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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
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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
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
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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?
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Math for Personal Finance
• Solution: $1000 x .025 = $25
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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
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.
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Check Your Financial IQ
• What is the relationship between liquidity and interest?
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Check Your Financial IQ
• In general, the greater the degree of liquidity, the lower the interest rate offered
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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
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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
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
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
© 2010 Pearson Education, Inc. All rights reserved 0-15
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
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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
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)?
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Math for Personal Finance
• Solution: $5,000 x 1.04 = $5,2000
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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
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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
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Figure 13.1
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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
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
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
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Check Your Financial IQ
• In general, how do people manage to achieve a higher rate of interest in their bank accounts?
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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
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
Figure 13.2
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Figure 13.3
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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
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
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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
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
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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
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
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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
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Figure 13.4
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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
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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
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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
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
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
Employer-Sponsored Retirement 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
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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)
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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
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
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?
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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 = $4500.
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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
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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
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Check Your Financial IQ
• What role do employers play in the retirement savings of many people?
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Check Your Financial IQ
• The offer retirement benefits as a way of attracting good employees
© 2010 Pearson Education, Inc. All rights reserved 0-53
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
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
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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)
© 2010 Pearson Education, Inc. All rights reserved 0-56
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
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
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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
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