Let your money do some work
Assembling the groundwork for Investments, Retirements and Tax-Advantaged Accounts
Want an opinionated beginner read before this post? Check out my first article: Grownup Escapades: Handling Finances. This post intends to cover deeper as to why’s and how’s of investing, retirement accounts, tax-advantaged accounts and opinionated financial strategies one can play.
Note that I am NOT a licensed financial advisor or a professional financial analyst — and that this writeup is mostly meant for informative purposes. Take this and any grain of information — especially about personal finance, with as much scrutiny and suspicion.Do your own research as well — scrutinize any institution or strategy where your money and effort is going into.
Savings and Investments — Why does one save and invest (why not just YOLO it out?)
Let us first dive into tackling our finances and answering some of the big questions: “What preliminary steps can one take to arrange their financial life?, ”“How does one save and strategize?” and “Why does one invest?”
Be real with your finances — due diligence and damage assessment
As one’s income, means and stature in life rises, also seemingly comes what feels like a societal and social pressure to spend more — showcasing one’s wealth and “success” through extravagance and flashiness. Reality TV shows of millionaires, along with Instagram posts run a-plenty abound with seemingly well-off individuals with jet-setting lifestyles, all with vacations and purchases that are funded by what seems like a bottomless bank account. This can often seep as a form of influence to one’s psyche — and before one realizes it, they have stretched themselves thin of resources and accumulated massive debt. There is nothing wrong if this is the life one wants for themselves — we all only live once. However, if one wants to account for things like early retirement or a secure financial future for one’s family, choices have to be made.
Debt and bills are the reality for most Americans — and assessing the damage along with getting real with what may not be a rosy and positive financial picture is the first step in turning the tide of the battle against your finances. This often means making your own opinions and judgement calls like prioritizing paying off credit cards and bills with more aggressive interest rates, maybe even before you could potentially build up your own emergency fund. This also may mean living well below your means — holding off on big purchases and being highly cognizant of your expenses. When it comes to being on the negative on the balance sheet, putting the hard work now frees up your future self by an exponential factor — use violence of action in cutting down the most aggressive debt (based on interest rates) whenever you can.
Before you start with investing, tackle any debt first. It simply does not make sense to gamble on short-term hopes of overnight success on a stock market that has historically averaged (and note — your results WILL most often vary — there are higher probabilities of negative short-term returns in the market) an annual return of 9.8%~ when your credit card bill is at at an 18% or worse, 24.99% interest rate. You will end up owing more money to the bank in interest faster than you can plug that hole with earnings from investments. Never invest using borrowed money. Making this mistake is the same as giving your bank an assured investment on your debt (as you accrues interest over the years) with an un-assured investment on the market. Do not jeopardize yourself.
Start with the basics first — aggressively tackle any debt, then lay down a strong base for your emergency funds. These emergency funds should be highly accessible in the event that money has to be withdrawn. Only when you have built those 2 pillars can you start looking at what else your money can do for you. It might even take years when you take into account norms such as most people starting out with student loan debt — avoid the siren songs and keep forging through the hard but common sense path.
I’m all good now! I’ll stick all my leftover money in savings
The Federal Reserve aims for a 2% inflation rate annually (source: Federal Reserve — federalreserve.gov/faqs/economy_14400.htm). If you stuck $1 on a savings account back in 2000 and retrieved it in 2021, you would find yourself not being able to buy things you were able to buy for $1 in 2000. Using the Bureau of Labor Statistics calculator, you would actually need $1.56 in 2021 to be able to afford the same things, on average, than what you used to be able to afford for $1 back in 2000. It gets clearer the larger the amount — what you could have afforded for $10,000 in 2000, would now, on average, cost you $15,496.56 in 2021. Now, this is not a 1-for-1, apples-to-apple comparison (one can buy a smartphone now; there was no modern concept of a smartphone you could have bought 20 years ago) — however, this is more easily realizable over the years with societal goods and services that have more or less, stayed the same — living arrangements like rent for one, and cars for another. Your money has depreciated by simply sitting on a savings account.
There are ways to circumvent this. For one, you can seek out a high-yield online savings account to try to combat this rate of depreciation. For another, there are also certificate of deposits as well as money markets which can have more aggressive interest rates. However, sticking your money simply in savings — especially large sums of money in savings above what you can consider an emergency fund and especially in traditional brick-and-mortar banks with low interest rates, is letting it suffer depreciation over time. This is an acceptable cost for emergency funds (and the size of this is completely dependent on you), and should be considered a necessary price for fighting life’s hurdles and emergencies. Seek out high-yield savings accounts to keep this cost of inflation low against your own funds.
Why should I care saving so early for retirement? Why should I invest? — A look into compound interest, early birds and patience
“The stock market is a device for transferring money from the impatient to the patient.” — Warren Buffett
“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” — Albert Einstein [disputed]
The short, simplistic & catchy answer: Every $1 invested now, becomes $2 in 10 years, $4 in 20 years, $8 in 30 years and $16 in 40 years.
The long and complicated answer: Investing is a personal choice. Furthermore, past historical returns, even when they have held true for 120 years, is never a guarantee of future returns. We all have the proverbial choice of enjoying the here and now OR setting aside resources for a hopefully bigger payoff in the future. This decision is ultimately yours to make, but it is a balancing act. You would not want to deprive yourself of every human pleasure in making life comfortable and enjoyable — of enjoying memories and adventures along the way in pure service of chasing “tomorrow”. On the other hand, it might also be unoptimal to seek out every hedonistic pleasure possible in the present, at the cost of a burdened future. This requires introspection and alignment.
Now, back from the philosophies of life: The above capability of the market to compound the original invested principal is the reason why practically all retirements — most likely even yours (through your retirement account) — operate using the securities (stock/bond) market. The earlier you start and big, the less hard work you’ll need to put in towards your retirement and the more you’re letting the market do the hard work for you, compared to someone who started out later with a smaller contribution.
Let’s set an example in the above figure, assuming a market return of 7%: who do you think will make more upon retirement at their age 60 — someone who saves $500 a month for retirement for 10 years from their age 20–30 years, then completely stops working when they hit age 30, or someone who saves $500 a month for retirement from their age 30–60 years. You’d probably think the latter — they contributed $500 a month for 30 long years, compared to the other lazy dude who only contributed $500 a month for 10 years and stopped working. However, it’s exactly the opposite — the “lazy” dude made $631,045.97 vs the hardworking individual who made $566,764.72. Compound interest shows its power here — and the advantage of the “lazy” dude over the hardworking individual gets bigger, the higher the market return.
However, past historical returns — even if they stayed true for years, is not an indicator of future market performance and hence the importance for a diversified investment portfolio. Never put your eggs in one basket — look across large-cap (big corporations) and small-cap (smaller businesses). Look across sectors — from technology to energy, industrials to healthcare. Look at home and abroad, from within the United States — by far having the current undisputed leading market in the world, to other markets — particularly emerging markets like India, Latin America, Russia, China and many more, who will have more of the global economic pie in the coming decades. Take a gander at your own retirements — it will most likely be invested in a portfolio composed of stocks and bonds. As you come closer to retirement age, most retirement accounts are invested on target-date mutual funds. These target-date mutual funds slide the stock portion of one’s portfolio away from stocks and more towards investment-grade bonds as you gets older (AAA corporate bonds and US treasuries — any lower-quality bonds, especially junk bonds, will start to have stock-like aspects of risk associated with it which would defeat the purpose of diversifying with bonds for a regular investor) such that during your retirement, economy upswings and downswings even while withdrawing funds (and thus, realizing your investments), would not jeopardize you during your years of retirement.
Using the historical return results of the S&P500, the median annual return for a 40-year investment has been 9.99%~. This means that half of all investment portfolios that solely stuck with the S&P500 index over the years generated an annual return of 9.99%~ not considering inflation and 6.414%~ considering inflation. Even the worst 40-year investment generated an annual return of 4.9%~ not considering inflation and 3.187%~ considering inflation. If this same money was stuck in savings, it would have generated a modest return (depending on the bank’s interest rate) and would most likely be a negative return when inflation is considered — your purchasing power has been eaten by inflation over time. Notice also that the minimal possible return is alleviated the longer one keeps their investment in the S&P500. For example above, the worst possible annual return for a 1-year investment was -62.283%~ (note, negative!) vs a 4.90%~ (note, positive!) for a 40-year investment. Note that all of this has nothing to do with your intelligence or capability as an investor — just pure patience.
Need for money over time
Notice that as shown above, the probability of obtaining a subpar profit/return on your investment increases the shorter your window of investment. Avoid holding short-term on investments as much as possible. Larger short-term capital gains tax rates as well as higher probabilities of a bad return can quickly consume your investment money.
This is one of the pivotal reasons for structuring a sound emergency fund, preferably highly accessible and stored in a high-yield savings account. Come life’s temporary bumps and challenges to unemployment and crisis, the funds stored in your savings and checkings should hold you out from digging into your investments. Remember that concept of inflation talked about earlier? Consider that a small price to pay for a semblance of your own financial safety net. If you were in a bad shape and your investment portfolio at that point in time, was also in a bad shape, you will end up taking a loss by converting those stocks into cash. If you had pre-allocated funds to weather the storm, you would have been able to avoid touching your investments instead. The size of this emergency fund is completely up to you, but a good starting rule is a highly accessible savings account that could sustain your expenses for 4 to 6 months — however, this varies based on whether you find yourself self-employed or in a job industry with high turnover/hard-to-find a new gig (in which case, you would probably want to bump it up to a year). Assess, reflect and strategize based on your use case.
Planning for retirement
When one retires, the US government provides retirees a maximum of $3,895 a month (as of 2021) as part of Social Security — a completely public program to which we contribute to during our working years (a quick check at one’s W2 reveals our Social Security contributions). In 2019, the average monthly payment for Social Security was $1,478. However, this can change as the Social Security Program is currently expected to exhaust its reserves by 2037, at which point it would only be able to pay around 76% of the scheduled benefits — unless Congress decides to pass legislation to prevent this from happening (source: Social Security Government Website ssa.gov/policy/docs/ssb/v70n3/v70n3p111.html). Retirement also incurs a lot of costs and unknowns of its own, especially with the rising healthcare costs in the United States and the lack of ability to make traditional income after retirement, among many factors. Planning for retirement allows one to strategize and chart a stable foundation for this post-work/little-to-no income portion of our lives.
Practically all retirement accounts use the power of compound interest in the stock market. Under the hood, your contributions to a retirement account are invested in the stock market under a diversified portfolio, which is most if not all, configured to stocks on your younger years (encouraging greater growth) and slide towards bonds on your older years (encouraging greater stability when withdrawing money come retirement). Some retirement plans generally give greater latitude than others in this degree of control. You can try to chart out the amount of money you think you would need to live during retirement by estimating the money you would expect to need to live with per year during retirement. Deduct 70%~ of the the expected annual Social Security benefits (use the Social Security benefit estimator at ssa.gov/benefits/retirement/planner/AnypiaApplet.html, 70%~ accounting for Social Security issues as stated above). The leftover amount of money you will need per year, divided by the safe withdrawal rate of 0.04, is what you will want your retirement portfolio to reach before retiring.
As an example, say you expect to live with $60,000 a year in retirement (before taxes). Alas — this may sound a lot, but considering a 2% annual inflation, having $60,000 a year in 2051 is the same as having $35,000 a year now! You expect Social Security to pay out $16,800 a year (70% of what the retirement benefit calculator returned you). That leaves you with $60,000-$16,800=$43,200 a year to try to cover using my retirement accounts. With a safe withdrawal rate of 4% of your retirement portfolio, that means you’ll end up needing to attempt to build a portfolio of $43,200/0.04 = $1,080,000 during your working years. Using the compounding interest calculator at investor.gov/financial-tools-calculators/calculators/compound-interest-calculator, accounting for 30 years of saving for retirement, a post-inflation expected annual return of 6% and a $0 initial retirement balance, would demand that you contribute around $1,150 a month for retirement.
Pre-tax and Post-tax: What is that?
Most retirement accounts operate around the concepts of “pre-tax” vs “post-tax” contributions. The general rule of law by the IRS in its tax code is that you will only be taxed once a pile of cash and only once (as long as you are careful). Thus, this generally means that any untaxed contribution to a retirement account is taxed upon withdrawal and on the flip side, any taxed contribution to a retirement account, is tax-free upon withdrawal. However, gains made on this earned income through investments is subject to be taxed based on the rules set by the IRS and the type of retirement account you have (we’ll talk more about this below).
Pre-tax contributions is money one makes out/stores away to a retirement account before taxes are taken away, which thus lowers your taxable income. This could also mean money one deposits to a retirement account after taxes were already taken away during the course of your working year BUT end up claiming a deduction for during tax filing season (whenever possible) as a tax-deductible contribution, thus zero-ing out any tax one would have owed for that pile of cash you are contributing. For example, say you make $85,000 a year (and suspending the notions of other tax deductions at the moment). Part of your income made above $40,126 for 2020 is at the 22% tax bracket. If you max out your regular 401k contribution (with the IRS maximum for 2020 being $19,500) and contribute $19,500 to a regular 401k/403b/457, your actual take-home pay for the entire year would be $85,000-$19,500=$65,500, and the IRS will only calculate the income tax against that $65,500, not the original $85,000.
Post-tax contributions (also known as non-deductible contributions), on the other hand, is money one makes out/stores away to a retirement account after taxes are taken away and without making any attempts to claim a deduction against during tax time. These post-tax contributions do not lower your taxable income. For example, say you make the same $85,000 a year above and max’ed out your contribution of $19,500. Your take-home pay would be $85,000-$19,500=$65,500, but you would still be taxed for your entire $85,000, unlike the pre-tax contribution above where you can only expect to be taxed for the $65,500.
Regular 401k (and 403b/457) vs Roth 401k
Regular 401k (for-profit employer) along with their 403b and 457 variants (nonprofits/government) are all similar in that they are used to save up money for retirement using pre-tax contributions. Remember above that with pre-tax contributions, money one is depositing is still untaxed OR do plan to get a deduction for (as a deductible contribution). Your employer will typically provide you a retirement portal where you can control this contribution, but it will most likely be based on a percent of your gross income on your repeating paystub/paycheck that comes in monthly, bi-weekly or bi-monthly, depending on your employer’s paystub frequency. Some employers also perform a match, where for every dollar you contribute up to a certain amount, an employer may also match it up to a certain percent — it would be helpful to look into your employer’s benefits program to understand whether they do a match and how. Come during retirement time, when you pull funds from a Regular 401k, such withdrawals are taxed at ordinary income rates. For example, say you withdraw $80,000 from your 401k/403b/457 for the year (during your retirement) and Social Security gives you $30,000. You can expect to be taxed as if you made $110,000 income. In reality, the government has nice tax benefits to Social Security which can make this tax lower, along with other tax deductions for retirees.
On the other hand, a Roth 401k account is typically filled with post-tax contributions. Remember above that with post-tax contributions, money one is depositing has already been taxed AND do not plan to get a deduction for (as a deductible contribution). However, this comes with a benefit — come during retirement, any withdrawals made from a Roth 401k is not taxed. Generally, a Regular 401k account is more strategic for those who make more money now than in retirement (high-income earners and thus, expects to make less money during retirement than at the present, which potentially leads to a lower income bracket). A Roth 401k account tends to be more strategic when one expects to make more money in retirement (and thus, expects to make more money with the build-up of funds during retirement than at the present and thus, more taxes). Jim Cramer, an ex hedge-fund manager, typically recommends those around the 24% tax bracket downwards to a Roth 401k account (source: youtube.com/watch?v=c8ay1mI54VM).
You can also choose to contribute to both type of accounts as well, at the same time — the only limitations is the IRS limits for the total possible contributions to these accounts is $19,500 (as of 2020) per year. This limit does not include any employer match by your employer — just solely your contributions from your income. Both these types of accounts require you start withdrawing a certain amount when you reach a certain age (72 years old as of 2020). Also based on the new SECURE act legislation (passed in 2019), upon your death, any inheritor of your 401k account will also have to fully withdraw any funds in the account within 10 years of obtaining it.
Traditional IRA vs Roth IRA
Individual Retirement Accounts (IRAs) are generally useful if you currently have 1.) a retirement account through an employer (401k/403b/457) and would still like to fund more money into your retirement or 2.) have no retirement account from your employer. IRAs are also neat in that they generally give you greater control on how to invest for your retirement — traditionally, employer-sponsored retirement accounts (401k/403b/457) have a select choice of mutual funds you can elect to choose for the growth of your contributions for retirement. On the other hand, IRAs allow a lot of self-directed investing options, where you get to pick any specific stocks, bonds, exchange-traded funds and mutual funds in the stock market to your heart’s desire. The IRS has more information about Individual Retirement Accounts here — irs.gov/retirement-plans/individual-retirement-arrangements-iras.
The IRS allows anyone to contribute a maximum of $6000 to a Traditional IRA account on top of any other contributions you may have made to a 401k/401b/457 account, regardless of your income level, for any given year. There are no income limits to making a contribution to a Traditional IRA, but whether those contributions are tax-deductible (like a traditional 401K) or non tax-deductible (like a Roth 401K) depends on how much money one makes, whether they or a spouse currently contributes to a 401K/401b/457 account and many more. The IRS has set those rules out at irs.gov/retirement-plans/ira-deduction-limits. Any post-tax contribution amount/contributions you did not claim a tax deduction for to a traditional IRA will be tax-free when you withdraw upon retirement. Any pre-tax contribution, and for that matter, gains on even the post-tax contribution amount will be taxed based on the income tax brackets you are at during retirement. Just like a 401k/403b/457 plan, you are also required to start withdrawing money after 72 years of age.
Unlike Traditional IRA accounts, the IRS limits those who can contribute to a Roth IRA account (as can be seen on the figure above). Those who make $140,000 and above as a single filer or $208,000 are not allowed to make any contributions to a Roth IRA account. However, the power of the Roth IRA account comes in the fact that any contributions and even gains on a Roth IRA account are completely tax free upon withdrawal. Remember that with a Traditional IRA, gains on a post-tax contribution is taxed based on your income tax bracket during your retirement years. With a Roth IRA, you owe no taxes at all with those gains — and this can be powerful given that the stock market, as mentioned above, has the power to double your money every 10 years (such that money you store away now is 16x larger in 40 years) — all these gains are tax-free. Another advantage with a Roth IRA unlike a Traditional IRA is that you are not required to withdraw funds upon hitting 72 years of age — you can let the market keep compounding your funds and grow if you don’t find yourself needing that money come that age.
To recap: making post-tax contributions to a Roth IRA account is clearly more advantageous than a Traditional IRA account. The Traditional IRA account can only be advantageous when you qualify for tax deductions based on the rules set by the IRS at irs.gov/retirement-plans/ira-deduction-limits. However, the Roth IRA is clearly superior for the case where one puts in money that had income tax already taken away AND don’t plan to take a deduction for. The only downside is, Roth IRA has an income level requirement — high-income earners are not allowed.
Wait — Backdoor Roth (& Mega Backdoor Roth) conversions for high-income earners and super-savers — and they are completely legal!
“Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.” — Congressional Conference Report
As discussed above, making post-tax contributions to a Roth IRA account is clearly more advantageous than making a post-tax contribution to a Traditional IRA account. However, Roth IRA contributions are not allowed for people who make a certain amount of income and up.
The limitation for high-income earners is circumventable by what is known as a backdoor Roth contribution — simply make a post-tax contribution to a Traditional IRA, letting those funds settle for a day (making it clear for taxable purposes to the IRS that those funds were in a Traditional IRA account), and then make a conversion of those funds to a Roth IRA account (hopefully avoiding making any earnings on those funds while they sit on a Traditional IRA account — those gains in that time is taxable). Voila: anyone, regardless of their income level, can contribute to a Roth IRA account!
That post-tax contribution on your Traditional IRA, which will gain money in the stock market throughout the years (note above: if the future followed historical patterns, this means doubling every 10 years so that on average, so that contributions made 40 years in the past would be 16x larger on average), would have had those gains taxable based on your ordinary income tax bracket during retirement. However, making the conversion of those funds to a Roth IRA zeroes out the taxes even on those gains — making any of the funds on your Roth IRA account tax-free.
There is a way to take this up a notch of making a Mega Backdoor Roth conversion, allowing you to stash more post-tax contributions and make tax-free withdrawals (on both contributions and gains) during retirement — but this process can be a bit more complicated and requires more coordination. Researching “Mega backdoor Roth” as well as talking to your employer’s Regular 401K/401b/457 plan company can help you coordinate this yourself. Essentially, with a Mega Backdoor Roth (unlike the backdoor Roth), you are not just limited by the $6000 that you can place on a Traditional IRA that you then make a Roth IRA conversion for — this can be as large as $37,500 a year for anyone under 50 years of age, if you were to fully utilize the maximum post-tax allowable contributions to a Regular 401k/401b/457 plan (and provided you and your employer made zero pre-tax contributions). You can max out the post-tax contribution to a Regular 401k/401b/457 (NOT a Roth 401k) account to your employer, then request a transfer of those funds over to a Roth IRA account. If you want to do this, this information is available throughout the internet. There will also usually be internal murmur about this with your co-workers on how to do this process, and if there isn’t, get in contact with someone from your company’s Regular 401k/401b/457 managing company. Note however, that some Regular 401k/401b/457 plans do not allow post-tax contributions and your mileage may vary. This process is also error-prone — seek out the advice of a professional financial advisor for more details.
Other Tax Advantaged Accounts
Personal Choice Retirement Accounts
Some employers have 401k/401b/457 plans that allow you to control how your retirement is invested on the stock portfolio, instead of the plan solely controlling the type of investment that is being made out for you — most likely in a pre-configured investment portfolio composed of some stocks and bonds. Consult with your employer/human relations department about whether you have the ability to do self-directed investments for your retirement — this can often go under the name “Personal Choice Retirement Accounts” or “Self-Directed Retirement Investing”. This allows you to control your own retirement investment portfolio, instead of being boxed in to your retirement plan’s select set of stocks.
This also comes with the responsibility of making informed and diversified investment picks on your retirement money — this is not the time to put all your retirement funds to something like Gamestop (GME) — air on the side of well diversified mutual funds and exchange-traded funds. It is also important to note that on one’s younger years, one would want aggressive growth and should have more of their portfolio in stocks, but as one gets nearer to retirement, one would want to increase the amount of bonds in their portfolio for a more stable set of funds in retirement.
Health Savings Accounts (with Health Savings Brokerage Accounts)
Health Savings Accounts are one of the most tax-advantaged accounts — you make pre-tax contributions, can withdraw tax-free for “qualified” health expenses at any time and when you retire, withdrawal rules are a lot like a regular 401k/401b/457 — they are taxed on your income level during retirement (unless you use them for “qualified” health expenses — which will still be tax free). Any money on an HSA lives year after year until you use them — you never lose them unlike similar accounts like an FSA. They are a lot like bank accounts — you can request your HSA provider to give you an HSA debit card. The IRS contribution limit in 2020 was $3,600 for those who have their own high deductible health insurance plans and $7,200 for a family-based high deductible health insurance plan. What qualifies as a health expense for an HSA is pretty generous (check out irs.gov/publications/p502#en_US_2020_publink1000178851) — just keep the receipts for tax bookeeping. What’s more, say you have a high-deductible health insurance plan but your spouse or child do not — they can still use your HSA for these qualified expenses, tax-free!
If you don’t have a Health Savings Account but have a high deductible health insurance plan (they tend to be the cheapest health insurance plans so you most likely have one if you’re trying to save money — check your health insurance), you can open an HSA through your provider and contribute to that HSA. You also have the choice of opening an HSA through an external company like Fidelity (fidelity.com/go/hsa/why-hsa) and Lively (livelyme.com). If you choose to switch health insurance plans to a non-high deductible health insurance plan, you can still withdraw funds tax-free for qualified health expenses from an HSA, but you just cannot contribute/deposit money during those times you have a non high-deductible health insurance plan — until you switch back. If you change employers or are even self-employed, you can keep your HSA with you. You can even keep many HSA accounts open — so long as the sum total you contribute to for a given year abides by IRS limits (as stated above) and you are eligible to make a contribution.
Upon getting a Health Savings Account, look up how to invest extra funds on your HSA into your HSA plan’s set of mutual funds, or into an attached Health Savings Brokerage Account. A Health Savings Brokerage Account, much like what a Personal Choice Retirement Account allows one to self-manage their own investment portfolio in a 401k/401b/457, will allow you to control and choose specific stocks/bonds out in the market to control how your funds are invested beyond your HSA’s limited set of mutual funds. Take advantage of the fact that the gains on an HSA is untaxed, unlike investing on your own brokerage — with costs of healthcare rising, one will need all the help one can get from compound interest.
Health Care Flexible Spending Accounts (and their variants)
Unlike Health Spending Accounts, Flexible Spending Accounts (FSAs) can be contributable to no matter whether you currently have a high-deductible health insurance plan or not. However, FSAs are acquired strictly through an employer and thus, self-employed people cannot get them. Moreover, any unused money deposited to an FSA disappears after the fiscal year (some employers provide a grace period of an additional 2 months). Just like an HSA, contributions to an FSA are pre-tax. The qualified expenses that an HSA and FSA are pretty similar, as well as the ability for a spouse or a dependent (child of yours) to use them without any penalties.
There are variants of a Health Care Flexible Spending Account, like Dependent Care Flexible Spending Accounts (DCFSAs) and Limited Care Flexible Spending Accounts (LCFSAs). However, those variants are much more limited in the scope of what they can cover as a qualified expense — DCFSAs only cover expenses like before/after school care, summer day camp and babysitting. LCFSAs typically cover dental and vision related expenses only.
Due to the use-it-or-lose-it behavior of these types of accounts, they’re only helpful if you are sure to use the funds that you plan to put into those types of accounts — if you’re going to use those funds anyway, might as well get a tax deduction out of it and save money based on your tax bracket.
Opinionated Financial Fighting Strategies
Planning big purchases with conservative FDIC-insured high-yield savings/CDs (Certificate of Deposit) OR aggressive but risky post-tax Roth contributions
Maybe, you are planning to put a good down payment for a property a few years from now, potentially strategizing an aggressive market offer that would be more tantalizing to a bank/homeowner you’re buying the property from, when compared to the other offers in town. In the mean time, you can stick your money into a variety of accessible areas — a high-yield savings account, a certificate of deposit or as a post-tax contribution on a Roth IRA/Roth 401k to plan for such a big purchase.
High-yield savings accounts offer the most liquidity — you can withdraw cash out of a savings account at any time. Almost all savings accounts at US banks today are FDIC-insured — you do not have to worry about what happens to the market. Whenever the time arises to buy a house, you have the choice to do so when your funds are in a high-yield savings account — little work is needed to timing and coordinating a purchase. You like the price of a property? You got the money in the bank? Fire away.
Almost all Certificate of Deposits that can be obtained from US banks today are FDIC-insured — you also don’t have to worry about what happens to the market. They can also offer more aggressive interest rates when compared to high-yield savings accounts, giving you a bit more money years down the road when you decide to make that purchase. However, you are often limited as to when you can access the funds that are stored on a CD — most types of CDs with superior interest rates than that of a high-yield savings account would require that you lock away funds for some set amount of time — ranging from months to years.
Post-tax contributions on a Roth IRA (note contributions — the amount of money you’ve deposited into a Roth IRA account, not earnings, and not conversions coming from Backdoor/Mega Backdoor Roth, which must abide by the 5-year rule — hrblock.com/tax-center/irs/early-withdrawal-penalties/) can be pulled at any time. This can often provide a more aggressive profit on your stored money which then helps you accrue savings for retirement, all while waiting for that large purchase. However, because that money would be invested in the market, withdrawals are thus not insulated from market up-and-downs. Particularly being forced to withdraw when the market isn’t particularly doing well to do your purchase, will be disadvantageous to you — your account may even have less than what you contributed over time, at that point in time you decide to make a purchase! What is more, your investments are not FDIC-insured — the value of securities can go up and down at any time.
Filling up retirement account buckets — Fulfill employer match, then HSA, then Regular 401k tax-deduction limit, then backdoor Roth, then Mega Backdoor Roth, then …
First and foremost: filling up retirement buckets is a matter of whether if you have the financial means to do so or not. You will find yourself going up across these buckets the more income and flexibility you have to do so.
- The first step to try to achieve would be to completely match your employer retirement match — or you’ll just end up throwing money away that your employer is giving you for free to match your contributions for your retirement. Employers often do something to the effect that up to a maximum percent of your gross income, they’ll match whatever dollar you contribute with another dollar.
- The second step would be to try to max out your Health Savings Account contributions — the IRS allows individual HSA holders to stash $3,600 (and $7200 for those in family health insurance plans) in 2021 with tax-free contributions. This HSA is accessible penalty-free in retirement for any type of withdrawal whatsoever and is also tax-free and penalty free for qualified health expenses you may have at the present or nearby future. Invest whatever money you can in your HSA in the market to get some growth.
- The third step would be to fill up the Regular 401k tax deduction limit, which was $19,500 for 2020. Doing so brings down your taxable income by $19,500 and gives you more money in retirement. If you are not on the Regular 401k camp and is instead on the Roth 401k camp, fill this up to the contribution limit (also $19,500 for 2020).
- Last but not least, if you still have the flexibility to do so, perform backdoor and mega-backdoor Roth contributions, or do a regular Roth IRA contribution should you be allowed to do so considering you meet the IRS income limit (as discussed above).
Got flexibility? HSA receipt bookkeeping and timing withdrawals
For tax purposes, it is always strategic to keep all records of receipts and bill statements for any expense you used a Health Savings Account to cover for such that if you ever are audited by the IRS, that you have sufficient proof that you made are qualified health-related tax-free withdrawals. Most HSAs allow you to keep these receipts on your online account.
However, when you withdraw this money is up to you. You can choose to withdraw money for that qualified expense at the moment you need it OR save the receipt, pay for that with your current credit card/debit card and then claim that money 5–10, even 30 years from now. Why? Say instead of withdrawing $1000 now from your HSA, you keep it their for 5 years instead of withdraw 5 years from now. Assuming a post-inflation return of investing that $1000 in an HSA of 7%, that $1000 would have become $1,402.55. You made $402.55 in profit for simply waiting to withdraw for 5 years. Now, this is completely up to whether you are financially flexible enough to make such a decision — if you’ll be in credit card debt with such a choice, then just withdraw at the moment: again, no sense in trading a 7% return for a credit card with an 9% APR or worse.
Passive/Active investment portfolio allocation across accounts
Considering the latitude of investments you can make across your Personal Choice Retirement Accounts (PCRAs) for your 401k/403b/457, your Health Savings Brokerage Account (HSBAs) for your Health Savings Account (HSAs), your Individual Retirement Accounts (IRAs) and your personal brokerage accounts, it can be quite overwhelming to handle investing across all these mediums.
I have personally kept this as a strategy: choose passive, diversified, market index, low expense ratio mutual funds for all my retirement accounts (401k/403b/457 and IRAs) as well as HSAs and I do a more active approach with my brokerage accounts, which are still heavily dominated by diversified exchange traded and mutual funds. I don’t have time to manage my money and research specific companies full-time and I don’t want to — I have my own goals I want to achieve in life and most likely, you do too. With index-based funds like ETFs and mutual funds, I can go after a basket of holdings that targets specific sectors or nations and fire and forget. Money is a tool and though you have all of these other specialized add-on tools to your disposal to get more out of your money, arrange them in a way that does not disrupt your life but rather, makes it easy for you.
There are many great resources out in the internet — use them at your disposal. Utilize the above array of financial tools and seek out those that seem most appropriate to you depending on your means, income and capabilities.
Saving and investing much and early Traditional 401k/403b/457 will most likely provide the bulk of your financial firepower in retirement. Roth IRAs and the ability to perform post-tax contributions with backdoor and mega backdoor Roth contributions allow you to take this up a notch and stash more money for retirement with tax-free gains, which can help complement the money you would get out of your 401k/403b/457 accounts. With their tax-free withdrawal nature, you can start withdrawing funds during the last few years before you officially retire, where you may find yourself wanting to do an early retirement or a less stressful job with less income without bumping you into a higher tax bracket during those years. Specialized tax-advantaged accounts like Health Savings Accounts allow you to take financial planning and saving further, by not only allowing you to save additional funds for retirement (functioning similar to a traditional 401k/403b/457 plan), but also, as a tax-free tool to paying for any qualified expense covered by such accounts.
If you found this story helpful, please smash that clap button once 👏, or multiple times 👏👏👏👏👏 . Don’t hesitate to reach out if you have any of your own tips and tricks — I would love to hear from you!