Understanding the Mathematics of Personal Finance

A BENCHMARK SAVINGS PLAN

In order to understand the advantages (and possible pitfalls) of a fixed annuity, it’s useful to compare the annuity to a personal savings plan. The spreadsheet on my website Ch11FixedAnnuities. xls will help with these calculations. Go to the IAWPC tab (I ’ Il explain this mysterious acronym soon). This example is shown in Table 11.1 .

In this spreadsheet, I chose a starting month as month #1 so that the month number and the number of months gone by would be the same. The spreadsheet fixes the starting year at 1; I did this because we we’re looking at years into the plan rather than actual dates.

I want to receive a payment of $2,500 each month, for 20 years, from this account. The annual percentage rate (APR) is 4.0%. My tax rate is 25%.

The calculated principal is $413,930 (top of column H). This is the amount that I have to deposit so that this account can fund my $2,500 monthly withdrawals for 20 years. Each month, the balance accrues interest. This interest will help to fund the plan. When I’m earning interest, I suddenly have a partner in this enterprise—the IRS. Savings bank interest is taxable. Each year, in month 4 (April), I have to pay income taxes.

With the tax rate entry set to 25%, the spreadsheet shows that in April of year 2, I must mail off $4,052 tax payment on this interest.[29] The tax bill column (column

K) shows all the tax bills for the 20 years of the plan, and the PV column (column

L) shows the present value of these bills reflected back to day 1.

For this example, the present value of the taxes is $37,322 (see the top of column L). You’ll need this much available to pay for your taxes if you want this plan to be adequately funded to give you $2,500 a month for 20 years.

Having to take federal income tax into consideration forced an increase of $37,322 in principal. Now let’s see if there’s a way of saving some of this money.