Inc. All rights reserved 0-9

10 Check Your Financial IQ What is the relationship between liquidity and interest? 2010 Pearson Education, Inc. All rights reserved 0-10

11 Check Your Financial IQ In general, the greater the degree of liquidity, the lower the interest rate offered 2010 Pearson Education, Inc. All rights reserved 0-11

12 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 2010 Pearson Education, Inc. All rights reserved 0-12

13 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 2010 Pearson Education, Inc. All rights reserved 0-13

14 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 2010 Pearson Education, Inc. All rights reserved 0-14

15 Interest Bearing Savings Accounts Savings accounts are accounts that you can withdraw money at any time, but do not provide checkwriting 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 2010 Pearson Education, Inc. All rights reserved 0-15

16 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 2010 Pearson Education, Inc. All rights reserved 0-16

17 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 2010 Pearson Education, Inc. All rights reserved 0-17

18 Math for Personal Finance 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)? 2010 Pearson Education, Inc. All rights reserved 0-18

19 Math for Personal Finance Solution: $5,000 x 1.04 = $5, Pearson Education, Inc. All rights reserved 0-19

20 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 2010 Pearson Education, Inc. All rights reserved 0-20

21 Money Market Deposit Account (MMDA) MMDAs provide only very limited checkwriting 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 2010 Pearson Education, Inc. All rights reserved 0-21

22 Figure Pearson Education, Inc. All rights reserved 0-22

23 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 2010 Pearson Education, Inc. All rights reserved 0-23

24 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 2010 Pearson Education, Inc. All rights reserved 0-24

25 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 2010 Pearson Education, Inc. All rights reserved 0-25

26 Check Your Financial IQ In general, how do people manage to achieve a higher rate of interest in their bank accounts? 2010 Pearson Education, Inc. All rights reserved 0-26

27 Check Your Financial IQ By choosing options that limit liquidity for example. NOW accounts versus checking accounts or CDs versus savings accounts 2010 Pearson Education, Inc. All rights reserved 0-27

28 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 2010 Pearson Education, Inc. All rights reserved 0-28

29 Figure Pearson Education, Inc. All rights reserved 0-29

30 Figure Pearson Education, Inc. All rights reserved 0-30

31 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 2010 Pearson Education, Inc. All rights reserved 0-31

32 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 2010 Pearson Education, Inc. All rights reserved 0-32

33 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 2010 Pearson Education, Inc. All rights reserved 0-33

34 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 2010 Pearson Education, Inc. All rights reserved 0-34

35 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 2010 Pearson Education, Inc. All rights reserved 0-35

36 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 2010 Pearson Education, Inc. All rights reserved 0-36

37 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 2010 Pearson Education, Inc. All rights reserved 0-37

38 Figure Pearson Education, Inc. All rights reserved 0-38

39 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 2010 Pearson Education, Inc. All rights reserved 0-39

40 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 2010 Pearson Education, Inc. All rights reserved 0-40

41 Employer-Sponsored Retirement 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 2010 Pearson Education, Inc. All rights reserved 0-41

42 Employer-Sponsored Retirement Plans 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 2010 Pearson Education, Inc. All rights reserved 0-42

43 Employer-Sponsored Retirement Plans 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 2010 Pearson Education, Inc. All rights reserved 0-43

44 Employer-Sponsored Retirement Plans Definedcontribution 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 2010 Pearson Education, Inc. All rights reserved 0-44

45 Employer-Sponsored Retirement Plans 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) 2010 Pearson Education, Inc. All rights reserved 0-45

46 Employer-Sponsored Retirement Plans 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 2010 Pearson Education, Inc. All rights reserved 0-46

47 Employer-Sponsored Retirement Plans 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 2010 Pearson Education, Inc. All rights reserved 0-47

48 Math for Personal Finance 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? 2010 Pearson Education, Inc. All rights reserved 0-48

49 Math for Personal Finance Solution: His employer will contribute an additional $3,000 x $.50 = $1,500 so his total contributions will be $3,000 + $1,500 = $ Pearson Education, Inc. All rights reserved 0-49

50 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 2010 Pearson Education, Inc. All rights reserved 0-50

51 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 2010 Pearson Education, Inc. All rights reserved 0-51

52 Check Your Financial IQ What role do employers play in the retirement savings of many people? 2010 Pearson Education, Inc. All rights reserved 0-52

53 Check Your Financial IQ Employers offer retirement benefits as a way of attracting good employees Pearson Education, Inc. All rights reserved 0-53

54 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 2010 Pearson Education, Inc. All rights reserved 0-54

55 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 2010 Pearson Education, Inc. All rights reserved 0-55

56 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 definedcontribution plans) 2010 Pearson Education, Inc. All rights reserved 0-56

57 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 2010 Pearson Education, Inc. All rights reserved 0-57

58 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 2010 Pearson Education, Inc. All rights reserved 0-58

59 Websites Cgi.money.cnn.com Pearson Education, Inc. All rights reserved 0-59