Individual retirement accounts, or IRAs, were established by the U.S. government to encourage saving. An individual who deposits part of current earnings in an IRA does not have to pay income taxes on the earnings deposited, nor are any income taxes charged on the interest earned by the funds in the IRA. However, when the funds are withdrawn from the IRA, the full amount withdrawn is treated as income and is taxed at the individual's current income tax rate. In contrast, an individual depositing in a non-IRA account has to pay income taxes on the funds deposited and on interest earned in each year but does not have to pay taxes on withdrawals from the account. Another feature of IRAs
that is different from a standard savings account is that funds deposited in an IRA cannot be withdrawn prior to retirement, except upon payment of a substantial penalty.
a) Greg, who is five years from retirement, receives a $10,000 bonus at work. He is trying to decide whether to save this extra income in an IRA account or in a regular savings account. Both accounts earn 5 percent nominal interest, and Greg is in the 30 percent tax bracket in every year (including his retirement year). Compare the amounts that Greg will have in five years under each of the two saving strategies, net of all taxes.
If Greg invests in the IRA, his net value (after taxes) five years from now will be: $_____??
If Greg invests in the normal savings account, his net value (after taxes) five years from now: $________????
Greg will be better off if he invests in the .
b) In light of Greg's situation, does the existence of IRAs as an investment option increase his likelihood to save when considering the effect of changes in the real interest rate?
In light of Greg's situation, does the existence of IRAs as an investment option increase his likelihood to save when considering the psychological theories of savings?