What’s Your Plan For a Financial Independence Day?
May 10, 2023Continue reading “What’s Your Plan For a Financial Independence Day?”
Which Federal Tax Breaks Still Apply To College Costs?
May 01, 2023When it comes to education, most financial planning centers around saving and investing for college. This focus makes sense because we’d all like to be able to cover our education expenses that way in an ideal world and not need to borrow a dime. But in the real world, that’s rarely the case.
Fortunately, parts of the tax code can help lift some of that burden if you know how to use them. As you can imagine, this is an area that we get a lot of questions about during the tax-filing season. So let’s take a look at some of these tax breaks and how you might be able to qualify for them.
The American Opportunity Credit (AOTC)
Since it’s a credit, you can deduct this one right off your taxes up to $2,500 (100% of the first $2k of eligible expenses and 25% of the next $2k) per student (you, your spouse, or a dependent) for up to 4 years of undergraduate tuition and required fees and materials, including books.
However, the credit phases out once your modified AGI reaches $80k for those filing single or $160k for joint filers. On the other hand, 40% of it is refundable for people who don’t earn enough to owe income taxes.
The Lifetime Learning Credit (LLC)
This credit is similar to the American Opportunity Credit, but it’s a little smaller. This credits up to $2k or 20% of the first $10,000 in expenses. That amount begins to phase out when MAGI exceeds $80k or $160k. These amounts will not adjust for inflation for the foreseeable future. It’s also a nonrefundable credit, whereas the AOTC may be refundable. The credit max of $2,000 is per tax return (per family) and not per student.
However, it’s more flexible since it’s not limited to undergraduate education. Thus, you can use it for graduate or qualified job-related programs or just a few courses you take here and there. Unfortunately, you cannot take Both credits for the same student in the same year.
Tuition and fees deduction
This deduction expired at the end of 2017 and was renewed retroactively in December 2019. So, if you had tuition and fees that were deductible from 2018 to 2020 that you didn’t claim (because they had not extended the law at that time), it’s worth looking into amending your tax return to request a refund.
No double-dipping
It’s important to point out that you can only use one of these tax breaks (assuming you qualify). These tax breaks also don’t apply if you’ve used funds from another tax-free account, like a 529 plan or Coverdell account. They also don’t apply if you’ve used other forms of tax-free educational assistance like Pell grants or Veterans’ programs.
In other words, there’s no double-dipping allowed. (This restriction doesn’t apply to funding sources that are generally tax-free, like loans or inheritances and gifts.) So the trick here is to withdraw money from a 529 or Coverdell account for no more than the amount of qualified expenses that aren’t covered by one of these other tax breaks.
Student loan interest deduction
The tax benefits don’t necessarily stop with the tuition bills. Suppose no one can claim you as a dependent on someone’s tax return. Your MAGI is also less than $85k or $170k joint (with phase-out beginning at $70k or $140k joint). In that case, you can deduct (without having to itemize) up to $2,500 of interest yearly on student loans that you’re legally obligated to pay. That last part means you can’t deduct interest for loans in your children’s names even if you make the payments.
Education is expensive and is rising faster than inflation. The good news is that we can offset some of that cost on our taxes. The bad news is that these breaks can be complex. So, unless you have a good tax preparer, you’ll have to take some time to understand them, which can be an education in itself. So why isn’t there a special tax break for that?
The Risks Of Employer Stock
November 15, 2021One of the biggest risks lurking in people’s investments is having too much in a current or former employer’s company stock. What’s too much?
Rule of thumb
You should generally have no more than 10-15% of your investment portfolio in any single stock. It’s worth noting that an investment adviser can lose their license for recommending more than that.
More than just a stock when it’s your job
So why is this such a bad idea? What if your company stock is doing really well? Well, remember Enron, anyone? While it’s practically impossible for a well-diversified mutual fund to go to zero, that could easily happen with an individual stock. In that case, you could simultaneously be out of a job and a good bulk of your nest egg.
Now, I’m not saying your company is the next Enron. It could be perfectly managed and still run into trouble. That’s because you never know what effect a new technology, law, or competitor can have, regardless of how good a company it is.
Nor does the company have to go bankrupt to hurt your finances. Too much in an underperforming stock can drag down your overall returns, and even a well-performing stock can plummet in value just before you retire. As volatile as the stock market is as a whole, it’s nothing compared to that of an individual stock.
Why do we over-invest in our own companies?
So why do people have so much in company stock? There are two main reasons. Sometimes, it’s inadvertent and happens because you receive company stock or options as compensation. For example, your employer may use them to match your contributions to a sponsored retirement plan. Other times, it’s because people may feel more comfortable investing in the company they work for and know rather than a more diversified mutual fund they may know little about.
A general guideline is to minimize your ownership of employer stock. After all, the expected return is about the same as stocks as a whole (everyone has an argument about why their particular company will do better, just like every parent thinks their child is above average). Still, as mentioned before, the risks are more significant. That being said, there are some situations where it can make sense to have stock in your company:
When it might make sense to keep more than usual in company stock
1) You have no choice. For example, you may have restricted shares that you’re not allowed to sell. In that case, you may want to see if you can use options to hedge the risk. This can be complicated, so consider consulting with a professional investment adviser.
2) You can purchase employer stock at a discount. If you can get a 10% discount on buying your employer’s stock, that’s like getting an instant 10% return on your money. If so, you might want to take advantage of it but sell the shares as soon as possible and ensure they don’t exceed 10-15% of your portfolio.
3) Selling the stock will cause a considerable tax burden. Don’t hold on to a stock just because you don’t want to pay taxes on the sale, but if you have a particularly large position, you may want to gift it away or sell it over time. If you do the latter, you can use the same hedging strategies as above.
4) You have employer stock in a retirement account. This is a similar tax situation because if you sell the shares, you’ll pay ordinary income tax when you eventually withdraw it. However, if you keep the shares and later transfer them out in kind to a brokerage firm, you can pay a lower capital gains tax on the “net unrealized appreciation.” (You can estimate the tax benefit of doing so here.) In that case, you may want to keep some of the shares, but I’d still limit it to no more than 10-15% of your total portfolio.
5) You have a really good reason to think it’s a particularly good investment. For example, you work at a start-up that could be the proverbial next Google. It may be too small of a company for analysts to cover, so it may genuinely be a yet-to-be-discovered opportunity. In that case, go ahead and get some shares. You may strike it rich. But remember that high potential returns come with high risk so ensure you’ll still be financially okay if things don’t pan out as hoped.
The ups and downs of the stock market typically get all the media and attention. But your greatest investment risk may come from just one stock. So don’t put all your eggs in it.
Are You Financially Immune From The Next Emergency?
March 17, 2020The following post is an excerpt from the Financial Finesse Personal Finance FORBES Blog. You can read the original post in its entirety here.
In many ways, emergency planning is the Rodney Dangerfield of financial planning. It gets no respect. The typical advice is to simply stash away enough cash savings to cover 3-6 months of income and then move on to more exciting topics like investing and retirement planning.
However, an event like the coronavirus has shown that merely having emergency savings is not enough. Just like an investment portfolio, a properly diversified “emergency portfolio” requires more than just savings in the bank. Here are the elements you’re going to want to make sure you have before the next big disaster:
1) An emergency kit
No, you don’t need to become a full-on “doomsday prepper.” You just need some basic tools, first aid supplies, and enough food and water to last at least 3 days. You can get checklists from the Department of Homeland Security and the Center for Disease Control. You can then supplement it with supplies for those types of disasters that are most common for your area.
2) Food reserves
If the emergency lasts more than 3 days, you’ll still want to be able to eat. Rather than purchasing specialized “emergency rations,” you can simply bulk up on long-lasting food that you already eat. At the very least, it’s something you know you’ll need and can benefit from even if no emergency ever happens. In fact, you’re likely to save money this way. Simply replace the items as you use them and perhaps add items when they’re on sale.
A food reserve can also be part of your regular emergency fund, thus reducing the amount of savings you need. After all, you can eat it when you’re unemployed too. Sure, you would miss out on the less than 1/10th of a percent (minus taxes) you’d otherwise be earning with that money in the average savings account. But according to the most recent CPI release, the inflation rate of food at home over the last 12 months ending in January was about 0.7%, so you’d actually be saving a little more than what you likely would have earned keeping that money in the bank.
3) Physical cash
No matter how adequate your emergency supplies are, you never know what you may need to purchase from someone else in an emergency. That’s why they say “cash is king.” Although the financial world refers to bank deposits and money market funds as “cash,” in a true crisis, banks may be closed, ATMs may not be working, and money market funds may not be available if the stock market is suspended (as it was after 9/11). Some preppers like to keep gold coins for this reason, but people may not know how to judge their value in a crisis. Instead, consider keeping at least a few hundred dollars in physical cash (even if it’s under the proverbial mattress).
4) Emergency savings
None of this means you won’t still need some savings in the bank. You can’t exactly use food to replace items damaged in a storm or fire. Nor is credit a good substitute for savings since lines of credit can always be cancelled, which is all the more likely during tough economic times or when you’re unemployed—the two times you’re most likely to need it. For this reason, you may want to use any low-interest (below 4-6%) credit available to you before your cash reserves so you can preserve them as long as possible.
How much do you need in savings? Even so-called “financial gurus” don’t agree. Dave Ramsey suggests a starter emergency fund of about $1k until you’ve paid off all your high-interest debt. Suze Orman recommends having 8 to 12 months’ worth of expenses in savings before paying off debt. What you decide to do may depend on your personal comfort level, the availability of other sources of financial support, and how risky your income is. You can use this calculator to get an idea based on your expenses and how difficult it would be to replace your income.
These savings should be somewhere safe and accessible like an insured bank or credit union account. If you want to maximize your interest, consider a rewards checking account. They can pay over 5% in interest, and many will reimburse your ATM fees as long as you’re willing to bank remotely, use direct deposit and electronic statements, and use your debit card 10-15 times a month.
5) Adequate insurance
No matter how much savings you have, it probably won’t be enough to cover some of life’s biggest financial disasters. That’s why you need adequate health, auto, renter’s or homeowner’s, disability, and life insurance. If you’ve accumulated a lot of assets, you may also want to consider enough umbrella liability and long-term care insurance to “CYA”: cover your assets.
Whether it’s the current threat of a possible pandemic or potential terrorist attacks, natural disasters, or financial crises, many experts fear that our world is only getting more dangerous. No one knows when the next disaster will be. The only question is whether you’ll be ready.
Is It The Right Time To Convert To Roth?
December 09, 2019Are you wondering if you should convert your retirement account to a Roth by the end of the year? After all, there’s no income limit on IRA conversions and many employers are now allowing employees to convert their company retirement plan balances to Roth while they’re still working there. At first glance, it may sound appealing since the earnings in a Roth can grow tax free, and who doesn’t like tax free? However, here are some reasons why now might not be the time for a Roth conversion:
3 reasons you might not convert to Roth this year
1) You have to withdraw money from the retirement account to pay the taxes. If you have to pay the taxes from money you withdraw from the account, it usually doesn’t make financial sense as that money will no longer be growing for your retirement. This is even more of a tax concern if the withdrawal is subject to a 10% early withdrawal penalty.
2) You’ll pay a lower tax rate in retirement. This can be a tricky one because the tendency is to compare your current tax bracket with what you expect it to be in retirement. There are a couple of things to keep in mind though. One is that the conversion itself can push you into a higher tax bracket. The second is that when you eventually withdraw the money from your non-Roth retirement account, it won’t all be taxed at that rate.
Let’s take an example where you retire with a joint income of $125,900 in 2022. Because of the $25,900 standard deduction for married filing jointly, your taxable income would be no more than $100,000. Of your taxable income, the first $20,550 would only be taxed at 10%, and everything from there up to $83,550 is taxed at 12%. Only the income over $83,550 is taxed at the 22% rate. As a result, you would be in the 22% bracket but actually pay only about 13% of your income in taxes.
You can calculate your marginal tax bracket and effective average tax rate here for both your current and projected retirement income. (Don’t factor in inflation for your future retirement income since the tax brackets are adjusted for inflation too.) The tax you pay on the conversion is your current marginal tax bracket, but the tax you avoid on the Roth IRA withdrawals is your future effective average tax rate.
3) You have a child applying for financial aid. A Roth conversion would increase your reported income on financial aid forms and potentially reduce your child’s financial aid eligibility. You can estimate your expected family contribution to college bills based on your taxable income here.
Of course, there are also situations where a Roth conversion makes sense:
6 reasons to consider converting to Roth this year
1) Your investments are down in value. This could be an opportunity to pay taxes on them while they’re low and then have a long-term investment time horizon to allow them to grow tax free. When the markets give you a temporary investment lemon, a Roth conversion lets you turn it into tax lemonade.
2) You think the tax rate could be higher upon withdrawal. You may not have worked at least part of the year (in school, taking time off to care for a child, or just in between jobs), have larger than usual deductions, or have other reasons to be in a lower tax bracket this year. In that case, this could be a good time to pay the tax on a Roth conversion.
You may also rather pay taxes on the money now since you expect the money to be taxed at a higher rate in the future. Perhaps you’re getting a large pension or have other income that will fill in the lower tax brackets in retirement. Maybe you’re worried about tax rates going higher by the time you retire. You may also intend to pass the account on to heirs that could be in a higher tax bracket.
3) You have money to pay the taxes outside of the retirement account. By using the money to pay the tax on the conversion, it’s like you’re making a “contribution” to the account. Let’s say you have $24k sitting in a savings account and you’re going to convert a $100k pre-tax IRA to a Roth IRA. At a 24% tax rate, the $100k pre-tax IRA is equivalent to a $76k Roth IRA. By converting and using money outside of the account to pay the taxes, the $100k pre-tax IRA balance becomes a $100k Roth IRA balance, which is equivalent to a $24k “contribution” to the Roth IRA.
Had you simply invested the $24k in a taxable account, you’d have to pay taxes on the earnings. By transferring the value into the Roth IRA, the earnings grow tax free. This calculator helps you crunch your own numbers.
4) You want to use the money for a non-qualified expense in 5 years or more. After you convert and wait 5 years, you can withdraw the amount you converted at any time and for any reason without tax or penalty. Just be aware that if you withdraw any post-conversion earnings before age 59½, you may have to pay income taxes plus a 10% penalty tax on them.
5) You might retire before age 65. 65 is the earliest you’re eligible for Medicare so if you retire before that, you might need to purchase health insurance through the Affordable Care Act. The subsidies in that program are based on your taxable income so tax-free withdrawals from a Roth account wouldn’t count against you.
6) You want to avoid required minimum distributions (RMDs). Unlike traditional IRAs, 401(k)s, and other retirement accounts that require distributions starting at age 72 (or 70½, depending on your age), Roth IRAs are not subject to RMDs so more of your money grows tax-free for longer. If this is your motivation, remember that you can always wait to convert until you retire, when you might pay a lower tax rate. Also keep in mind, Roth conversions are not a one-time-only event. You can do multiple conversions and spread the tax impact over different tax years if you are concerned about pushing your income into a higher tax bracket in any particular year.
There are good reasons to convert and not to convert to a Roth. Don’t just do what sounds good or blindly follow what other people are doing. Ask yourself if it’s a good time for you based on your situation or consult an unbiased financial planner for guidance. If now is not the right time, you can always convert when the timing is right.
When Should You Exercise Your Employee Stock Options?
April 05, 2019Do you have employee stock options that you’re not quite sure what to do with? Should you exercise them and take the gain now (if there’s no gain, it’s a moot point) or hold onto them a little bit longer for potentially higher profits down the road? Here are some things to consider:
Can you exercise them?
Before you even think about whether you should, you might want to see if you could. There are two main reasons that the answer to that question may be “no.”
- The first is if your options aren’t vested, generally meaning that your employer won’t allow you to exercise them until a certain period of time (usually between 3-5 years) passes. This is basically a way of keeping you at the company for a bit longer and encouraging you to work for the long-term good of the company since you’ll directly benefit if the company’s stock price is higher after your vesting period.
- The second reason is if the current stock price is lower than the strike price, which is the price that your option allows you to buy it at. For example, if the current stock price is $75 per share and your strike price is $50 per share, then by exercising your option you can buy the shares at $50 and immediately sell them for the current market price of $75 for a $25 per share profit (less applicable taxes, fees, and expenses). That’s the fun part. But what if your strike price is $75 and the current market price is $50? In that case, your options are said to be “underwater,” which is about as fun as it sounds (and we’re not talking scuba diving here).
When will your options expire?
Just as you can’t exercise your options before they vest, you can’t exercise them after they expire either, which is pretty much what it sounds like. Many places will automatically exercise your options at the expiration date as long as they are “in the money” (the opposite of “underwater”) so you may want to check and see if that’s the case. If not, you’ll want to keep track and make sure you exercise them before they expire.
Do you have too much invested in your company stock?
This is a biggie because if you make this mistake, it can really wipe you out financially if the wrong things happen. As risky as the stock market is as a whole (remember 2008?), any individual stock is a whole lot riskier. After all, the overall stock market practically can’t go to zero, but an individual company can, and sometimes they do (remember Enron?).
No matter how safe and secure your employer seems to be, yes, this applies to your company too. Experts in behavioral finance say that we humans have a “familiarity bias,” which is a tendency to overestimate the value of things we know.
After all, you never know what can happen. Pick your villain. You can work for a company that makes great products in a growing field only to find that someone has been cooking the books (corporate crooks) or that a sudden change in the law has a devastating impact on your industry (politicians).
The risk is amplified when you consider that your job, and perhaps your pension, are tied to this company too. It’s bad enough to lose your job and much of your pension. It’s even worse to lose your nest egg at the same time. For this reason, some financial professionals suggest not even investing at all in the industry you work in much less your employer.
How much is too much?
So how much is too much? A rule of thumb is to have no more than 10-20% of your total portfolio in any one stock. In fact, pension plans aren’t even legally allowed to invest more than 10% of their assets in company stock. This is one reason that a lot of companies these days limit the amount of your 401(k) savings that you can have allocated to company stock.
What else would you do with the money?
If you have high-interest debt like credit cards, you’ll probably save more in interest by paying them down than what you’d likely earn by holding on to your options. Beefing up your emergency fund to 6-12 months of necessary expenses could be another good choice. In the unfortunate event that something did happen to your company, you’ll be glad you have some savings rather than underwater options.
Unless you have good reason to be particularly optimistic about your company’s growth prospects (don’t forget that thing about familiarity bias), diversifying the money into mutual funds or other stocks keeps you invested while significantly reducing your risk.
If you haven’t maxed out tax-sheltered accounts like a Roth or traditional IRA, you could use the proceeds from your options to fund them. You still have until April 15th to contribute for last year.
Will your tax bracket be higher now or in the future?
Remember that $25 per share profit we talked about earlier? Well, Uncle Sam will want his cut but the amount can vary. If you have non-qualified stock options, you’ll have to pay payroll and regular income tax rates on it. If you’re in the 24% tax bracket and about to retire next year in the 12% bracket, waiting that year could save you 12% in taxes.
On the other hand, if you have incentive stock options, there are more possibilities. If you exercise the option and sell the stock in the same year, you’ll pay regular income tax rates just like with the incentive stock options, but no payroll taxes.
However, if you exercise the options and hold the stock for more than a year (and 2 years from when the options were first granted to you), then when you eventually sell the stock, the difference between the price at which you sell the stock and the price at which you exercised the option is taxed at lower long-term capital gain rates (currently maxed at 20%) rather than higher ordinary income tax rates (currently maxed at 37%).
In the example we’ve been using, if you held the stock after exercising your options and the stock price continues going up from $75 to $90 then you’ll owe long-term capital gains taxes on the $40 per share difference between the current $90 market price and your original $50 strike price. However, you may owe alternative minimum tax under this scenario so consider consulting with a tax professional.
With either type of option, there could be some reasons to delay. But don’t let the tax tail wag the dog. These tax benefits can be outweighed by the risks of having too much in company stock or the benefits of using the proceeds to pay down debt or build up an emergency fund. The important thing is to understand each of your options (no pun intended) to decide what makes the most sense for you.
Why You Might Not Want To Put All Your Retirement Savings Into Roth
March 25, 2019If you have the option of making Roth contributions to your employer’s retirement account, should you do it? With a traditional pre-tax contribution, you only pay taxes when you withdraw the money. With a Roth contribution, you pay the taxes before you contribute, but the earnings can be withdrawn tax-free as long as you’ve had the account at least 5 years and are over age 59 ½.
The ‘gurus’ may not always be right
I recently spoke to one employee who has made all Roth contributions and so virtually all of her retirement savings (except for matching contributions) is in a Roth 401(k). When I asked her why, she said it was because she heard from Suze Orman and Dave Ramsey that this was a good thing to do.
One of the problems with taking financial guidance from media personalities is that their advice tends to be overgeneralized. In this case, I’d say it’s worse than that because I would argue that most people are better actually better off making mostly pre-tax contributions even if they retire in the same tax bracket!
It’s still a good idea to have some pre-tax savings
When this employee retirees, almost all of her income will be tax-free. (Her taxable income will be low enough for her Social Security benefits to be tax-free and her husband has no retirement savings.) That sounds great except that if she and her husband were retired today, they would still be eligible to have at least $24,400 of tax-free income in retirement because of their standard deductions, even without the Roth.
If she had contributed to a pre-tax 401(k), she would have paid no tax on the contributions and then no tax on $24,400 of withdrawals each year. (The next $78,950 would still only be taxed at 10 or 12%, much less than the tax rate she would have avoided on her contributions.)
Not too late to fix it
The good news is that she still has plenty of time to make future pre-tax contributions and lower her current taxes before she retires. This would allow her to either save more and/or use the tax savings for other goals. However, her projected retirement income based on these future contributions would still not allow her to take full advantage of her standard deductions in retirement.
It’s still a good idea to have some Roth
This isn’t to say that everyone should make all pre-tax contributions either. There are good reasons to have at least some money in a Roth account, especially if you plan to retire before you’re eligible for Medicare at age 65 since having some tax-free income can lower your health insurance premiums in the exchanges.
A Roth account can also be more beneficial if you think your tax brackets will actually be higher in retirement. Roth IRAs also have other benefits in terms of more flexibility with investment options and withdrawals.
The moral of the story
So what’s the moral of the story? Don’t always believe what you hear or read from so-called “financial gurus.” Their advice/entertainment is meant to be generalized and may be misapplied to your situation. Instead, seek out more personalized guidance from a qualified and unbiased financial planner.
Are You Investing In The Right Account For Your Goal?
March 12, 2019When it comes to investing, we talk a lot about “asset allocation” but what about “asset location?” Are you investing in the right account(s) for your goal(s)? Let’s take a look at some common financial goals and which account(s) might be best for them:
Emergency fund
The key here is easy access to your money in case of an emergency. Most tax-advantaged accounts have restrictions and penalties for most withdrawals, but the Roth IRA is an exception. You can withdraw the sum of your contributions at any time and for any purpose without tax or penalty. If you withdraw earnings before 5 years and age 59 ½, you’ll probably have to pay taxes and a 10% penalty on those withdrawals, but the contributions always come out first.
Buying a home
A traditional or Roth IRA can be a good choice here since you can withdraw up to $10k penalty-free (and tax-free from a Roth IRA after 5 years) for a home purchase if you and your spouse haven’t owned one in the last couple of years. (Since Roth IRA contributions can always be withdrawn tax and penalty-free, the $10k limit can be applied just to the earnings.)
You may also be able to borrow from your employer’s retirement plan to purchase a home and have a longer time period to pay it back than with a regular retirement plan loan.
Retirement
If your employer offers a match, start there so you don’t miss out on the free money. Once you’ve maxed the match, you can also contribute to an IRA if you prefer having more flexibility than what your employer’s plan offers. An HSA can also be part of your retirement savings since the money can be used penalty-free for any purpose at age 65 (and will still be tax-free for qualified medical expenses including some Medicare and long term care insurance premiums).
Education
The most popular option is a 529 plan, which allows the earnings to be withdrawn tax-free for qualified education expenses. The plans are run by the states and each has different investment options. You’re not required to contribute to the plan for the state you live in or where you child goes to school, but some states offer special state income tax breaks for contributions to your own state’s plan.
If you prefer more flexibility, you can also contribute to a Coverdell Education Savings Account, which has similar federal tax benefits, but contributions are limited to $2k per year and the money has to be used by the time the beneficiary turns 30. Finally, you can withdraw money from an IRA penalty-free for education expenses, but make sure you’re not jeopardizing your retirement.
Of course, if you max out the contribution limits of any of these accounts or just don’t want to tie up your money, you can always contribute to a regular taxable account too. If you’re still not sure which account(s) makes sense for you, consult with a qualified and unbiased financial planner. Just don’t let indecision about which account to save in prevent you from saving at all!
Your One Stop Guide To Retirement Planning
March 01, 2019Do you feel overwhelmed thinking about retirement planning? It’s one of the most common topics we’re asked about. One way to make it more manageable is to break it down into a series of decisions:
How much do you need to save?
This is the most complex and the most important question. After all, none of the other questions matter if you don’t have enough in retirement savings.
While there are lots of rules of thumb, the actual number depends greatly on your particular situation like your expected retirement expenses, how much you’re projected to receive in Social Security and pension benefits, when you plan to retire, how much you’ve currently saved, and how aggressive an investor you are. Your best bet is to run a retirement calculator that takes these factors into account. If you’re unable to save the amount you need, consider slowly increasing your retirement savings over time (some retirement plans have a contribution rate escalator that will do this for you automatically) and/or adjusting your retirement goals.
Where should you put your retirement savings?
First max out any match your employer is offering you. It’s hard to beat a 50% or 100% guaranteed return on your money.
Second, contribute as much as you can to an HSA if you’re eligible. That’s because the money not only goes in tax-free but can be used tax-free for qualified health care expenses, which you’ll almost certainly have in retirement. (This includes select Medicare and qualified long term care insurance premiums.) HSAs can also be used for any purpose penalty-free starting at age 65. That’s why you might also want to avoid tapping into your HSA even for qualified health care expenses and instead invest it to grow for retirement.
Unless you have unique investment options in your employer’s retirement plan that you want to take advantage of, you might want to contribute to an IRA next. That’s because you’ll have more flexibility in how the money is invested (almost anything) and how it can be withdrawn. You can use IRAs penalty-free for qualified education expenses and up to $10k for a first-time home purchase. Roth IRA contributions (but not earnings) can also be withdrawn for any reason without tax or penalty. If your income is too high to contribute to a Roth IRA, here’s a backdoor method.
Then go back and contribute as much as you can to your employer’s retirement plan. (If you have access to a 457, start with that because there’s no early withdrawal penalty.) If you max out your pre-tax and/or Roth contributions, see if you can make after-tax contributions and convert them to a Roth to grow tax-free. Finally, if you’ve maxed out all of the above, other options include cash value life insurance or just a regular taxable account.
How should you invest your retirement savings?
You may want to invest in your employer’s retirement plan, an HSA, a Roth IRA, and a taxable account all differently. However, the commonality is to make sure you’re properly diversified according to your time frame and risk tolerance and to minimize costs as much as possible. Then stick with your plan and don’t chase performance or try to time the market. If you take these steps, you’ll find that investing is actually the simplest part of your retirement planning.
What insurance policies will you need?
You need to consider your options for health insurance before you’re eligible for Medicare at age 65 and for supplementing basic Medicare coverage afterwards. Keep in mind that Medicare and other health insurance policies don’t cover long term care. Medicaid does but it may require you to spend down most of your assets and a growing number of institutions no longer accept it so you may want to consider a long term care insurance policy. Finally, if you’re worried about running out of money in retirement, an income annuity provides you income you can’t outlive.
How will you get income from Social Security, pensions, and retirement savings?
You’ve spent your whole life building up retirement assets and now you’ve got to decide how to use them. If you can afford to delay Social Security, you may want to do so to allow your retirement and survivor benefits to grow. If you can take a pension as a lump sum, here are some things to consider. Finally, see how much you can safely withdraw from your retirement savings and how to minimize taxes on those withdrawals.
As you can see, there’s a lot involved with retirement planning, but breaking it up into key decisions can help. (You should address the first three questions now, the fourth when you get closer to retirement, and the last in retirement.) If you have more questions or would like to walk through the decisions, you may want to consult with an unbiased financial planner. In any case, make sure you have a plan and continue to monitor and update it periodically. Your future (retired) self will thank you.
How Do You Decide Where To Open An Investment Account?
February 22, 2019When it comes to investing, once you’ve decided how to divide your money between types of investments, which investments to pick, and what type of account to contribute to first (401k or IRA, pre-tax or Roth) there’s another decision you’ll need to make: where should you actually open the account?
If you’re just contributing to your employer’s retirement plan, there’s not much of a choice. On the other hand, if your tax accountant just told you to open your first IRA, leaving the comfort and safety of your workplace benefits can be intimidating. Alternatively, you may already have outside accounts but feel unsatisfied with your current broker/mutual fund company and are looking to make a switch.
A range of options
When I started my financial career, it was pretty simple. There were full-service brokers that also charged full commissions and there were no-load mutual funds and discount brokerages that offered little or no help to investors. Now, there are a range of options in between that can give you some of the best of both worlds. Here are some questions to consider:
Are you looking for investment advice?
If so, your choice of advisor may dictate where you invest. There are generally 3 ways you can go for advice. I’ve worked in all three environments so I can tell you that they each have their pros and cons.
1. Traditional full-service broker. One option is to use a traditional full-service broker that charges a commission for investments that you purchase through them. For example, a full-service broker may charge a “load” for mutual funds, which can sometimes be as high as 5.75%. Be aware that for some investments, such as annuities and class B and C mutual funds, those commissions can be hidden as part of another fee.
For bonds, the commission can take the form of a reduced yield. In addition to many of the big names like Merrill Lynch and Smith Barney, many banks, credit unions, and insurance companies offer investments this way.
Advantage: You only pay for the advice you take and it can be cheaper in the long run than paying a percentage of your overall account every year.
Disadvantage: These “advisors” may be tempted to sell you products that make them money rather than you. If you go to a financial advisor and he/she tries to convince you to invest in insurance products right off the bat, you may want to keep shopping – there is a place for those investments, but that’s often a red flag that the advisor is looking to make the most money for themselves rather than help you grow yours.
2. Independent registered investment adviser (RIA). They generally charge you an annual fee, usually around 1% of the assets they manage for you, or in some cases an annual retainer or hourly rate. Your investments are usually held at a separate discount brokerage firm like Charles Schwab, Fidelity, or TD Ameritrade, or at an independent brokerage that you’ve probably never heard of. This separation can help prevent Bernie Madoff-type fraud, but it also means that you may have to go to one place for advice and another for administrative issues.
Advantage: You can get more objective advice and often more comprehensive financial planning.
Disadvantage: Fees can be higher in the long run and many RIAs won’t even accept clients with accounts smaller than $250k, or often $500k or more.
3. Discount brokerage. Several discount brokers like Schwab, Fidelity, and Vanguard have also started offering advice at a lower cost. The depth of the advice depends on how large your account is, but their starting threshold is generally lower than an RIA, and they tend to charge less as well. You might also be able to get some free fund recommendations if you’re willing to forgo ongoing management and simply rebalance your portfolio periodically.
Advantage: Lower balance required and lower fees.
Disadvantage: You most likely won’t ever meet face-to-face with your advisor and their advice will be limited strictly to your investments, which may not take into account your personal goals for the money.
What do you want to invest in?
If you can’t answer that question, you may want to revisit the previous one. If you do know what you want, this is the question to start with. After all, some companies may not even offer the particular type of investment you’re looking for, and some places may charge more for it than others. For example, it’s generally cheapest to buy Vanguard and Fidelity funds directly from the source. Your choice of investment should determine your provider, not the other way around.
How do you invest?
How you’ll invest matters too. If you’re actively trading stocks every day, you might want to look for in-depth research, trading tools, and quality execution, along with low fees for trading. On the other hand, those factors won’t be as important if you’re just buying a few mutual funds to hold, where you should be more focused on ongoing fund fees.
What are the fees?
Either way, costs are an important consideration because they can really eat into your returns over time. Fortunately, competition has driven commissions on stocks down to as low as $2.50 a trade at Just2trade, and many brokerage firms offer a variety of mutual funds without any loads or transaction fees (NTF or non-transaction fee funds) so see if any of them offer the funds you want for free.
If you’re transferring from another company, the previous company may charge you a hefty fee on the way out, but some companies will rebate those fees, up to certain amounts, back to you if you transfer your account to them. Finally, look out for maintenance fees, especially on IRAs.
How convenient is it?
Once you’ve narrowed your search, see how close the brokerage firms’ branch offices are to you or if they even have one (many only do business over the phone or Internet). Some brokerage companies also provide FDIC-insured banking services. In addition to allowing you to have everything in one place, these accounts can pay more than traditional bank accounts and may even rebate your fees for using another bank’s ATM.
Your choice of brokerage companies probably isn’t something you want to decide based on which office you happened to walk by or which television ad you remember. It will affect how much and what type of advice you get, what investment options are available to you, how much you pay in fees, and your overall investing experience. There is no one best choice for everyone, but some will certainly make it easier for you to achieve your goals than others.
Do You Really Need To Break Your Expenses Down Into Wants Versus Needs?
February 14, 2019When it comes to budgeting, the conventional wisdom is that we should divide our expenses into “wants” and “needs.” Even our own Expense Tracker worksheet does this. But I think it’s actually a waste of time and let me tell you why.
Want or need?
First, there’s no clear line between “wants” and “needs.” You should see the debates that often happen in our budgeting workshops about what’s a need versus a want. Many would argue that their morning coffee, smart phone, Internet access, and cable TV are all “necessities” while others would call them luxuries. The same debates can happen between couples or even internally.
It’s also not just that we have different ideas of what constitutes a necessity. Each category of spending is a mix of need and want. For example, food is clearly a necessity but most of what we actually spend on food probably isn’t. The same goes for clothing, housing, the car we drive and even electricity.
We don’t really need all of our “needs”
Thinking of certain spending categories as needs can also make us think of them as untouchable. Yet, some of the biggest sources of savings can come from choosing lower cost housing, driving an older car, spending less eating out, looking for discounts on groceries, and reducing cable and phone bills. Focusing on just the “wants” like entertainment and shopping can cause us to miss these opportunities, and blow our budget because we miss those things. It’s also important to be honest with yourself about this when a crisis hits.
Discretionary v. non-discretionary
Besides, unless you’re truly living on a subsistence income, I don’t know anyone who only spends money on wants. So if we’re going to spend on a mix of wants and needs, what’s a better way to characterize spending categories? I prefer to think of spending as discretionary vs non-discretionary.
This doesn’t mean we have no discretion over “non-discretionary” expenses. It just means we’re not exercising that discretion on a regular basis. For example, while it’s certainly not an example of good budgeting practices in any other sense, the federal government essentially breaks down its expenses into entitlement programs like Social Security and Medicare and discretionary expenses like our military and education programs. The difference is that entitlement programs are on auto-pilot while Congress and the President fight about discretionary spending every year.
How to classify
With your own budget, non-discretionary expenses would be things like rent or mortgage payments, insurance premiums, utility bills, and subscriptions. While they may fluctuate over time, they’re generally determined by decisions we make in advance like where to live, which mortgage and insurance coverage to get, and what cable, phone, and gym plans to sign up for. We should take some time and go through each of these to make sure we’re getting the best value for our money. But after that, they’re pretty much on auto-pilot until something changes.
On the other hand, we’re constantly making spending decisions about things like eating out and shopping. How much we spend on these items can also vary considerably from month to month. Rather than try to budget for each of them in advance, which can be pretty difficult, you can give yourself a fixed monthly or weekly “allowance” to cover all of them.
The idea is that you get to spend as much as you like but when the money is gone, it’s gone until the next allowance period. Likewise, whatever you don’t spend can carry over to be splurged in the future. You can then decide what feels more like a want versus a necessity with each purchase.
The reality is that almost every expense can be a “need” or a “want” based on your perspective. What’s important is that you’re prioritizing your spending according to what’s important to you. Arbitrarily splitting your expenses into needs and wants won’t do that. Thinking through each and every expense will.
3 Common Myths You Probably Believe About Taxes
February 04, 2019One of the areas that I find to have the most misconceptions is taxes. After all, Einstein is quoted as saying that the hardest thing to understand is the income tax…and that’s when it was a lot simpler than it is now! Here are the biggest ones I’ve seen as a financial planner:
Myth 1: Your goal should be to minimize your taxes above all else.
No one likes to pay taxes, but making the goal solely about minimizing what you pay implies you should earn no income so you have no tax liability. More realistically, this idea comes up most frequently when people are reluctant to pay off their mortgages because they’ll lose the tax deduction
Reality: There are good reasons not to pay down your mortgage early, but the mortgage interest deduction isn’t one of them. While the mortgage interest deduction can reduce the cost of interest, it’s still a cost. The deduction simply makes mortgage debt cheaper than non-deductible debt with the same interest rate. Don’t let the tax tail wag the dog and instead focus on maximizing after-tax returns.
Myth 2: Your marginal tax rate is the percentage of your income that you pay in taxes.
In other words, if you’re in the 24% federal tax bracket the thought is often that it means you pay about 24% of your income in federal taxes. In my experience this is how most people think about tax rates.
Reality: You only owe the marginal tax rate on income in that bracket. So, you would only owe 24% on any income over that amount and the rest would be taxed at lower rates. This is why you’ll probably end up paying a lower average tax rate on your 401(k) withdrawals in retirement even if you retire in the same tax bracket. (Your contributions come off the top and avoid that marginal rate, while a lot of the withdrawals will be taxed at the lower rates.)
Myth 3: You need a tax accountant to take advantage of various loopholes to reduce your taxes.
This is probably one of the main reasons people hire tax preparers. It’s also true for anyone who doesn’t feel comfortable using tax software.
Reality: Tax accountants can be helpful if you own a business or investment property since many of the deductible expenses are ambiguous, but tax software should do the job for the average person. The reality is that most of what you can do to reduce your taxes is in the planning before the taxes are prepared. That mostly means contributing to tax-advantaged accounts like 401(k) plans, IRAs, and HSAs. A good financial advisor can also help you minimize taxes on your non-sheltered investments.
5 Reasons Why I Think Everyone Needs Their Own Financial Plan
January 28, 2019Does everyone need a financial plan? Apparently Wealthfront’s co-founder and CEO doesn’t think so. He claims that young people don’t really need a plan if they’re either single and currently saving money, or married, currently saving money, and not planning to have kids, or are single and can’t save. He argues that the first two should generally be okay even without a plan and the last would benefit more from a budgeting app.
However, here are some reasons that even young people in these situations probably need a financial plan:
1) They need insurance and estate planning.
Financial planning isn’t just about saving. In fact, one of the most important things for many young people is having adequate health, property and casualty, and disability insurance. This is especially true if they haven’t had enough time to build up enough savings to help cope with these risks.
Estate planning may seem like something just for older and wealthier people, but let’s not forget that Terri Schiavo was only 26 years old when she fell into a vegetative state without proper planning. That’s why it’s never too early to get the basic documents in place like an advance health care directive, durable power of attorney, beneficiary designations, and a will. Many employers even offer legal benefits to draft these documents for free or at a reduced cost.
2) They may need help prioritizing debt vs saving.
Many young people are tempted to pay down low interest student loans when they may be better off building emergency savings, capturing the match in their retirement plan, paying down higher interest debt, and/or saving for a down payment on a home. Of course, there are situations when paying down those students loans is the better course of action. That’s where financial planning comes in.
3) They may not be saving enough for retirement.
Many young people just stick to the default contribution rate in their retirement plans or contribute just enough to get the match. This could put them on track to be woefully unprepared for retirement, while even a small increase in their contribution rate could mean early retirement after decades of compounding.
4) They may not be fully utilizing tax-advantaged accounts.
I’ve seen many young people investing in a taxable robo-advisor account (like Wealthfront’s) when they could be benefiting from tax-free growth in a Roth IRA and/or HSA or just contributing more to their 401(k). Many are simply unaware of the benefits or how flexible these accounts can be.
5) Their investments may be improperly diversified or too expensive.
Many young people are either investing too conservatively for their time horizon or aren’t adequately diversified in their attempt to invest more aggressively. They also often don’t realize the impact of fees on their long term investment performance or even what fees they’re paying.
This is not to say that everyone needs to pay thousands of dollars for a 100-page “financial plan” that they probably won’t even read. However, practically everyone can benefit from having a chat with an unbiased financial planner who can help them uncover what they’re missing and what they should focus on at this stage in their financial life. (If they’re really fortunate, they may even be able to get this for free from their employer as part of a workplace financial wellness program.)
Why A Roth IRA Makes A Great Emergency Fund
January 23, 2019Financial planners generally say that one of the most important financial goals should be to have enough emergency savings to cover at least 3-6 months of necessary expenses. As long as you meet the income limits (or can get around them without tax issues), one option to consider for your emergency fund is a Roth IRA. Here are 3 reasons why:
No penalty on early withdrawal of contributions
Unlike other tax-advantaged retirement accounts like a 401(k) and a traditional IRA, early (before age 59 ½) withdrawals of contributions to a Roth IRA are not subject to taxes or penalties. Early withdrawals of earnings may be subject to taxes and penalties, but the contributions come out first.
As an example, if you contribute $5,500 to a Roth IRA and that $5,500 grows to $6,000, you can withdraw the $5,500 at any time and for any purpose without tax or penalty but not the $500 of earnings. (Note that any money you convert to a Roth IRA has a 5 year waiting period before it can be withdrawn tax and penalty-free.)
Your money is more protected
The main benefit of a Roth IRA is that those earnings can grow to be tax and penalty free once the account has been open for at least 5 years and you’re age 59 ½. This can essentially shield your earnings from taxes. In the meantime, Roth IRAs also have stronger protections from creditors and can avoid probate when you pass away.
You’re less likely to use it frivolously
More important than protecting your money from creditors, probate, or even the IRS might be protecting it from you. Because of the benefits of keeping it saved in the IRA, you’re probably less likely to spend your Roth IRA frivolously than if that money was in a regular account. (It also doesn’t hurt that you have to fill out a form for each withdrawal).
By contributing your emergency savings to a Roth IRA, you can build your emergency fund without missing the annual Roth IRA contribution limits. One last thing to keep in mind is that you’ll still want to put your Roth IRA money in something safe like a bank account or money market fund if it’s part of your emergency fund. Once you’ve accumulated enough savings somewhere else, you can then invest it more aggressively for retirement.
5 Common Tax Myths About Gifts
January 04, 2019Did you receive or give any large monetary gifts to family or friends this holiday season? We often get questions about the tax implications of gift-giving this time of year, so let’s take a look at some of the most common tax myths about gifts:
Myth: You have to pay tax on gifts you receive
Reality: You don’t owe tax on gifts that you receive. Instead, the giver of the gift may owe tax. This may seem counter-intuitive but the whole point of the gift tax is to prevent people from using lifetime gifts to avoid paying the estate tax.
Possible caveats
There are a few caveats to this though. The first is that gifts from your employer or in appreciation of your work may be taxable as income. That’s why tips are technically taxable even though they’re usually a voluntary gift rather than a required payment for service. (Don’t worry. Small de minimus gifts like a holiday turkey from your employer are excluded from tax.)
Second, if you’re given property that appreciated in value since the giver purchased it, you get the giver’s cost basis. That means that if you later sell it, you’ll have to pay a tax on the difference between what you sell it for and what the giver purchased it for. It’s kind of like a delayed tax on part of the gift’s value.
For example: Your grandfather gives you 50 shares of stock worth $20/share, and he paid $1/share for it long ago. You’ll be responsible for the capital gains tax on the $19/share gain when you sell the stock.
The final caveat is that if you’re fortunate enough to receive over $100k in gifts from one or more related foreign individuals or trusts or more than $16,076 from a foreign corporation or partnership, then you’ll have to file Form 3520 with the IRS. That’s not because foreign gifts are taxable. The IRS just wants to make sure that you’re not claiming what would otherwise be taxable foreign income as a nontaxable gift.
Myth: You have to pay a tax on gifts you make that are over $14k per year
Reality: First, the annual gift tax exclusion is now $15k per year. There are several other things to keep in mind too. One is that you can give an unlimited amount to a qualified charity or to your spouse without owing tax (unless your spouse is a non-citizen, in which case the annual exclusion is $152k in 2018 and $155k in 2019). You can also give an unlimited amount if you send a gift directly to a medical or educational institution. That’s one reason (I’m sure you can think of more) that it may make more sense to write a check directly to junior’s college rather than writing him a check for that purpose.
The $15k is also per person, so you can theoretically give $15k gifts to a virtually unlimited number of people each year tax-free. (If this is your intention, don’t forget the person you heard this from.) You and your spouse can also combine your $15k exemptions to give a $30k tax-free gift.
Finally, even if you go over the exclusion limit, you still probably won’t owe anything to the IRS, at least not yet. That’s because the amount you go over the limit just reduces the $11.18 million (going up to $11.4 million in 2019) that you can give tax-free over your entire life or at death. Even if you don’t owe anything right now, you still have to file a gift tax return for going over the limit though.
Myth: You can avoid the gift tax by loaning money at no interest and than forgiving the loan
Reality: To be considered a loan, you have to treat it like a real loan. That means putting the terms in writing, including the repayment schedule, and charging a fair market interest rate. If you forgive the loan, it will be considered a gift at that point. If you want to stay under the $15,000 annual limit, you can forgive the 1st $15,000 of payments each year.
Myth: Charitable contributions can always be deducted from your taxable income
Reality: First, the gift must be to a qualified tax-exempt charitable organization. You can ask the charity if they qualify or search for the charity on this IRS site. If you receive something of value for your gift, you can only deduct the difference between what you gave and what you got in return. Finally, the charitable deduction has to be itemized. That means if your total itemized deductions (which includes your mortgage deductions) are less than your standard deduction, the charitable donation won’t reduce your taxes. (more on that here)
Myth: This is all you need to worry about
Reality: Certain states have their own gift taxes and other states may treat charitable deductions differently, so you may need to file in your state even if you don’t have federal tax implications for your gift. Be sure to check what your own state’s laws are.
What I Learned In 2018
December 26, 2018Editor’s note: As 2018 draws to a close and we launch 2019, I’ve asked each of our bloggers to reflect on their own personal goals, plans or thoughts on the past or upcoming year. Our hope is that you not only draw inspiration from our sharing over the coming weeks, but also that we are all able to feel more connected through our shared human experience and recognize that no matter where we are on our personal financial wellness journeys, that we all have similar hopes, dreams and struggles. Happy holidays! Here’s what Erik has to say:
As we approach the end of the year, it’s a good time to review your progress toward your financial goals and begin thinking about your goals for the new year.
Tracking toward FIRE
In my case, my main goal is to save and invest for financial independence/early retirement (now popularly called “FIRE”). Despite spending more on dining out than I wanted to this year, I’m currently still on track to achieve my goal of having enough assets to cover my basic expenses in about 2-3 years.
Celebrating my anniversary as a real estate investor
The most significant update is that next year will be my 5 year anniversary as a real estate investor. In reviewing the performance of my rental properties, the bad news is that the cash flow has been less than I hoped for, mostly due to higher than expected vacancies and maintenance expenses. The good news is that the properties have appreciated a lot more than I thought they would, which has more than outweighed the lower cash flow.
One thing I learned about myself
One thing I learned is that your risk tolerance can vary based on the type of risk with different investments. For example, I’m much more comfortable with the ups and downs of the stock market than the uncertainty of maintenance expenses, perhaps because I’m simply more familiar with stocks. I also like knowing that I can easily and quickly access my stock investments by selling them at any time, while real estate takes much longer to sell and the final sales price can vary considerably from its estimated value.
For these reasons, I’m considering selling at least some of my rentals next year and reinvesting the proceeds in a more liquid and diversified investment portfolio of stocks and/or index funds. At the very least, I’m no longer planning to buy more properties, especially with today’s higher mortgage rates.
How about you? Are you still on track for your goals? What lessons have you learned? What changes, if any, do you plan to make to your finances for 2019? It’s the perfect time to review those things this week.
Why I Love My High Deductible Health Insurance Plan
December 18, 2018I once talked to a fellow employee at Financial Finesse who wasn’t very happy about our health insurance plan. I was surprised because I love it. It turns out that she just didn’t understand how it worked. We both had a high deductible plan with a health savings account (HSA), a relatively new type of plan that’s becoming more common as traditional insurance premiums continue increasing.
Passing the savings along to employees
In my case with single coverage, Financial Finesse pays lower premiums because I currently have to spend $1,500 each year before most of the insurance coverage will kick in. My coworker didn’t think that sounded like a great deal for us employees.
However, the other side is that Financial Finesse uses the premium savings to put $1,500 each year tax-free into my health savings account that I can then use tax-free to pay that $1,500 deductible. (You can also use your HSA tax-free for non-qualified medical expenses for you as well as for your spouse and dependents even if those expenses aren’t covered by your health insurance.) As a result, I don’t really pay anything out-of-pocket until I’ve spent all of that $1,500 and then I only owe a small co-insurance percentage after that.
Letting the money pile up
The best part is that I pay no taxes on this money and unlike with a flexible spending account, I get to keep whatever I don’t spend in the HSA at the end of the year. That doesn’t mean I can take the money and splurge it on a trip (at least not without paying taxes plus a 20% penalty on it), but it does mean I can invest that money in my HSA tax-deferred until age 65. At that time, I can spend it on anything (including a trip) without penalty, use it tax-free for medical expenses (including some Medicare and long term care insurance premiums), or just let it continue to grow tax-deferred.
Why it’s even better than saving in my 401(k)
Another thing I love about HSAs is that I can also add about $2k pre-tax to it this year since the total contribution limit is $3,500 per year for a single person in 2019. If I have the deposits deducted from my paycheck, I also don’t have to pay the payroll tax on it. Not even 401(k) contributions let you avoid that. When you consider that HSAs offer you both pre-tax contributions AND the potential for tax-free withdrawals, there’s an argument for funding it even ahead of your employer’s retirement plan (after you’ve maxed the match) and an IRA.
When you add the premium savings, employer contributions to your HSA, and tax savings from your own contributions, high deductible health plans can be a great deal (especially the less you spend on health care and the more you pay in taxes). So what’s not to love for a relatively healthy professional? Apparently not much. Once I explained all this to my then colleague, she loved it too.
What Happens To Your HSA If You Leave Your Job?
December 11, 2018One advantage of an HSA (health savings account) is that the money you contribute is yours to keep. Unlike an FSA, it’s not use it or lose it. Even if you’re no longer enrolled in an HSA-eligible high deductible health insurance plan, you can continue to use your HSA tax-free to pay out-of-pocket qualified medical expenses. At 65, you can even use it for any purpose without a penalty (and it’s still tax-free for eligible expenses including some Medicare and long-term care insurance premiums).
What to do with HSA money when you leave a job
What happens to your HSA once you leave your job? Generally, you can leave the account where it is, but you also have the option to transfer it to a new custodian without any tax consequences. In fact, you may even be able to transfer your HSA while you’re still employed at your job.
This can especially be a good idea if you want to invest your HSA since the investment choices vary based on where you have your account. You can see a breakdown of fees and investment options of some of the top HSA providers here.
What I’m doing with my HSA — without leaving my job
For example, I chose to transfer my HSA to Health Savings Administrators since I could invest all of the money in the account (many providers require you to keep a balance in cash), the fees are relatively low, and it provides access to specialized index funds from Dimensional Fund Advisors (DFA) that you normally can only access through a DFA-approved advisor (which means you usually have to pay their advisory fee).
This doesn’t mean they’re right for everyone. If I didn’t plan to invest the money or if I preferred other investment options, I may have made a different choice.
The one place you can’t take your HSA
There is one place you can’t take an HSA with you. When you pass away, your HSA money will be paid out to your beneficiaries and will be fully taxable. They don’t have the option to defer withdrawals like an inherited retirement account. For that reason, you may want to choose beneficiaries with a low tax bracket or even a charity as your beneficiary. Or just make sure there’s nothing left in the account when you die…
The whole idea of an HSA is to give you more control over your healthcare spending. Remember, it’s your money. Make sure it’s working hard for you, wherever that may be.
3 Different Lanes To Financial Independence For Early Career Workers
November 30, 2018You’ve heard the cliché: When it comes to saving for retirement, young people have time on their side. The earlier they start saving, the better. So what would happen if you started saving for retirement at age 22? A lot can happen in the years between, but here’s a look at three different retirement roadmaps that a 22-yr old earning $50k a year (with no raises) and earning an 8% average annualized return on their investments might take:
The slow lane
How you’d save
In the “slow lane,” let’s say you contribute 6% to your 401(k) to get your employer’s full 3% match. You’d retire at age 65 with $1,678,104. Yes, you’re a millionaire, but before you get too excited, that would only be about $716k in today’s dollars assuming a 2% inflation rate.
What that will look like in retirement
Using a 4% withdrawal rate, that 401(k) would produce about $29k of annual income. You would also receive about $15k in Social Security benefits at age 65 or about $11k if we factor in Social Security’s projected shortfall. Your total income would be $40k or about 80% of your current income, which is in the range of what most retirement experts figure the average retiree will need.
What to do if you are getting your match but don’t think you’re on track
If you’re getting your match but think that a comfortable retirement is out of reach, you may be underestimating the power of compound interest over long time periods and may actually be on track to retirement. On the other hand, it’s more likely that you got to a later start and didn’t start saving to your match at 22. The best way for you to find out is to run a retirement calculator and see if you’re on track. If not, you can see how much more you would need to save to get on track.
This all sounds okay, but who wants to drive in the slow lane and work until 65? Keep reading.
The center lane
How you’d save
In the “center lane,” you would max out an HSA (health savings account) and contribute 10% to your 401(k) with a 1% automatic annual increase. You retire at age 55 with $1,937,807. In today’s dollars, that would be about $1 million or enough to produce $40k of income, which hits that magical 80% mark even without the Social Security benefits you would later receive!
How to make it happen
To make this happen, you would need to be eligible for an HSA by choosing a high-deductible health insurance plan, which are becoming increasingly common. It also makes sense to try to max it out after getting the match in the 401(k) because the money goes into an HSA pre-tax, can be invested and grow tax-deferred, and can then be taken out tax-free for qualified medical expenses. No other account has that triple tax benefit.
Finally, you would need to use the HSA as a retirement account by not dipping into it even for medical expenses. One other note about HSAs, in addition to tax-free distributions for medical expenses in retirement (including Medicare and long term care insurance premiums) you can also take taxable distributions without penalty for non-medical purposes starting at age 65—i.e., it can be another source of retirement income.
Things to think about in the center lane
There are a couple of possible concerns with retiring early though. First, you would need to cover the cost of health insurance until qualifying for Medicare at age 65, but with access to the Affordable Care Act exchanges this shouldn’t be too much of a problem. In fact, if you have tax-free money in a Roth account, you can qualify for higher health insurance subsidies since eligibility is based on taxable income.
This brings us to the second potential issue. Isn’t there a 10% penalty on retirement plan withdrawals before age 59½? Yes, but there’s also an exception that as long as you work until the year you turn age 55 or older, you can withdraw money from your then current employer’s 401(k) with no penalties. (This doesn’t apply to a prior employer’s 401(k) or IRAs so keep that in mind before you roll money into one.)
The fast lane
How you’d save
As exciting as retiring at 55 sounds, how about retiring at 50? In the “fast lane,” you would max out both your HSA and your 401(k). At age 50, you would have $2,111,194—or about $1.2 million in today’s dollars—in retirement! That produces 97% of your working salary plus you’d still get Social Security later. (To avoid early withdrawal penalties, you can take “substantially equal periodic payments” under Rule 72(t) until age 59½.)
Of course, the challenge to driving in the fast lane is being able to save that much. The key is to max out those accounts before you even have a chance to spend that money and live on the rest of your income. If that sounds impossible, keep in mind that lots of people are living on much less.
Things to think about in the fast lane
The hardest part is potentially having to downscale your standard of living. This is where being 22-yrs old really has an advantage. After all, you may have just been recently living with no income at all in a dorm room or in your parents’ home so less of an adjustment might be needed.
Finally, keep in mind that our calculations assumed no raises, which is probably not realistic, especially for someone so young in their career. That means any income from raises or promotions could be used to finance a growing lifestyle. The upside for delaying that lifestyle is being financially independent at age 50 and having an extra 15 years to do whatever you want. In the meantime, your extra savings would provide a greater level of financial security and freedom.
So if you’re just getting started in your career, which lane will you drive in? Do you want to take the slow and easy approach to retire comfortably at age 65? Would you rather drive a little faster to retire early at 55? Or are you up to the challenge of life in the fast lane?
How You Can Now Protect Your Credit For Free
November 26, 2018Are you worried about identity theft? There’s no need to pay a monthly fee or even a one time fee for credit protection. As of this fall, you can now place and lift a security freeze on each of your credit reports (Experian, TransUnion, and Equifax) for free.
What exactly is a security freeze? A security or credit freeze prevents anyone from opening credit in your name without your PIN. Without a freeze, an identity thief could use stolen personal info to open credit and run up debt in your name, ruining your credit score.
Is there a downside to placing a security freeze? Now that it’s free, the only cost is the few minutes it takes to place the freeze and the few minutes it would take to temporarily lift the freeze and then restart it each time you apply for credit. Just be sure not to forget your PIN.
How do you place the security freeze? You have to place it with each credit bureau individually. If you request it online or by phone, they have to place the freeze within one business day. If you request it by mail, they have to place it within 3 days of receiving the request. You can learn more, including the contact info for each credit bureau, here.
Is a security freeze all you need to protect your credit? First of all, it won’t address any bad info that’s already on any of your credit reports. (It’s been estimated that about 70% of credit reports have errors on them that could be hurting people’s scores.) It’s bad enough to be penalized for your own mistakes so you certainly don’t want to be penalized for someone else’s. You can check your credit reports for free every 12 months at AnnualCreditReport.com and dispute any mistakes you see there that could be hurting you.
I would also suggest credit monitoring, which you can also get for free for all the bureaus through CreditKarma.com (which covers TransUnion and Equifax) and FreeCreditScore.com (which covers Experian). Credit monitoring lets you know if anything happens to your credit that a security freeze wouldn’t stop.
For example, I once had a doctor’s bill go to the wrong address so I never paid it. I got a notification from my credit monitoring service and was able to fix the problem without it even being reported on my credit report. Otherwise, the bill likely would have gone into collections and negatively impacted my credit.
What else should I know? Do it now. This is one of the things that’s easiest to procrastinate since there’s no immediate benefit. The problem is that you never know when you may need it and by then, it will be too late.