Tax Time Examples
Photo Credit: Nick Lee

In the previous post, we reviewed several useful tax breaks available to most people. Let’s now look at a few examples, starting with a few things one can do to lower his or her tax burden for last year (2016).

  1. Individual Retirement Accounts ($5500 per person, $6500 for those over 55). Must be funded by April 18th, 2017 to count towards 2016 taxes.
  2. HSA contributions ($3350, individual, $6750 MFJ) can still be made until April 18th, 2017.
  3. Solo 401k contributions can be made until 4/18 provided you have already elected to make them by December 31st of 2016. Weird rule, but that’s the law.
  4. SEP contributions for small business owners.
  5. Take any credits for expenses incurred during 2016 that reduce your Adjusted Gross Income (AGI), i.e. student loan interest, tuition credit, moving expenses, etc.
  6. Evaluate eligibility for the following tax credits/deductions based on AGI:
    1. Retirement Savings Credit
    2. Earned Income Credit
  7. Calculate the amount of itemized deductions (mortgage interest, property tax, charitable contributions, etc.) and compare that with the standard deduction, taking the larger one.

A great way to see what effects the above tax credits and deductions listed above is to use Intuit’s TaxCaster app or website. After optimizing last year’s tax situation, there’s quite a bit that can be done in 2017 to improve the current year’s tax situation.

  1. Maxing out HSA contributions ($3400, individual, $6750 MFJ)
  2. Maxing out 401k ($18,000) plus another $6000 for those 50 and over
  3. Maxing out Traditional or Roth IRA funds ($5500 per person plus another $1000 for people over 50)
  4. Determining Itemized Deductions for 2017 (mortgage interest, property taxes, charitable contributions, etc.)
  5. Adjusting FSA ($2550) and Dependent Care contributions if a qualifying life change occurs during the year.
  6. Planning to pay college expenses if applicable.

To see how some of the tax credits and deductions apply in black and white, there are a few case studies below along with links to the simulated 1040 form. References to line numbers are for the IRS 1040 form that is the standard form for preparing and filing taxes.

Sample 1040 Walk Thru, Case #1

Debbie and Joe Example are a couple who has been starting on the path to saving more and paying less taxes. They each gross $60,000 per year, have two children, one is eighteen and attending college and the other is eleven. They contribute 10% of their paychecks to 401ks, and max out their HSAs, IRAs, and FSAs and have $2000 in additional cafeteria plan spending for healthcare and dental insurance premiums. They receive $5000 per year total in qualified dividends, $250 in capital gains. They have itemized deductions of $15,000, student loan interest of $500 and have spent $2000 toward their college child’s tuition and pay $5000/yr for dependent care while at work.

Total W-2 income (line 7) is $96,700 ($60,000 x 2 – $12,000 -$6750 – $2550 – $2000). From this amount, the capital gain ($250) gets added (line 13), but the qualified dividends do not (line 9b). IRA contributions ($11,000) reduce AGI (line 32) as does student loan interest ($500, in line 33). This results in an AGI of $85,450 even though their actual gross income was $125,250 ($60,000 x 2 + $5000 + $250)–a pretty decent income reduction.

That AGI is further reduced before calculating the tax owed. First, the standard or itemized deduction is applied (line 40). Here, since the itemized deduction is higher, they use the itemized value of $15,000. Next, the $4050 exemption per family member is applied (line 41). This brings down the taxable income to $54,250 (line 43), less than half of gross income. The preliminary tax value is then computed by looking it up in the IRS’s tax tables and a value of $7214 is entered (line 44). The dependent day care credit (line 49) would be $600 ($3000 [max allowable] x 20%). Additional credits would come from the education credit (lines 50 and 68), leaving a total tax bill of $3334. Not too bad considering their gross income and earnings totaled over $125,000 for an actual average tax rate of 2.7%. However, paying even that small amount was more than they wanted, so they decide they can do better.

Example Family Taxes

Example family Case #2:

Let’s rewind the clock and start the same year again (easier for comparative purposes), but this time giving Joe Example a pay bump to $70,000. Debbie is now the owner of a small business whose net income is also $70,000 before any contributions/deductions are made. They first decide to max out their 401ks to $18,000 each, with Debbie able to contribute as both an employer and employee. We’ll keep all other expenses the same, except this time, the Examples elects to do a Dependent Care FSA instead of claiming a credit. Joe’s net income is now $40,700 ($70,000 – $18,000 – $6750 -$2550 – $2000). Debbie’s income will be reduced by 25% for the employer contribution to her solo 401k and she puts in $18,000 as the employee portion for a total of $35,500 (on line 28). Her net income is then $29,500 ($70,000-$17,500-$18,000-$5,000).

Total AGI is $58,950. Taxable income is $27,500. Tax owed in $3,201. Total credits amount to $3000 which includes child tax credit and the education credit. Total tax owed is $201* on an AGI of $58,700 ($145,250 in gross income) or 0.3% average tax rate, which is much lower than the 15% marginal tax rate for the bracket they are in.

Example Family Taxes Take II

All told, even though the Examples pulled an extra $20,000 in income in the second example, their taxes dropped over $3000 or 94% lower than the first example. They did that by taking full advantage of the business retirement plans, a deductible child care deduction (rather than the credit) and maxing out 401ks. They should still have sufficient income for spending with their remaining taxable income ($70,200), $5250 in dividends and capital gains, plus a variety of tax advantaged money that is earmarked for certain expenses: $5000 for dependent care, $6750 from HSA for medical expenses, $2550 from FSA for dental and vision, $2000 in college tuition for a total of $91,750 of potential expenses. Additionally, they saved a whopping $64,500 for their retirement. Not a bad job, especially when keeping their income tax owed to $201.

Case #3 The Earned Income Credit

Changing the Example’s situation to a case where now Joe is laid off from his job and Debbie’s business folds. Debbie is able to find a lower paying job at $50,000 a year, but has no 401k. They only net $3000 in capital gains for the year. They do not plan to use Dependent Care until Joe finds another suitable job. They determine that they will need an average of $3500/month to meet their expenses or a total of $42,000 annually. They expect to fully use the money from their HSA and FSA contributions this year for allowable medical expenses, so they elect to max out those contributions. Even though they saved a lot in the previous year, they know they need to keep saving for retirement.

They would like to fully fund their IRAs at $5500 each, but when looking at tax calculator, they realize that they would only need to contribute about $2750 in a Traditional IRA to get the full tax benefit and that additional contributions do not reduce their taxes. Also, they’re in the 10% tax bracket, so they would be best served to “pay” the tax now and let the money grow completely tax free, so they contribute the remaining $8250 to Roth IRAs. When we say “pay” taxes at 10%, we’ll see that there is actually no tax owed-quite the opposite-they get a tax refund, even if they contributed no money to federal taxes. Their total income** (line 22) is now $38,950 ($50,000 +$250 – $2000 – $6750 – $2250). After discounting the Traditional IRA contribution of $2750 and student loan interest of $500, their AGI is $35,700.

Going through the remaining items on the back of the form, their itemized deductions are still $15,000 and exemptions are $16,200, leaving them with $4500 in taxable income. Looking at the tax tables, the income tax owed is $428, but when they get the results from TaxCaster, they see that in fact, the government owes them $4217! How could that be? They were expecting to get $1000 in child tax credit and were hoping to get almost their $2000 back in tuition credits, but there’s still almost $2000 extra coming back to them that they didn’t pay in. Enter the Earned Income Credit (EIC).

The EIC was designed to help those who are working but have a modest income. In this case, the EIC gave the Example family almost $2000 in supplemental income that allows them to meet their budget needs while still allowing them to save some money for retirement. The EIC has quite a few stipulations and is based on filing status, number of children and income. Those with relatively moderate investment income (above $3400) are also excluded.

Returning to this third case, the Examples had a total income of $53,250, including job and investment income. They had to pay a total of $2983.50 in Social Security and Medicare taxes (7.65% of $39,000). Assuming they use the full HSA and FSA contributions for allowable expenses as part of their $42,000 annual budget, they have sheltered those funds from taxes, but are able to use them when the expenses occur. The only portion of their income that is not available for use during that year is the Traditional IRA contribution of $2750, though they could access it by paying the tax and a 10% penalty if needed. Contributions to a Roth IRA can be withdrawn tax and penalty free, but any earnings would be subject to the 10% early withdrawal tax. Credit card rewards could also be used to add some additional income to provide an additional income buffer.

Along with the EIC, the total income available to cover expenses is $43,484 ($53,250 – 2983.50 -$11,000 +$4217), more than covering the needed expenses of $42,000. Plus, because of the way the IRA contributions are setup, the Examples can file their tax return for the previous year and claim IRA contributions will be made by the mid April deadline and get their refund back before actually having to put the money into their IRA, so in cases where the cash is tight, this is a nice cash flow bonus, but having some time to make the contribution after receiving the refund.

Example #3

Wrapping it up

Tax planning is neither glamorous nor very exciting, however, spending a couple of hours to understand the basics and not-so-basic tax planning strategies can save people significant sums of taxes, even in situations where income is relatively low. Moreover, since basic tax laws don’t change much year to year, strategies generally only need to be tweaked after they are initially established or as family situations change (new baby, marriage, divorce, children in college, new jobs, new business, etc.) Proper tax planning, once done will streamline future tax filings and allow people to keep more of their money in their pockets, or hopefully, in their investment accounts.

Wait, trees have to do taxes too?
Photo Credit: Angie Flowers

Disclaimer: The above tax examples are the author’s attempt to illustrate some of the tax advantages available in the tax code. The author makes no guarantee that the above examples are compliant to all IRS rules or to anyone’s actual tax situation. Consult a tax adviser or online tax preparation software to get a more detailed estimate of an individual tax situation.

*These calculations do not reflect the self-employment tax for Social Security and Medicare (15.3% total), which is double the employee amount (7.65%), nor the self employment deduction for taking paying them. The goal of this post was to focus on federal income taxes only, assuming Social Security and Medicare taxes were paid quarterly, like they are supposed to. Trying to replicate this on Taxcaster will result in the program computing self-employment taxes, which are significantly more than actual federal taxes, which is where the Taxcaster program differs from these results.

**This is different from tax line 22 total income which excludes cafeteria contributions like HSA and FSA, as well as medical, dental and vision premiums.


Tax Time

Photo Credit: Phillip Ingham

What Time is It? Tax Refund Time!

Now that 2016 is finally over, Americans will soon be receiving  reminders of the good, bad and the ugly in their finances last year.  These digital and paper tax forms are intended to help them prepare their taxes. It is estimated that American’s waste 6.1 billion hours (695,000 years) preparing and filing their taxes each year. This breaks down to over 19 hours for every single person in the US. About half those hours are for personal filings and half for business. Assuming an average cost of $25/hr (either real or opportunity), that’s $152.5 billion sucked from our lives, each year.

Preparing and submitting federal and state taxes can be daunting for many, which would explain why so many procrastinate it until the bitter end. Taxes are overly complicated and can be overwhelming at first, but a little knowledge as well as some on-line tax preparation software assistance can take most of the complexity and drudgery out of calculating taxes.

Hiring a tax professional or do it yourself?

Many people simply don’t want to deal with the headache of preparing and filing their own taxes and are happy to pay someone to take their box of documents and convert it into a tax return.  For those with very complex returns that does make sense. For example professional athletes generally have to file returns in each state where they played, and must allocate how that income by how many games they played in each state. For people with significant business income/expenses, it is also likely that a tax professional will complete that return.

For the rest of us who don’t have too many complex filing situations, on-line tax preparation software like Intuit’s TurboTax, Tax Act or even Credit Karma’s new free filing tool are sufficient to complete and check the personal return. This software generally does a good job of getting the return completed based on entering all your information, but doesn’t give many tips on what to do to get more back or how to optimize taxes based on what goals you have. There are a few popular credits and deductions that people can take, along with a few less common ones. Unless someone is familiar with the tax code, he might not know to investigate a certain tax break. It should be emphasized that this list is not comprehensive and there are caveats to some of the items below, but most common tax prep software will ask the appropriate questions. Using on-line software reduces my tax prep time to around 2-3 hours including small business info, and lots of deductions and credits. With average refunds in the $1000’s, it’s time well spent.

Deductions vs. Credits

A common question when people file taxes is what is the difference between a deduction and a credit. In general, credits directly reduce the taxes paid, dollar for dollar. For example the child tax credit will reduce the taxes owed by up to $1000. Deductions, on the other hand reduce your taxable income by a set amount, but your tax rate determines how much of a discount is applied to your taxes. For someone in the 15% marginal tax rate, a $1000 deduction would reduce their taxes by up to $150, but someone in the 25% rate, could see a tax benefit of up to $250 on the same $1000 deduction. The marginal tax rate is the tax rate on the final dollar of income earned, not the average rate.

Photo Credit: Pictures of Money

Primer on Common Tax Breaks

For a brief explanation of some of the basic tax advantaged accounts, including 401ks, IRAs, HSAs, FSAs, please refer to the previous post on the Pieces of Rightirement. Additional tax breaks are briefly explained below. Please note that  the main points are summarized and further details on eligibility would need to be determined.

SEP/SIMPLE/Solo 401k Retirement plans-available to many who own a small business. These funds are similar to regular 401ks but allow the business owner to contribute both as an owner and as an employee. These accounts permit much larger total contributions than might be available through an employer. On a pure contribution limit consideration, Solo 401ks offer the largest opportunity to contribute as one contributes to the plan as both an employer (25% of income or $53,000, whichever is lower). SEP and SIMPLE plans have similar features, but some differences as well.

Student loan interest-one of the few deductions that lowers Adjusted Gross Income (AGI). Limited to $2500 per person or per couple-one of the few tax breaks that penalizes Married Filing Jointly (MFJ) filers. Deduction starts phasing out at the $65,000 single/$130,000 MFJ and is unavailable at incomes above $80,000 and $160,000 for singles and MFJ, respectively.

American Opportunity Tuition Credit-one of the great tax benefits of sending a child to college. The credit gives up to $2500 back per child who is enrolled in eligible post-secondary schools in the form of a tax refund. The first $2000 of that is dollar for dollar of contributions, so covering $2000 per year is a no-brainer as it all gets credited back (provided the payer has tax enough to offset the contribution). The next $2000 contributed is credited at 25% back. This is good for the first four years of post-secondary education and is per calendar year. Additionally, 40% of the credit is refundable, meaning that if there is insufficient tax remaining to be paid to the IRS, the filer could get $800 back in tax refunds on $2000 spent even if no tax is owed. The other 60% can only be used to reduce the taxes due to the government.

Itemized Deductions-filers have the option to claim the standard deduction or itemize their deductions for a given year. Most often, people either don’t bother to itemize as they don’t understand what it means or find it complicated and avoid it. Most itemized deductions fall in several categories: medical expenses over 7.5% of AGI, property taxes, state and local taxes, mortgage interest, charitable contributions, casualty or theft losses and job expenses. Since medical expenses beyond 7.5% are not common, especially when discounting FSA and HSA expenses, they won’t be covered here, but might be a slight comfort to those experiencing serious ailments. State and local taxes, mortgage interest and property taxes are more common, especially when the filer is a home-owner. Charitable contributions refer to any money or goods donated to approved charities. Taken together, these items can significantly reduce taxes in some situations and usually take less than an hour to complete the forms with tax software.

Child and Dependent Care– actually two types of tax break can be claimed-an FSA type reduction of payroll taxes and/or a tax credit based on AGI:

  1. Credit will drop up to 35% of eligible daycare expenses from taxes. The maximum amount of expenses for 1 child is $3000 and for 2 or more it’s $6000. If the 35% tax credit rate is assumed, the max tax credit would be $1050 for 1 child and $2100 for 2+ children. Children must be 12 or under or otherwise unable to care for themselves. Can include a spouse or other dependent that is unable to provide care for themselves. Must exclude expenses paid for with the Dependent Day Care FSA money.
  2. Dependent Care FSA-type account that allows filers to pay for eligible care with pre-tax dollars-before federal, state and possibly Social Security taxes. Contributing to the Dependent Care FSA reduces eligibility for the Dependent Care Credit-generally dollar for dollar.

Retirement Savings Contribution Credit-A well-intentioned credit is the equivalent of the tax break unicorn–it benefits only a very small minority of tax filers. The idea of this credit was to incentivize less prosperous individuals and families to contribute to retirement plans by offering a tax credit for contributions. The credit is available for up to 50% of the retirement contributions made to 401ks and IRAs. The downside is that most people who could benefit are in one of the following groups:

  1.  Too cash poor to contribute
  2. Get no benefit as other tax breaks zero out their tax liability before calculating the Retirement Savings Credit, or
  3. Have income that is too high to claim the credit.

The credit starts at 50% of contributions for AGIs up to $18,500 for singles, $27,750 for Heads of Households (HoH) and $37,000 for MFJ, up to $2,000 per person/$4,000 per couple. The credit drops to 20% of contributions for incomes up to $20,000 (single), $30,000 (HoH) or $40,000 (MFJ). It drops to 10% of retirement contributions for incomes above those in the 20% range until hitting the maximums of $30,750 (single), $46,125 (HoH) and $61,500 (MFJ). Even at the 10% contribution rate, it’s possible to get the maximum $2000  credit by contributing at least $14,500 to a 401k and $5500 to an IRA. These even work for Roth IRAs, so in theory, you could double dip in the before-tax and after-tax columns. If one contributes $5500 ($6500 for those over 50) to a Roth IRA, she can claim a 10-50% immediate credit on herr taxes AND not pay taxes on any growth in the Roth as long as she withdraws the funds after 59.5 years old. This is one of the few hybrid tax options that can beat out an HSA for low income workers, as there’s an immediate 50% tax credit back (i.e. $2000 back for a $4000 contribution) plus never paying taxes on those gains in the future.

Child Tax Credit-Up to $1000 per child in money back in your pocket, so you can actually afford the cost of raising them. Credit is good for incomes up to the $75,000 (single) and $110,000 (MFJ) thresholds when the amount begins to be reduced by 5% for every $1000 earned over the threshold. This credit is also fully refundable in some situations, so if you’ve used up all your tax credits and owe nothing in taxes, the government could actually pay you up to $1000 per child.

Earned Income Credit-a refundable credit for low and moderate workers, often for those with children. Intended to provide additional income for those at or near the poverty line and who might be considered the working poor. The credit is based on AGI as well as the filing situation and number of children. Investment income above $3400 disqualifies the filer from the credit. Maximum credits are $506 (no children), $3373 (one child), $5572 (two children) and $6269 (three or more children). Difficult to quickly compute-use online tax software to compute.

Said No One Ever…
Photo Credit: Martha Soukup

The table below summarizes many popular tax breaks and shows where in the standard 1040 form they are listed. Those before the AGI in lines 37 and 38 affect AGI, those afterwards do not.


Form 1040 Line # Tax Benefit Description Credit or Deduction Max credit/ deduction (Ind. / Fam.) Deadline Income Phaseout (Ind. / MFJ) or other limitations? Notes
7 Flexible Spending Account Deduction $2,550 12/31 None Use it or lose it calendar year limitations
7 401k Deduction $18,000 12/31 Catch-up contributions of $6000/person allowed if 50 or over.
7 Dependent Day Care FSA Deduction $5,000 12/31 Contribution can’t exceed taxable compensation Can be used together with Dependent Day Care Credit, but can’t cover the same dollars of expenses.
7 or
Health Savings Account Deduction $3450 /
28 Solo 401k Deduction $18,000 employee, 25% up to $53,000
32 Individual Retirement Account Deduction $5500 /
4/15 Covered by work retirement plan?
Ind: $72,000
MFJ: $119,000
Spouse not covered by work retirement plan?
MFJ: $196,000
Not coverd by work plan?
No limit
Catch-up contributions of $1000/person allowed if 50 or over
33 Student Loan Interest Deduction $2,500 12/31 $80,000 / $160,000
34 Tuition Credit Deduction $2000 / $4000 12/31 $80,000 / $160,000 (AGI as of line 33) Can’t be combined with credit on line 50 for same student.
37 & 38 Adjusted Gross Income N/A
40 Mortgage Interest Deduction Interest on:
≤$1,000,000 mortgage loan
≤$100,000 Home Equity loan
12/31 $261,500 / $313,800
40 Property Tax Deduction None 12/31 $261,500 / $313,801
40 Charitable Contributions Deduction 30% of AGI 12/31 No Limit
48 Foreign Tax Credit Credit/Deduction % of foreign income vs. total income 12/31 This credit/deduction can be very complex depending upon the situation.
49 Dependent Day Care Credit Credit 20-35% of eligible expenses 12/31 None Max expenses: $3000 for 1 child, $6000 for 2+ children. Can be used together with Dependent Day Care FSA, but can’t cover the same dollars of expenses.
50 Education credit Credit $2500/child 12/31 $80,000 / $160,000 100% credit of first $2000, 25% of next $2000. 40% is refundable.
51 & 68 Retirement Saving Contribution Credit Credit $2000/$4000 12/31 $31,000 / $62,000 Tiered rates from 50% down to 10% credit based on income
52 Child Tax Credit Credit $1000/child 12/31 $75,000 / $110,000 Refundable Credit. Reduced by 5% for every $1000 over the threshold values
53 Residential Energy Credit Credit 10-30% of expenses depending upon type of expense 12/31
66a Earned Income Credit Credit 0 kids: $510
1 child: $3400
2 children: $5616
3 or more children: $6318
12/31 Individual:
$15,010 – $48,340
$20,600 – $53,930
Income Phaseout limit dependent upon # of eligible children (0-3+) and filing status

That’s a whole lot of information to process. In the next blog post, we’ll break down how to use this information to plan and claim the most tax breaks.

Health Savings Account-Best Tax Free Account Available

Photo Credit: Alexandr Pak

The Little Saving and Investing Engine that Could

One of the biggest concerns to most people is how to pay for expected or unexpected medical costs. Medical costs are a significant contribution to many bankruptcies in the United States. We can’t realistically plan on staying healthy our whole lives to avoid paying for medical treatment.

One of the juiciest tax breaks out there is the humble and shy Health Savings Account or HSA. Most people have either not heard of it or confuse it with its older sibling, the Flexible Spending Account or FSA. HSAs and FSAs share several common features including tax advantages on contributions and withdrawals that are used for covered medical procedures. They can reduce one’s taxable income while at the same time allow folks to set aside money for medical treatments.

FSAs have the significant limitation that they can only be used during a calendar year and any left over funds are forfeited at year end (or in some cases $500 can be rolled into the following year). They do have one advantage that the entire contribution for the year can be used before all of the money has been contributed. If one wants to put in $2500 for the year and has surgery or other medical expense in January, that whole $2500 is available to cover the cost immediately.

Health Savings Accounts on the other hand, must be used with a High Deductible Health Plan (HDHP). Current IRS contributions limits for 2017 are $3400 for self-only and $6750 for a family (plus $500 or $1000 catch-up contribution if over 55). HDHPs and HSAs might not be the ideal plan for people with chronic diseases, unfavorable genetic histories, high prescription drug costs or for those who expect to have a baby if lower deductible plans are available. On the other hand, for those whose only options offered through their employer are high deductible, HSA-eligible plans, who have no large anticipated medical costs in the coming year it’s an easy choice.

What HSAs Were Actually Designed To Do

HSAs were signed into law back in 2003 as part of the  Medicare Prescription Drug, Improvement, and Modernization Act. They were envisioned to help low and middle income families pay for medical treatments with before tax dollars. HSAs allow people to stash away tax deferred money each year and let it accumulate until a medical expense is incurred. Like many tax advantaged plans, a custodian is required to administer the plan and make sure that there is some accountability and that the law is followed. Custodians do not own the money in the plan, but are required to oversee that the plans are administered according to the law.

By design, HSAs allow anyone with a HDHP to put away money each paycheck toward future medical costs. This money is not subject to federal tax and is usually also exempt from state taxes. If included in a cafeteria benefit plan through an employer, these contributions are also not subject to Social Security and Disability taxes. They provided a juicy incentive to encourage people to save for large medical expenses and not be penalized for that savings, kind of like a 529 plan is to college savings. The hope was that as people became responsible for their medical expenses, they would demand quality care at a fair price. That hope so far has not really materialized. The overall impact of HSAs to the health care system in general is debatable, but not a subject of this post.

The bonus feature that an HSA has is that the money is not taxed coming into the account, when interest or dividends are paid or capital appreciation occurs, or when the money is withdrawn for medical expenses. It is just about the only tax-free money most Americans can get and stay on the right side of the law. Contrast the HSA with the 401k or traditional IRA. Both the 401k and IRA funds allow the participant to contribute money that is tax deferred, that is they don’t federal pay tax (but do pay Social Security) on the contributions until they are withdrawn, at which point they pay the nominal tax rate for ordinary income for any withdrawals. If the money is withdrawn early, i.e. before age 59.5, they also pay a 10% penalty in addition to federal and state taxes.

How to Hack an HSA Became a Primary Emergency Fund and Secondary Retirement Fund

When a qualifying medical expense is incurred, the HSA owner can elect to

a) pay the expense directly with a debit card linked to the HSA account, or

b) request reimbursement through the HSA custodian, or

c) not take any action and let the money sit in the account.

At first glance, option A might appear to be the easiest as it’s the most convenient and for some it might make sense. Option B might be better for those who have a large expense and want to wring out a few additional credit card points or miles out of the transaction. Option C is the best option for those who have sufficient assets to cover the expense and keep the money in the HSA account. Those options are detailed in the figure below.

Maximizing HSA Tax Advantages


Let’s dive deeper into the details of Option C above and why it makes an awesome emergency/retirement fund. Many HSA accounts feature an investment option that allows the owner to invest the money contributed to an HSA until such time that he or she needs it for a medical expense. There is no “use it or lose it” constraint like there is for a FSA, so contributions made 5 or 10 years ago can be used to pay for medical care today or in future years, even if the participant is no longer in an HDHP plan.

There is also no requirement that someone reimburses herself immediately for medical expenses incurred. If one determines that she can pay her medical bills from current savings without dipping into her HSA funds, she could just log the expense in Mint or Personal Capital, or a spreadsheet as an expense available for future HSA reimbursement. This amounts to a super tax-advantaged emergency fund: she can invest up to $3400 (single) or $6750 (family) a year in any of the investment funds within the HSA, pay all medical expenses out of pocket and let the investment grow through the years until such time that she needs the money, then withdraw the money needed, provided she’s had at least that amount in medical expenses. The only stipulation is that the expense must have been incurred on or after the year the HSA account was established. She would pay no federal or state taxes on that withdrawal, even if the investment appreciated significantly.

Don’t have a decent selection of investments in your HSA account? No problem. You can transfer HSA accounts to a different custodian to manage, often even while maintaining the current HSA active (check with your custodian or company HR department to confirm). There are a variety of custodian options to consider. Vanguard does not currently serve as a custodian for HSA accounts but have partnered with Health Savings Administrators to manage the accounts that use Vanguard funds. The fees are non-trivial: $45 per year plus 25 basis points ($25 per $10,000 invested) per year on top of the Vanguard expense ratios. If the market returns somewhere in the 7% average range, a $10,000 investment would yield about $625 after the fees listed above included the Vanguard expense ratio. On the other hand, a $10,000 cash investment would only return about $50 per year if left in a cash fund that pays a “generous” interest rate–even a moderate expense ratio investment is better than cash in the long term.

For people in my situation with fund options that range from mediocre to terrible, it doesn’t make sense to switch account custodians when the account is under ~$20,000- when the amount saved from lower expenses is less than the fees charged by the new administrator. The fund with the lowest expense ratio in my HSA is 0.45% or $45 per $10,000 invested-not bad, but not great. For a similar fund serviced by Vanguard, that ratio is 0.05% or 9 times less than my current fund.

As discussed in You Get (to Keep) What You (Don’t) Pay For, one percentage point has a significant impact on future investments, so shaving that cost down as much as possible is recommended. Unfortunately, that expense ratio is artificially low for the Health Savings Administrators HSA account as there’s a 0.25% of total asset charge by the custodian to own this fund, so I’m only saving a minuscule 0.10% and that’s before the $45 annual fee they also impose. At $25,000, my cost each year at the present custodian would be $112.50, but if I transfer that amount, my total cost would be $120, so I probably won’t be switching at least for a few more years. For those with plan options with expense ratios hovering around 1%, that switch would make much more sense.

A word of caution: there are some really bad HSA funds out there-some of the worst in my plan charge 1.5% expense ratio per year plus a 5.75% one-time sales load-an advertising fee that works out to almost 4 years worth of their already sky high expense ratio, or just over one year at 7% return to get back up to the initial contribution amount!

Photo Credit: Sun Wayne


Many HSA administrators offer a range of investments so you can grow your money and keep up with inflation. These plans are a key part of reducing taxes and early retirement strategies, especially if you have income available to cover the medical expenses up front. Essentially, you max out your HSA each year, invest it in inexpensive index funds (if available), pay for all medical expenses out of pocket and record the amounts, and when you absolutely need the money, withdraw what you need, marking your recorded expenses as paid. And, voila! you have created some completely tax free money and all you had to do was have medical expenses.

What happens if you never accrue enough medical costs to withdraw your entire HSA investment? You can start withdrawing from an HSA like you would an IRA at 65 years old. The humble HSA is the best answer to avoiding the $2 = $1 dilemma: you pay no federal income tax, state income tax, social security, or Medicare tax on any contributions to the HSA. Additionally, if you are on an Affordable Care Act medical plan that includes a subsidy, your subsidy will likely also increase as your Adjusted Gross Income decreases, meaning your monthly premium will go down. That, my friends in a tax-advantaged account!

You Get (to Keep) What You (Don’t) Pay For

You’ve been Marketed!

Photo Credit: Keoni Cabral
Photo Credit: Keoni Cabral

The American consumer has been barraged by advertisements and commercial messages for years. These messages whether stated, subliminal or superliminal as well as peer pressure can cause the average consumer to deviate from the completely rational economic model consumer, homo economicus, of high school economics.

Marketing agencies earn millions of dollars crafting enticing ways to encourage people to spend money on almost every product or service under the sun. Product placement in movies and television is rampant. It would be nearly impossible to completely ignore the deafening chorus of messages compelling people to “buy! buy! buy!”

Companies spend millions, even billions of dollars convincing us that we need to buy X to be happy/cool/attractive/thin/intelligent. That marketing cost is built into the products that we then consume, even when identical or closely-related products exist at a fraction of the retail price.

It’s often been said that you get what you pay for. So much has this become ingrained in our minds that we often take the reverse statement to also be true: “you pay more, therefore you get more,” which is patently not true.

First, a couple examples: Two different labels of the gallons of milk in your store are produced in the same plant even though one might cost an extra dollar or more. The only difference is the label affixed to the front. It the fancier label worth the extra dollar? Does it add to the pleasure of the cookie dunking experience? Similar examples can be found in fine wines and even peanut butter and jelly sandwiches. We tend to assume that a costlier product has more intrinsic value without being able to objectively quantify any difference in quality of the good or service.

A recent Freakonomics podcast cited a surprising statistic: over 90% of pharmacists buy generic drugs when they are available. If specialists in the field whose job it is to know about drug chemistry, biology and safety overwhelmingly choose the  generic that is chemically equivalent to the name brand and significantly less expensive, why don’t more people do it? Mostly it’s because parents don’t want to feel that they’re “cheaping out” on their kids health, when in fact, the name brand and the generic are chemically the same. People are willing to pay a premium to feel better about spending money on their kids’ health.

Another prime example of marketing can be seen in evaluating different types of mutual funds. Some charge a fee of 1% or even 2% or more of the total assets each year to run a portfolio that over 75% of the time doesn’t beat the S&P 500 index in a given year. Taken over several years that chance drops even further to just over 10% in 5 years. Outperforming funds in a given year generally do not repeat that performance the following year.

Does paying more guarantee you get more? Hardly ever. Vanguard and Fidelity are well-known in the investment community for their  low-cost index funds. Index funds are funds that don’t try to beat the index, rather they just track it (minus a low expense ratio). These index funds tend to outperform more expensive and over-hyped actively managed funds. Their out-performance of active funds tends to increase as the comparison time increases.

Someone who makes a round-trip fallacy–thinking paying more gets more would be out not only that extra fee, but at retirement would be out also the extra appreciation that was taken out every year due to fees. Over twenty, thirty or forty years, that is a huge pile of missed appreciation.

Just as an example, assuming two otherwise equivalent funds with one having an expense ratio of 1% more, both returning 7% annually (before expenses), $25,000 annual contributions over 25 years, the lower cost fund would be worth $1.58 million vs. $1.37 million for the more expensive fund. That’s over $200,000 difference of missed dollars in an investment account. It would take nearly another two years at the higher fee annual return rate (6%), while still contributing $25 grand a year to surpass the $1.58 million mark! That’s a lot of time to pass over a simple 1% difference. Now all those dollars didn’t go to the manager or broker, most are actually the result of the lost compounding year after year.

While the phrase “you get what you pay for” is often still valid, it is not a universal axiom that paying more for something equates to a superior product or service. So how can we distinguish truth from fiction or, said another way, can we separate meaning from marketing?

Emotional vs. Logical Reasoning

Hype is a four letter word that sums up the emotional message to which marketing often appeals. There aren’t regular appeals to logic and reason in your typical 30 second ad spot. Numbers and logic aren’t exciting, sexy or good for selling things that you don’t really need, but having you imagine yourself at the beach surrounded by young attractive people, doing fun things sells a whole lot of fizzy beverages.

Humans are emotional creatures. When confronted with challenging situations, we rarely take the time to reason out the pros and cons and instead follow our gut instinct. We are often short-sighted, thinking only about what we want now instead of what we will want in the future.

Overcoming the emotional, childish brain is a learned behavior that takes time and lots of will power to say no more than once. This is especially important on big ticket items like cars, houses, many big electronics, furniture, appliances, etc. Some tips for being more Spock-like in your reasoning:

  1. Take time to look objectively at what you are desiring to purchase and ask the hard question why you are really wanting it? Is it a want, a need or a passing interest?
  2. Make a list of the pros and cons of making a significant purchase. Does it put me in a better or worse situation?
  3. Ask if I want to spend $100 on this widget, if someone offered me either $100 or this widget, which would I pick?
  4. Sleep on a decision before pulling the trigger on a big purchase to allow the impulse to buy die down.
  5. Compare similar options/brands. Am I getting the best value for what I need? Look at the specs, not the glossy marketing flier.
  6. Make a list of requirements and desirements for big ticket purchases, i.e. for a car, I need 5 seats and a fuel economy of x miles per gallon, but I’d really like heated seats and a backup camera. Put a value on your desirements before actively shopping and stick to your guns.
  7. Consider the total cost of owning the doohickey. How often does it need to be maintained or repaired. How long will it last under warranty and how long do I expect it to last? Could I sell it when I’m done with it?
  8. Once a decision to purchase the item is made, look for ideal times to purchase if the purchase can be delayed for a time. Buying seasonal items near the end of the intended use season can often save you half the cost and is still almost new when the 2nd season comes around.
  9. If you determined to make a large purchase, write down somewhere how you expect to feel a day, a week and a month later. Circle back at those times to see if your expectations were met.
  10. Set short, medium and long term financial goals which help refocus on saving and not spending.


Photo Credit: Dheepak Ra

Photo Credit: Dheepak Ra

The above questions need not be used in every single decision, but if you find yourself easily swayed by advertisements, keeping up with the Jones’s or Smiths or whomever, these questions might help evaluate purchase decisions more objectively and also aid in curbing those buy-it-now impulses that drain your wallet.

Reducing your exposure to the constant barrage of advertisements and sales pitches will also do wonders for your pocket book. Several years ago while watching a live TV production that went to commercial my young daughter asked in disappointment, “What is this? What happened to the show?” It hadn’t occurred to us that through the magic of commercial free media like Netflix, Amazon Video and others, our children hadn’t seen a commercial in a very long time. They also hadn’t continuously pestered us for the latest and newest toys, foods, clothes or Mercedes Benz that are featured prominently in television advertising. Bonus parent points!

As we looked at our media consumption further, we found that we often listed to podcasts, audio books, Spotify or commercial-free radio in the car. Our children weren’t getting the U.S. Marketing Association’s recommended daily dose of advertising messages pounded into their skulls and yet, they were somehow oblivious to the fact that they didn’t have the latest American Girl doll or action figure set, and yet, by all accounts, they were still happy. Please don’t rat me out to the advert police, but living in a world with less advertising is great.

While completely filtering out the marketing machine can be an impossible task, with internet, school, work, billboards, etc, but learning self-restraint is so much easier when there’s less to fight off. Building self-control when young is especially powerful when it comes to controlling spending and pays off in the long run.

That’s not to say the emotions are meaningless, only that we as humans are susceptible to well-crafted marketing ploys and it will serve us  and our wallets well to evaluate the underlying reasons we buy things to ensure they are consistent with our true values.

Social Semi-Security


Social Security Benefits

Social Security has constantly been discussed, debated and called out by political friends and foes, yet has largely remained the same for decades, with a few minor tweaks. Designed and implemented in the 1930’s during the depths of the Great Depression it provided a backstop for those whose pensions and other savings would not be enough. It is one of the three legs of the retirement stool, the others being pensions and personal savings. In addition to providing retirement benefits, it also provides several insurance type benefits, including life and disability coverage. SS does provide funds to children under 18 and the remaining spouse caring for them, should the beneficiary pass away. It also provides disability payments to people who are deemed disabled and unable to work.

What has changed since social security’s implementation is that people are living longer, and more people withdrawing from the fund relative to those who are contributing. The latest projection indicates that at some point in the future around 2034, the Social Security Trust Fund will be exhausted and it would only be able to pay out what is being paid in. Current projections are for the fund to only be able to pay about 75% of promised benefits if no future changes are made. So Social Security benefits won’t go to zero, but it might be less than currently advertised.

Understanding How Social Security Benefits Are Calculated

Just like taxes, the calculation of Social Security is somewhat complex, but can be individually calculated using the Social Security calculator on the website.

Understanding the benefit formula is important to determine an optimal benefit accrual and withdrawal strategy. An overview from the Social Security Administration (SSA) is provided here.

The basic calculations:

  1.  Assume the minimum 40 Social Security credits have been earned. Credits can be accrued at a maximum rate of 4 per year, so a minimum of ten years is required to access the benefits.
  2. Social Security calculations require inflation adjustments for every year’s earnings to the present year (earlier years being multiplied by higher numbers as defined by the index factor table that can be computed here). Ex. $1 in 1960 is worth $11.60 in 2016, where $1 in 1990 is worth $2.21.
  3. Selecting the highest 35 years of inflation adjusted work history from step 2. If less than 35 years of work history are available, count them as zeros as we’re just summing the numbers.
  4. Finding the Average Indexed Monthly Income (AIME) by dividing the total calculated in step 3 by 420 (35 years x 12 months).
  5. Adjust AIME by using Primary Insurance Amount (PIA), which is described below.

The PIA formula pays out benefits at a progressive rate: lower earners receive a larger ratio of income relative to earnings when compared to higher earners. Higher earners still receive more, but in proportion to what they contributed. It does this by adding bend points to adjust the benefits similar to the federal progressive income taxes: lower earners receive more benefits dollar for dollar for what they contributed as compared to their higher earning peers.

Bend Points in SS Calculation
Bend Points in SS Calculation (

For any AIMEs at or below $856/month for 2016, the PIA adjusts the amount by taking 10% off, so for the $856 AIME, the benefit after PIA adjustment is $770. For AIMEs between $856 and $5157, the beneficiary receives only 32% of the amount above the first PIA bend point. So at the second bend point, someone with an AIME of $5157 earns 90% of the first $856 and 32% of the remaining $4301 for a total of $2146. SSA Income as a function of AIME is shown in the figure below.

SSA Income vs AIME
SSA Income vs AIME

Delaying Social Security Benefits

The other consideration about withdrawal strategies is to determine how soon you need to start withdrawing funds. There is significant benefits to waiting as long as possible to start receiving SS benefits up until age 70. For people born between 1943 and 1954, the full retirement age (FRA) is 66 and for those born after 1960 the FRA is 67. Between 1955 and 1959, the FRA rises by two months per year starting at 66. However, regardless of which group one finds oneself, he or she can start withdrawing as early as age 62. Taking the early payment will drop the monthly check by as much as 25-30%, depending on the year a person was born. For someone born after 1960, who receives $1000/month at FRA, she would only receive about $700 at age 62. Delaying that first withdrawal until after FRA, the benefit grows 8% per year, up to 24% at age 70. That same $1000 benefit would grow to $1240/month at age 70 (plus inflation adjustments as SSA calculates them). Delaying withdrawals beyond 70 does not grow the monthly check at all, so it is not advisable to delay past age 70. It makes sense to delay benefits for those people are around full retirement age and are in good health, have good family history in longevity and who don’t absolutely need money immediately.

When Taking Benefits Early Might Make Sense

For people who find themselves in one or more of the following situations, it might make sense to take the SS benefit early and deal with a lower monthly payment:

  • People in poor health
  • People with family histories of early mortality
  • People unable to work and who are not able to meet their regular expenses
  • A few instances where couples can follow more complex claiming strategies

People who decide to pursue an early claiming strategy would be well-served to have a financial adviser who specializes in SS claiming review your plan as there are many more complexities that can be summed up in a single article.

Couple Considerations

If all the isn’t confusing enough, we haven’t even discussed how SS is computed for couples. The basic concept is that spouses get either their own benefit or can receive half of their spouse’s benefit, whichever is more if both collect benefits at or after their respective full retirement ages. There are a myriad of special circumstances that might apply in certain situations.

Example Cases

As an example consider two different scenarios for single earners, Dan earns $40,000 today in social security eligible wages and has worked for 10 years. When he runs the inflation calculation, he finds that, amazingly, his income each of the previous 9 years is also $40,000 adjusted for inflation. Summing up all of those earnings, he has earned $400,000 of income that has been subjected to Social Security taxes. Since he has less than 35 years worth of earnings, none of those years are discarded. Provided he is at full retirement age, his AIME would be $952 (slightly above the first bend point) and his benefit would be $801 at FRA.

Jill earns $100,000 in 2016 and also finds that her previous 20 years also miraculously adjust to average exactly $100,000 per year for the previous 19 years. Her AIME would be $4762 which is pretty good. She is close to the 2nd bend point, but still in the 32% area. Her PIA would be $2020 at FRA. Here the progressive nature of the PIA is manifest: Jill will receive about twice Dan’s benefits yet she earned five times more over her working career.

If Jill continued to work another 20 years, keeping the same average income per year, her AIME would be $8333, but her benefits would only grow to $2622, or just $600 more per month than she would have had if she had stopped working 20 years earlier. Since Social Security only counts the top 35 years, 5 of those years are thrown out, and any earning above the $5157 AIME amount are only being applied at a 15% rate.

An interesting note is that if Dan and Jill were married, Dan would be eligible for more of a benefit through taking half of Jill’s benefit ($1010) than taking his own ($952) at FRA, assuming they are the same age.


Social Security is certainly complex and the ideal earning and withdrawal strategy can vary widely based on the individual or couple’s circumstances, earnings history and health expectations. Basing decisions about when one stops working on accrual of Social Security benefits is generally a bad idea, but if making that decision to exit the full-time workforce is quickly approaching, it definitely makes sense to evaluate how much to expect in Social Security over the course of the rest of one’s life. In many cases, retirees might find that working an extra year or two for a slightly higher benefit (or possibly no increased benefit at all) is not the ideal plan when considering they might have otherwise pursued a passion that doesn’t pay as well, but offers a much happier and less stressed life.

Social Security’s main benefit to those looking to retire early is that it provides a guaranteed longevity insurance in the event that other investments do poorly or that additional expenses crop up later in life. Delaying the start of Social Security until the maximum age of 70 while generate a 24% annual payout increase for the rest of one’s life and allows early retirees or anyone to be a little more aggressive in their investments knowing that they have at least some guaranteed income down the road.