Savings Annuities

Learning Outcomes

  • Calculate the balance on an annuity after a specific amount of time
  • Calculate interest earned and amount deposited in an annuity problem

Savings Annuity

For most of us, we aren’t able to put a large sum of money in the bank today. Instead, we save for the future by depositing a smaller amount of money from each paycheck into the bank. This idea is called a savings annuity. Most retirement plans like 401k plans or IRA plans are examples of savings annuities.

Glass jar labeled "Retirement." Inside are crumpled $100 bills

Listed below is the savings annuity formula.

Annuity Formula

[latex]P_{N}=\frac{d\left(\left(1+\frac{r}{k}\right)^{Nk}-1\right)}{\left(\frac{r}{k}\right)}[/latex]

  • PN is the balance in the account after N years.
  • d is the regular deposit (the amount you deposit each year, each month, etc.)
  • r is the annual interest rate in decimal form.
  • N is the number of years
  • k is the number of compounding periods in one year.

If the compounding frequency is not explicitly stated, assume there are the same number of compounds in a year as there are deposits made in a year.

For example, if the compounding frequency isn’t stated:

  • If you make your deposits every month, use monthly compounding, k = 12.
  • If you make your deposits every year, use yearly compounding, k = 1.
  • If you make your deposits every quarter, use quarterly compounding, k = 4.
  • Etc.

When do you use this?

Annuities assume that you put money in the account on a regular schedule (every month, year, quarter, etc.) and let it sit there earning interest.

Compound interest assumes that you put money in the account once and let it sit there earning interest.

  • Compound interest: One deposit
  • Annuity: Many deposits.

Recall order of operations

Using the order of operations correctly is essential when using complicated formulas like the annuity formula.

PEMDAS: First simplify like terms inside parentheses then handle exponents before multiplying or dividing. Do addition and subtraction outside of parentheses last.

Examples

A traditional individual retirement account (IRA) is a special type of retirement account in which the money you invest is exempt from income taxes until you withdraw it. If you deposit $100 each month into an IRA earning 6% interest, how much will you have in the account after 20 years?

This example is explained in detail here.

 

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A conservative investment account pays 3% interest. If you deposit $5 a day into this account, how much will you have after 10 years? How much is from interest?

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Solving For The Deposit Amount

Financial planners typically recommend that you have a certain amount of savings upon retirement.  If you know the future value of the account, you can solve for the monthly contribution amount that will give you the desired result. In the next example, we will show you how this works.

Example

You want to have $200,000 in your account when you retire in 30 years. Your retirement account earns 8% interest. How much do you need to deposit each month to meet your retirement goal?

View the solving of this problem in the following video.

 

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