How to Retire Early (Part II)

Come On, Take the Money; Running Optional

In the previous post, we discussed the plan to accelerate financial independence as much as possible using a combination of frugality, tax estimating, investing, credit card hacking, and adding a side hustle. In this follow-on post, we discuss having a plan for how to actually withdraw money from the plans after spending a life funding them.

Investment withdrawal strategy

Investing via alphabet soup retirement vehicles like HSAs, IRAs, 401ks is fairly easy once the accounts are set up. Withdrawals can be more complicated and require serious attention and planning to set up withdrawals that minimize any penalties and taxes, while at the same time maximize flexibility as goals, plans and investment returns deviate from the plan.

Early retirement requires some amount of money available for immediate use for any purpose. This will consist of a small cushion that includes a checking or savings account to cover immediate needs that might have to be accessed instantly. The general rule of thumb is to have between one to six months of expenses available in this account. Given that early retirees need to make the most of compound interest and likely have sufficient reserves available to withdraw on short notice, a month to 3 month’s worth of expenses is usually sufficient.

The other component of the accessible-for-any-purpose money would be those dollars invested in a taxable brokerage account that holds a low expense, diversified mutual fund or exchange traded fund. These can be converted to cash in a bank account, usually within a few days time. Since invested money earns more over time, the bulk of the anytime money should be put in here.

The next important component of the rightirement withdrawal fund is converting all those dollars stashed away in 401ks and/or IRAs. Most people think that funds in those accounts can’t generally be withdrawn before the age of 59.5 without paying penalties. These people are unaware of the fact that there are at least two ways to access that money early and without penalty.

 

Don’t Get Off Track

Early Retirement Account Withdrawal Strategy #1

The first is what many have termed the Roth IRA conversion ladder. To establish this Roth conversion ladder, one transfers an amount from a Traditional IRA to a Roth IRA, then lets it “season” for at least 5 years. He or she must pay any income tax owed on this transfer as it is considered income. After the 5 year seasoning, the contribution amount can be withdrawn without penalty just like it were a Roth IRA contribution. It should be noted that any growth of that contribution cannot be withdrawn penalty free until 59.5 years old.

This strategy is helpful for many who want to spread out their withdrawals to fill up low income years when the money won’t be needed immediately. The main disadvantage is the 5 year waiting period-it’s not possible to predict how much income you need in 5 years, so this strategy, while helpful, shouldn’t be the sole source of income before hitting age 59.5. The other downside is that it’s not generally advisable to pay tax on money 5 years before you can use it. This strategy is best utilized to fill up any extra income space that won’t generate additional federal taxes or in rare cases were higher income earns higher tax refunds, i.e. the Earned Income Credit.

Early Retirement Account Withdrawal Strategy #2

The second strategy of accessing retirement accounts early without penalty is known as the Substantially Equal Periodic Payments (SEPP) a.k.a. Section 72(t) of the tax code. SEPP allows a fixed amount to be withdrawn from IRAs (401ks would need to be rolled into Traditional IRAs first) each year for at least 5 years or until the account holder turns 59.5, whichever is longer. This means that someone that retires at 30 would have to keep the same amount for 29.5 years! Only one adjustment to the method used can be made, so choose wisely.

Calculating the permitted amount requires consulting several tax references to determine the allowable percentage (≤ 120% of federal mid-term rate, currently at 2.05%), one’s actuarial life expectancy rate, and the computational method (RMD, amortization or annuitization). This is a complex process and one should definitely review this with a financial adviser who is familiar with SEPP plans to make sure you don’t run afoul of IRS regulations. However, once the plan is established, it can become the principal source of income until the magical, if random age of 59.5 is reached and many of the tax restrictions governing retirement accounts disappear.

This strategy is preferred in many cases for several reasons. First, one would pay the tax on withdrawals the same year that the funds can be used. Also, this will slow IRA account growth so that one limits his/her Required Minimum Distributions (RMD) at age 70.5. The downsides to this strategy are 1) it’s complicated to set up, 2) it’s fairly restrictive once established and at 2.5% at present, annual withdrawals are limited to relatively low percentages of total account value for early retirees.  It’s also risky in that you could potentially owe penalties on all 72t distributions if you make an error in any year while you’re required to take them.

While setting up and making sure to follow the SEPP plan is difficult, it does permit one to access the money earlier than they otherwise would and if set up on an automated withdrawal schedule, it would limit the day-to-day or month-to-month management of withdrawals.

Early Retirement Account Withdrawal Strategy #3

Additionally, there is the option to accept the 10% penalty on withdrawals. While generally not the preferred option, it might be appropriate for someone who thinks he can retire and not withdraw retirement funds early, only to find that he’s a few months short of 59.5 and out of non-retirement funds. No one likes paying fees to take out their own money, but this strategy can be preferred if only needed for an unexpected event or short term need.

Early Retirement Account Withdrawal Strategy #4

The final option is do a hybrid of the first two options, setting up a SEPP withdrawal and doing smaller Roth IRA conversion ladders when taxable income is low enough to convert to the Roth IRA tax free. This can be ideal for people who have low expenses relative to their tax deferred account balances. This allows one to roll some cash over when income is low enough to roll traditional IRA money to a Roth IRA without paying any taxes. At the same time the SEPP plan can continue to operate as normal.

When combined with other tax advantaged accounts that have money available for withdrawal (Roth IRA contributions, HSA un-reimbursed expenses, etc.), this strategy can add some flexibility to manage early withdrawals while avoiding taxes/fees and also paying necessary expenses when they come up. On the downside as taxes and fees drop, generally, the withdrawal strategy increases in complexity with additional moving parts and IRA regulations coming into play. This is another example of the fire-and forget ideas mentioned in an earlier post: it takes initial effort to establish the strategy, but once in place can yield great benefits.

Photo Credit: Flickr

Regular Retirement Withdrawal Strategies

Moving on to the other components of a rightirement plan. We still haven’t discussed 401ks, which are often the largest retirement accounts people hold. 401ks can generally be accessed after age 59.5 penalty free. The money, which was not taxed when contributed, is taxed upon withdrawal, unless rolled over into a traditional IRA. Once the individual reaches the ripe young age of 59.5, she should use this and any Traditional IRA funds up to where federal tax is owed, as normal income tax rates apply to these funds, rather than the capital gains and qualified dividend rates that might be in a taxable account.

If more cash is needed to cover expenses after accessing the 401k and IRA to the point of paying federal taxes, money can be pulled from either a Roth IRA or an HSA for previously un-reimbursed medical expenses.

Social Security plays an important part of any retirement strategy. Delaying it until age 70 is preferred if a retiree has sufficient investments to cover expenses and is healthy enough to expect to live long enough to enjoy it. Social Security is essentially an annuity that is paid by the government and can be used to address  the longevity risk–living longer than the money lasts. For every year past 62 that Social Security is delayed (up to age 70), the monthly payment increases by around 8%. Try getting a guaranteed increase like that from any other source! Interestingly, almost half (46%) of retirees take SS payments at 62, the earliest possible and less than 10% of retirees eligible for Social Security payments wait past their full retirement age to begin taking payments.

Flexible Strategies for the Win

Photo Credit: RealCamShaz

Mixing and matching all the different available accounts, taking into account the benefits and limitations for each can seem daunting, but it does allow for a very flexible approach for contributing to/withdrawing from/transferring between the different accounts to provide the optimal mix of pre- and post-tax funds.

If you don’t have enough money in your taxable account to meet all of planned budget for the year and

  1. You’re under 59.5 years old, you can:
    1. Start an SSEP with an IRA
    2. Withdraw contributions from a Roth IRA
    3. Apply for a credit card with a juicy sign-up perk
    4. Withdraw funds related to medical expenses from an HSA
    5. Increase side-hustle income/hours
  2. You’re over 59.5 years old, you can also do all the above, plus
    1. withdraw directly from 401ks and IRAs (including Roths)
  3. You’re over 65 years old, you can do all the above plus
    1. Withdraw any money from an HSA as if it were an IRA
    2. Evaluate when to start taking Social Security
    3. Be covered under Medicare for medical insurance
  4. You’re 70 years or older, you can do all the above and should definitely begin taking Social Security

On the other hand, if you have the enviable problem of having more available investment money than needed, you can:

  1. Step up contributions to a Roth IRA conversion ladder
  2. Contribute to a Roth
  3. Reduce time spent on side hustle/outsource parts that you don’t enjoy
  4. Pay off debt
  5. Max out HSA/IRA/401k, etc.
  6. Contribute to your favorite charitable organization
  7. Harvest taxable gains/losses

There are some cases where it makes sense to report a larger taxable income. The most frequent case is for instances where there remains unused deductions or credits whereby generating additional taxable income, say by converting a traditional IRA to a Roth IRA, does not increase the tax owed. Additionally, there are cases in the Earned Income Credit where a larger income means a larger credit-you actually get paid via a tax credit for earning more money (though that threshold is pretty low).

Optimizing time spent by reducing or re-balancing a side hustle allows for doing more of what you want and offloading undesirable tasks. Reducing any debts like mortgages or other low interest loans reduces future expected expenditures. Often when portfolios have been doing well for several years, it can be time to rebalance by paying off student loans or mortgage debt as the likelihood of continued above average returns drops as returns revert to the mean.

Harvesting capital gains/losses is good to do, especially in cases where there’s sufficient tax headroom to claim 0% long term capital gains. Selling an investment and buying it again serves to step up the basis of the investment-the break-even price that is reported on future returns. Having a higher basis lowers the capital gains to be claimed in future years, or increases capital losses if the market drops.

The Elephant in the Room: What about health insurance?

Retiring early in the United States was made much easier with the passage of the Affordable Care Act (ACA or ObamaCare). Before the passage of the ACA, it was difficult to find insurance plans outside of an employer and those who had pre-existing conditions were especially at risk of being denied coverage. Some early retirees were able to find catastrophic coverage that had a low premium and a very high out of pocket limit and only covered limited medical issues.

Under the ACA, insurance was made available to anyone regardless if their employment provided coverage or not. For people who did not have coverage through their employer, there were subsidies built into the bill to lower to the cost of the plan based on a person’s income, lower income people were given larger subsidies.

While the ACA did provide coverage to many who would otherwise be uncovered, it is not without a sizable list of detractors. As with any legislation, there are winners and losers. Healthy people and those with high incomes soon found themselves paying more for less coverage or having to pay a penalty while receiving no coverage. Also, while the ACA did address the affordability aspect by providing subsidies, it did very little in real terms of reducing the cost of care. As the costs of care rose, those without subsidies became more enraged with the plan.

Fast forward to today where people have elected representatives, the majority of whom oppose at least some aspects of the ACA, who have attempted to change the ACA to focus more on cost. Discussions are heated and efforts toward a viable alternative have so far been fruitless.

This uncertainly has caused many insurers to leave the marketplace until something more certain is enacted. In my state there will be many counties who are covered by 1 or even no ACA-compliant insurance on the marketplace. The remaining company has requested a 40+% rate increase. In other states premiums are projected to rise from the high single digits up to close to 50%.

Looking objectively at the health insurance debate, it’s hard to see the ACA at a national level remaining viable and affordable going forward. It’s also not clear what, if anything, the current party in power can or will do to address the failings of the ACA. In the meantime, early retirees are left in the lurch-they can opt to stay the course hoping the government can get its act together and come up with something meaningful that will a) allow people to maintain coverage and b) reduce the cost of care; or they can plan for a much more expensive health care plan and retire a year or two later; or they can start looking at foreign countries where healthcare is easier to access. None of those options are ideal for people who have already retired and have at least some reason to remain in the US. For those that have always wanted to see the world, this might be the kick in the pants that gets them going.

Summary

The tax advantaged options available to an early retiree are few in number but very useful and can be used with powerful effect. The downside is that there is increased complexity to fully utilize those strategies compared to those available to a 65+ retiree. There’s always the threat of changes in laws that might curtail their usage, but generally those already involved in a SSEP for example would likely be allowed to continue to use it.

Having multiple different retirement and regular investment accounts allows one to be extremely flexible in withdrawing what they need based on tax circumstances, unforeseen expenses (or windfalls), fund options, etc. It would be preferable to have a plan that allows for pulling from different accounts from year to year based on the circumstances of that year rather than a rigid “I’ll take X amount from account A and Y amount from account B until I hit 70 then take Social Security.” Knowing how much you expect to spend and how much you can take from non-retirement accounts before accruing tax are important considerations. Once those numbers are estimated, knowing how much you can withdraw from retirement accounts without penalty will provide confidence and flexibility after achieving financial independence. In part III of the How to Retire Early Series, we’ll walk through some examples in how to optimize withdrawals until hitting full retirement age.

How to Retire Early (Part I)

The Dream Within the American Dream

Photo Credit: Edward Musiak

Rightirement is setting yourself up to be financially independent to do whatever it is that you enjoy doing. Whether that means continuing to work a few hours a week, a month, a year or none at all to generate income, rightirement takes some planning to achieve financial independence. Yet for many people, achieving financial independence appears to be out of reach. With some careful planning and some smart strategies, it becomes not only attainable, but quite possibly earlier than one would expect.

Scott Adams, the creator of Dilbert, set out to write a book on finances, but ultimately didn’t because he couldn’t fill the pages. His entire “book” is as follows:

  1. Make a will.
  2. Pay off your credit cards.
  3. Get term life insurance if you have a family to support.
  4. Fund your 401k to the maximum.
  5. Fund your IRA to the maximum.
  6. Buy a house if you want to live in a house and can afford it.
  7. Put six months worth of expenses in a money-market account.
  8. Take whatever money is left over and invest 70% in a stock index fund and 30% in a bond fund through any discount broker and never touch it until retirement.
  9. If any of this confuses you, or you have something special going on (retirement, college planning, tax issues), hire a fee-based financial planner, not one who charges a percentage of your portfolio.

The above “book” is elegant in it’s simplicity with generally sound advice for how to allocate capital, establish a nest egg, grow it and protect oneself from unexpected life events. It is so simple yet most people (55%) struggle to complete the first step of writing a will. While the thought of contemplating one’s death is never easy, the actual time required to complete a will is generally a handful of hours and a meeting with a lawyer or some quality commercial software. It will likely take less time than the rest of the steps on Adams’ list.

At the risk of adding words but no value to a venerable comedic genius of the office experience, pursuing rightirement takes a few extra steps to achieve faster than the average retirement age of 63. This list is summarized below:

Steps to Rightirement

  1. Determine a vision and goals for rightirement:
    • what you want to do
    • when you will reach it
    • how much you will need after achieving rightirement
  2. Read Scott Adams entire “book” above and execute it
  3. Reduce all spending that doesn’t sustain or enrich your life
  4. Optimize federal and state taxes
  5. Develop a credit card cash/points strategy
  6. Start a side hustle/small business focused on your passion(s)
  7. Have an investment withdrawal strategy
  8. Revisit and readjust as necessary

The Details

Income

Determining what you want to do is a very personal choice and can vary widely between people and even between a single person as he or she ages. This blog makes no attempt to dream your dreams for you. However, having the dream firmly set in your mind gives focus and provides motivation to do what is necessary to achieve it.

What we will discuss is to go about planning a path to getting to that goal. For people who want to continue to work, at least part time, estimating how long and how much net earnings would be each year is a good first step. Assuming that this estimate closely approximates what would happen, one can leave the drudgery of 40+ hour work weeks and long commutes much earlier if she is willing to work a bit in the early years of rightirement. This also reduces the risk of poor investment returns in the early years after leaving the full-time work force.

The list above is flexible and can be tailored to fit one’s needs. For example, having a credit card strategy is not required to retire early, but it can get someone in the fast lane to achieving it by earning money back just for spending it. Maxing out retirement accounts is a foundation of financial independence in this blog and frankly, just about every personal financial media outlet or blog.

For those that are approaching Social Security full retirement age, it makes sense to get an accurate estimate from ssa.gov about their estimated monthly check. It generally makes sense to delay taking Social Security until age 70 if one is generally healthy, has good history of family longevity and has a sizable nest egg outside of Social Security. Knowing how much to expect to receive from Social Security will inform the rest of your rightirement planning.

Expenses

Reducing expenses has been discussed here and here. Reducing expenses is the most powerful way to achieve early retirement, because it lowers the hurdle of monthly income required to sustain a lifestyle and also because it allows a greater percentage of income to be devoted to investing, getting one to financial independence faster. It’s also important to keep expenses as low as appropriate after rightirement. Make sure to factor in medical care expenses that might be currently covered by an employer.

It can’t be understated the powerful effect that reducing unnecessary spending has on reaching financial independence. Reducing monthly expenses by $100 equates to a Rightirement Number that is $30,000 lower using the 4% rule ($100 $/month x 12 months x 25). Rolling that $100/month into an investment account will be worth over $17,000 in 10 years at a 7% growth rate. Combined with the lowered threshold from reduced expenses, you’re $47,000 closer to your Rightirement Number just by starting out saving $100/month and investing it instead.

Photo Credit: Jurgen Appelo

Estimating What You’ll Need

Once a reliable estimate is established regarding yearly expenses and yearly income, it’s time to figure out one’s Rightirement Number*. That Number is an approximation of how much is needed across investment accounts to continue the expected standard of living indefinitely. This calculation has been examined by many researchers, statisticians and early retirees. While there’s no final word on the exact “safe” value, most people tend to agree that a 3.5% to 4% withdrawal rate should be able to be sustained nearly indefinitely, provided that investment returns in the future are similar to those in the past. These assumptions includes different mixes of stocks and bonds and also allows increasing expenses each year to keep pace with inflation.

This will be discussed in more detail in a subsequent post, but for our purposes, we will assume a 4% withdrawal rate, plus a Social Security withdrawal at age 70 are sufficient to meet ones needs and thus would be financially independent. That is, for someone needing $30,000 per year in expenses, a nest egg totaling $750,000 would likely be sufficient to withdraw $30,000 the first year and more in subsequent years to maintain today’s purchasing power. For someone who is a little more conservative and wants to follow a 3.5% strategy, that Rightirement Number would be around $857,000. It’s important to note that these are just estimates based on historical data. Having a few thousand more or less than these numbers won’t statistically alter the outcome.

Minding the Tax Man

To turbocharge your savings, it literally pays to evaluate and optimize your tax situation. Legally paying a lower tax rate  now allows more of your money to compound year after year. It also increases the percentage of income that can be devoted to investment rather than paying to Uncle Sam. Assuming that the above $100 monthly expense was previously taxed at 39% (25% federal and 7% state and 7% sales tax), and that money is now put in tax advantaged accounts, like an IRA or 401k, you’re actually putting in $139 per month or over $23,700 in ten years, instead of the $17,000 above. If you still have room in your HSA, you also don’t pay the social security or medicare taxes for another 7.65% less in payroll taxes ($25,000 in ten years).

Credit Card Turbocharger

As mentioned in previous posts, here and here, credit cards can be an excellent tool to reduce total money outlays as they provide rewards, often in the form of miles or points that can be converted to cash, gift cards or travel. While the number of card redemption strategies are legion, even a basic 2% cash back card would provide a reasonable return of cash for the uninitiated in credit card hacking. Fidelity offers a 2% cashback card with no annual fee. Capital One also offers similar cards for both business and personal albeit with an annual fee. In my experience, a 30-60 second call to Capital One has always reimbursed me for the annual fee.

Adding in a couple of new credit card applications per person per year can easily net $1000 per person in sign-up bonuses alone. For a couple, that would amount to $2000 per year in rewards for spending that would likely have happened with or without the credit card. These rewards are generally not taxable so they go that much further to provide income for both pre- and post-retirees. Additionally, many cards provide other benefits like free car rental insurance, price match protection, no international transaction fees, access to airport lounges, free hotel nights, etc.

Building Up a Side Hustle

When left to follow their own passions, people generally find out that there are people who are willing to pay them for some of what they love doing. Whether it’s surfing, working out, real estate, or even gaming, there is a market for people’s expertise. Identifying ways to generate income from your passions is one of the best ways to keep mind and body sharp while still having fun and getting paid.

Summary

Progressing down the road to financial independence is exciting, whether you’re just hearing about the idea or are already there or somewhere in between. Having some measure of financial security goes a long way to reduce stress due to financial burdens and allows one to do more strategic, long-term thinking rather than figure out how to get by for another day. Establishing the foundation provided by Dilbert’s creator will go a long way to reducing stress and worry related to financial issues. Adding in the extra stability of lowered expenses, lower taxes, credit card benefits and starting a side hustle provides additional power to speed up the rate at which one can pursue his or her dreams.

 

Photo Credit: Christian Berding

In part II of this post, we’ll discuss multiple strategies of accessing retirement money earlier than normal, planning for unexpected and the gorilla in the room: how do you retire early in the United States and still have access to health-care?

 

*Rightirement Number is just a rough estimate of what you’ll need to sustain current life style. Hitting this number will not magically change your life and while it can be a good rough estimate, its important to not get too hung up on just getting to that number.

Tax Time Examples

https://www.flickr.com/photos/gamutless/10149012916/in/photolist-gsQkXj-7K3SbX-ctjSFU-7LcxcT-CDhDJ-drSLFg-Nqd7gn-6DsX32-Nqd6Zk-NuL6VE-6pc4tb-6Dt1m4-7TMBvF-6DxcDy-p9pa7T-qGkAdj-qGtgui-6Dt1TZ-qYU3X6-drSW7s-MzXUB8-q2TLkN-qYPiDN-9zQDfj-6Dx9pm-MezXZW-cuXQqf-6DsZm4-N9cBpL-rfcQYY-a6DZTM-6Dt2Hi-r8gAeF-6DxbXb-pEks8k-MK4GaL-z9JXVe-r3bLLd-qGtgK8-qSjpTY-6fpKEM-67U6nC-biaWZ4-6fnM8R-6fnExi-pUhtYL-4tnSX5-ijcJkF-r37xKF-9zW28D
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
25
Health Savings Account Deduction $3450 /
$6750
4/15
28 Solo 401k Deduction $18,000 employee, 25% up to $53,000
32 Individual Retirement Account Deduction $5500 /
$11,000
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
MFJ:
$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

Summary

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!