retirement plan

When an HSA-First Strategy Makes Sense

Many--perhaps most--articles about health savings accounts suggest that employees with an HSA who participate in a 401(k) plan should first contribute to the 401(k) plan the percentage of their compensation that enables them to obtain the maximum plan sponsor match, such as 3% on the employee's first 6% of compensation. Employees should then max out their HSA account contributions through payroll deductions. Once that's done, they should go back to contributing any additional dollars to their 401(k) plans.

While this strategy is indeed attractive, an even better one would be to change the sequence of the contributions. That is, employees should first max out contributions to their HSAs no matter their tax bracket, and once that's done, contribute to their 401(k) plans.

Break out that trusty old HP 12C and calculate any contribution, time horizon, and interest-rate combination. Then reduce that number by, say, 25% for tax to come up with the 401(k) balance. (An HSA demonstrates even greater superiority over an employer match in a 401(k) plan when withdrawals are made at a tax bracket higher than 28%, thereby illustrating the power of tax-free withdrawals in retirement. That is, the higher an employee's tax bracket, the larger the employer's 401(k) match must be to in order beat contributing to an HSA first.) 

A 401(k) plan will beat an HSA if left to retirement. However, reality intrudes when withdrawals are made from the 401(k) to pay for things like medical expenses and a participant in a 401(k) is slammed with taxes and penalties. This is why it makes the most sense to first max out HSA contributions and thereafter get the maximum company match from the 401(k).

Do the same for an HSA but then factor in a 7.65% (FICA) discount up-front and no tax deduction at the back end. In most calculations, the HSA-first strategy is ahead by one third. Then, add in a typical employer match of 3% on the first 6% in employee compensation and take the balance out at a 35% tax bracket. The result: HSA tax savings even beat the employer's match. And don't forget, 80% of employers that offer an HSA contribute $500-1,500 to an employee's HSA.

Once these two no-brainers are accomplished--max out HSA contributions first and then obtain a full company match for the 401(k) plan--only at that point should employees begin their retirement needs planning for the year and so on into the future.

For those who are uncomfortable with this strategy for whatever reason, perhaps they would prefer contributing simultaneously to both the HSA and the 401(k) account on a regular periodic basis throughout the year.

Apart from the issue of the sequence of contributions to an HSA and a 401(k) plan is the issue of the difference in the amount of contributions. For example, Employee A saves and invests $5,000 (a nice round number used even though it slightly exceeds what an individual 55 or older can currently contribute annually to an HSA) annually for 30 years in an HSA. Employee B also saves and invests $5,000 annually for 30 years in a 401(k) account. Employee A in the HSA will amass $611,729 while Employee B in the 401(k) plan will amass $423,699.

The differential in favor of the HSA of nearly $200,000 is due to avoiding payment of the (up-front) 7.65% FICA tax (or more in certain other states and localities) for 30 years of contributions. (Assumptions for the foregoing terminal amounts include a 25% income tax bracket, an 8% return, an HSA that's in the payroll deduction scenario to avoid paying 7.65% in FICA taxes and HSA assets are used for qualified medical expenses. Also, a 25% income tax bracket was applied for withdrawal of 401(k) money.)

Tax-Deferred Accumulation of Earnings and Interest on Contributions
Any earnings and interest generated on contributions to an HSA accumulate tax-deferred over time. When these accumulations are used to pay for qualified medical expenses or to reimburse an HSA holder for previous qualified medical expenses, they become tax-free distributions.

Tax-Free Distributions to Pay for Qualified Medical Expenses
In essence, HSA assets can be used to pay for anything tax-free. Suppose that HSA holders are able to max out contributions to their HSAs and pay for qualified medical expenses out-of-pocket through some or all of their careers. If the holders have kept their medical expense receipts over time, they can get reimbursed later for those expenses from their HSAs.

There's not even a need to have a current qualified medical expense; the HSA holder merely needs to have a receipt from any time in the past to get reimbursed. Qualified medical expenses, then, can arise from any year--not just the current one. This proactive strategy allows an HSA holder to augment retirement income tax-free rather than first pulling money from, say, its taxable 401(k) plan account. This could be helpful in cases where withdrawals from a 401(k) account could bump the holder into a higher tax bracket which could also result in higher Medicare premiums

Other instances of the versatility and flexibility of the HSA abound. For example, the fact that an HSA holder can contribute to an HSA until April 15 for the previous tax year (like an IRA) allows for a post-calendar year tax avoidance strategy. Suppose that a 56-year old self-employed worker had $4,000 in medical expenses and paid for them with (after-tax) out-of-pocket money because the worker didn't know that he or she was eligible for an HSA. A savvy investment advisor informed the worker about eligibility.

So before tax-time in April, the worker establishes an HSA and contributes $4,000, thereby avoiding payment of federal and state income taxes. (But not FICA taxes because the self-employed cannot establish an IRS section 125 cafeteria plan. However, LLC or LLP members might be able to establish a 125 plan if they have elected to be taxed as a Subchapter C Corporation; competent professional counsel should be consulted in such cases.) The worker then took out $4,000 from his or her HSA to reimburse himself/herself.

The result: a wash that saves a lot in taxes. This post-calendar year tax avoidance strategy demonstrates again that having a receipt for qualified medical expenses that were paid even far in the past allows an HSA holder to get reimbursed--assuming, of course, that the holder has been able to pay for its medical expenses out-of-pocket along the way.

Additional Advantages of HSAs
The Tax Cuts and Jobs Act passed by Congress last year failed to further expand the advantages of HSAs. However, it's thought that there will be a Medicaid/Medicare HSA provision as well as one to increase HSA contribution limits included in the 2018 Budget Reconciliation Act. In the meantime, here are some additional advantages of an HSA.

Full Vesting. Any contributions made to an employee's HSA by either the employee or its employer are immediately vested in the employee.

Portability. An HSA can be opened by a worker anywhere. For example, if employees don't like their employer-sponsored HSAs, say, because it's pricey and/or the investments are suboptimal (which is often the case), they can pull the assets from it and invest them elsewhere in an optimal HSA (within 60 days but without the rigmarole of a rollover). The downside to this non-payroll deduction scenario, of course, is that employees cannot take the 7.65% (or more) deduction for FICA taxes. Even if employees are currently ineligible to make contributions to their HSAs, the HSA always stays with them not their employers.

Flexibility. HSA holders can withdraw HSA assets or change them at any time while letting the HSA accounts accumulate, regardless of their current employer or current eligibility. In addition, there are no required minimum distribution rules or requirements to begin taking withdrawals at a certain age.

Sources of Contributions. Those other than HSA holders can contribute to a holder's HSA including a family member and, as noted, their employers.

Coverage for Family. HSA holders can use assets from their own HSAs to pay for qualified medical expenses incurred by spouses and their tax dependents even if they aren't eligible to establish their own HSAs or even if they have health insurance different than the holder.

At Death. At an employee's death, the HSA can be rolled over to a spouse tax-free, plus that spouse can continue to save and invest in the HSA. But if the HSA is rolled over to a nonspouse, the HSA balance is fully taxable like the balance in a 401(k) plan.

Medicare/Retirement. The Medicare Part B monthly premium (for visits to the doctor) is deducted from a recipient's monthly Social Security check. In such cases, however, an HSA holder can get reimbursed from HSA assets for these premiums as well as Part D monthly premiums (for drug prescriptions).


Use This Hack to Get the Most Out of Social Security

Getting the most out of Social Security is all about waiting as long as possible to start filing for benefits, right?

Not quite--especially if, as a business owner, you get to decide how you are paid.
You can actually live on a lot more money in retirement if you make some changes right now to your salary and take some steps to adjust your current tax bills, says Matthew Allen, a co-founder of New York City-based Social Security Advisors.

"Self-employed people generally have more flexibility in how to structure their income," he says. "That gives you a lot of good opportunities because of the way Social Security benefits are calculated."

The main tactic that Allen lays out below isn't over­whelmingly complex: Start replacing some of your salary with dividends, as long as you have a legitimate business reason to do so. (There's no required schedule for dividends, but you may wish to take them quarterly, for regular cash flow.) Meanwhile, boost your contributions to retirement savings accounts.
It's a simple enough change--but it's not a very obvious strategy until you understand how the Social Security and income tax systems work, and how the two interact.

What your current salary means

To survive in retirement, you'll obviously have to replace some of your current wages with other sources of income, including savings or pensions or government benefits. Social Security, of course, is the nation's cornerstone retirement safety net; it provided some 50.3 million retirees and survivors, or about 15 percent of Americans, with benefits in 2016. If you're planning on relying on Social Security, you probably already know that the amount you'll get at retirement varies depending on how much you've earned and paid into the system. What is less well advertised is that Social Security's benefit formula favors lower-income retirees, the assumption being that those who haven't earned high wages don't have much in savings.

Since low-wage workers are less likely to have other sources of retirement income, Social Security's graduated benefit formula gives them the highest "wage replacement" rates. Specifically, those who earned average monthly wages of $885, or $10,620 per year, get 90 percent of those wages replaced by Social Security benefits. But the replacement rate drops as you earn more, falling to just 15 percent for those earning more than $64,000 per year.

In other words, if you earn an average of $10,620 in each of the 35 years that Social Security will use to calculate your benefits, you'll be due a monthly Social Security payment of $796.50 at normal retirement age.

But if you earn 10 times that much--and pay 10 times as much in employment taxes--your monthly benefit would increase only by 3.5 times, to $2,747.92.

Can you pay yourself dividends instead?

Here's where your current tax bill comes in. You're paying Social Security taxes only on your salary, or earned income; dividend and investment income is exempt. So, as Allen suggests, you can minimize your employment tax by paying yourself partly through dividends, rather than through regular wages.

However, because this strategy will reduce your future Social Security income, it is wise to boost contributions to your retirement plans at the same time.

Let's say your business earns you $100,000 annually, of which you contribute $10,000 to your retirement plan. If you take the rest of your earnings in wages, you'll pay roughly 33 percent in employment and income taxes. But if you take $15,000 as dividends and increase your retirement contributions by $5,000 annually--thus cutting your wages by $20,000 a year--your overall tax rate drops to roughly 27 percent, for wages and dividends combined. In both cases, your after-tax take home is around $60,000--but if you adopt the latter strategy, you'll save about $5,000 in taxes each year.

Then, when retirement rolls around, you'll get slightly less in monthly Social Security benefits--about $316 per month in this example. But you'll also have dramatically more saved for retirement: about $750,000 more, assuming a 7 percent average return over 35 years. That's enough to pay you $3,322 per month for 35 years--about $3,000 more than you "lost" in Social Security benefits.

Make your dividends count

There's one big caveat. You need legitimate reasons to pay yourself dividends, rather than simply wages, for this to pass muster with the Internal Revenue Service, says Philip J. Holthouse, partner with the Los Angeles accounting firm Holthouse Carlin & Van Trigt. Otherwise, the IRS is likely to challenge your strategy and "recharacterize" your income as wages, levying the appropriate taxes and penalties in the process. And a tax court may agree.

So what are legitimate reasons to pay yourself dividends rather than wages? When a portion of your company's profits are derived from something other than your work as a "key employee."

If you employ anyone other than yourself (and any co-owners), or if you invest in machinery or equipment that is responsible for generating a portion of your company's revenue, it's considered reasonable to take wages for your work and dividends for the profit that was derived from your other employees or company assets.

There's no set formula for determining what portion of your income should be claimed as wages versus dividends. But realize that you may have to justify whatever formula you choose, so you should have a reasonable approach. You could research competitive wages in your industry and take any excess profit over that amount as a dividend, for instance. Or if you're able to directly attribute revenue to employees--or assets--that could work too.

However, the more of the company's earnings you take as dividends versus wages, the more likely you are to be questioned by the IRS, warns Holthouse. And if you run your business full time, you always have to pay yourself at least some wages.

"The idea that you could earn no wages from a business where you work full time has been pretty universally rejected by the IRS and the courts," says Holthouse. "Otherwise, if you have an argument with economic substance, you could very well win. It gets very fact-specific."

Given that this sort of dividend-income strategy could pique IRS scrutiny if misused, you may want to consult a tax professional before adopting it.

"Social Security is essentially one big math problem layered with 2,000 different rules," says Allen. However, he adds, many couples could end up collecting around $1 million in benefits over their lifetimes: "I can't think of anything else where it's as important to get it right the first time around."


4 Ways to Protect Your Retirement Investments From Your Emotions

We like to think that we make rational financial choices, but that isn't always the case when it comes to our money. Our personal financial decisions are frequently influenced by our emotions. Due to our inability to think long term and our fear around losing money, we make bad investing decisions all the time. Luckily, you can take some pretty basic steps to protect yourself from your irrational side when it comes to preparing for retirement.

Automate your investing. First, you should automate your investing whenever possible. Automated investing keeps you stashing away funds even when it seems like money is tight in your everyday life. If also keeps you from frittering away your funds on spending that feels good now before you can save that extra cash.

The first step is to enroll in your employer’s retirement plan, which will automatically deposit a portion of your paychecks in an investment account. If you’re self-employed or your employer doesn't provide a 401(k), you can set up an automated deduction to a retirement or investment account at the beginning of each month.

Also, remember to automate increases in your investing. When you get a raise, direct at least part of the “new” money to your retirement account right away. If you never see it hit your checking account, you’ll be much less tempted to spend it frivolously.

Get acquainted with your risk tolerance. Your risk tolerance basically means how willing you are to lose money in the market. If you have a high tolerance for risk, you might be able to get better returns on your investments, but it also comes with the possibility of losing more of your capital.

Everyone needs to find a balance between the risks and rewards of investing. But you need to determine your own personal level of risk tolerance. Will you lose sleep if your portfolio’s value drops dramatically overnight? Or can you ride out the market downturn knowing that things will turn back up eventually?

While some people like to micro manage their investments, a buy and hold strategy typically works best for most people. This means potentially holding some investments as they lose value while you wait for them to regain value.

If you can’t handle watching your investments rise and fall in value – or if you can’t afford to lose money because you’re nearing retirement – select less risky investments. This is why experts recommend shifting your portfolio from stocks into more bonds as you near retirement age. You can never completely eliminate risk from your portfolio, but you can mitigate it.

Consider target-date investing. One way to remove your emotions from your retirement investments is to let someone else make the decisions. Robo advisors offer services that make decisions based on a risk tolerance quiz when you open your account.

Another option is to choose a target-date retirement fund from a traditional investment brokerage. Target-date funds automatically adjust your portfolio based on how long you have before retirement. The gradual shift from stocks to bonds occurs without any input from the investor, which can help you make solid investment choices while being fairly hands off.

Imagine your future. Finally, take time to imagine your future as a retiree. It’s easy to overspend in the moment rather than saving money for later. One way to combat this is to take time to envision your retirement and what you want it to look like. If you want to fulfill a dream of spending retirement on the beach, then you better start saving today.


How Self-Employed Workers Can Invest for Retirement

Freelance and self-employed workers may wonder if they can truly save as much as those who work for others, but tax-advantaged investment opportunities abound for the disciplined and resourceful, tax and financial experts say.

"Working for yourself can create challenges when deciding how to save for retirement," says Brannon Lambert, of Canvasback Wealth Management in Raleigh, North Carolina. "The good news, though, is it also gives you flexibility and opportunities you would not have as an employee elsewhere."

Just about all self-employed retirement plan options are available with large investment banks like Fidelity, TD Ameritrade or Vanguard, which also offer low fees on funds and minimal initial investment requirements. Some are tax-deferred and some offer after-tax benefits.

"Regardless of what account type you choose, keep it simple, diversified and low cost," says Lawrence Solomon, director of investments and financial planning at OptiFour Integrated Wealth Management in McLean, Virginia. "Avoid the siren song of picking individual stocks or hot actively managed mutual funds, which have higher fees than passive, index-based funds."

Deciding which retirement plan one to pick can be tricky, particularly if your profits ebb and flow month to month or year to year. Corey Purkat, founder and CEO of Northwoods Fiduciary Advisors in Oakdale, Minnesota, says business owners should ask themselves: How much administrative work do I want to do for a retirement plan? How much can I realistically save? Do I plan to add employees in the near future? Will my spouse be joining the business?

The following plans can be established and you can pick a different one to contribute to annually as your needs change and business grows, Lambert says.

SIMPLE individual retirement account. SIMPLE stands for Savings Incentive Match Plan for Employees and allows employees to make annual pre-tax contributions of up to $12,500 ($15,500 if over 50), not to exceed profit. However, if the business is more profitable this contribution limit can be "limiting for a business owner looking to save more," Lambert says.

Matching employee contributions are a deductible business expense, Purkat says, so if you're the only employee you realize tax savings on both.

A SIMPLE IRA must be in place for three months before the end of the calendar year, Purkat says, and is the only employer plan that can be in a place in a single calendar year (meaning you can't contribute to a SIMPLE and a SEP IRA together).

Only businesses with 100 employees or less can set this up. As an employer you can either contribute 2 percent of your employee's compensation into the SIMPLE IRA or match the first 3 percent of their salary they contribute, Lambert says.

SEP IRA. A SEP IRA is easy to set up and allows a self-employed person to contribute up to 25 percent of their pre-tax compensation up to $54,000. If you have employees, they have to receive the same percentage match as the owner, Purkat says. A SEP only allows employer contributions, not any additional employee contributions.

Your contribution deadline is your tax filing deadline, which means you can "wait to see how much income you earned in a year and how much you can afford to save for retirement, without being locked-in to contributions during the year," says Ben Westerman, senior vice president of HM Capital Management in Clayton, Missouri.

A SEP also allows simultaneous contributions of up to $5,500 in a Roth or traditional IRA. The traditional IRA contribution can be made to the same account as the SEP to minimize administrative responsibility, Lambert says.

Individual 401(k). Self-employed individuals have the most flexibility with a solo or individual 401(k) plan. They can make an $18,000 employee contribution under this arrangement ($24,000 if over 50), plus an additional 25 percent of your total profits or compensation up to $54,000. Employee deferral contributions can be made up of pre-tax and after-tax Roth funds.

"If income is less than approximately $216,000 and you wish to save the maximum of $54,000, then an individual 401(k) is the best solution," Westerman says.

The plan participants must elect to make a contribution by Dec. 31 but actual contributions can be made up until your tax filing deadline. You can also use the individual 401(k) plan for your spouse if he or she works in the business. Any non-spouse employees would have to use another plan.

Though this option is tempting if it's only one or two participants, to satisfy IRS rules, Form 5500-SF must be filed annually if there's more than $250,000 in assets, Purkat says.

You have until Oct. 1 to establish an individual 401(k) and a SIMPLE IRA. Tax-free loan options are available and these plans typically receive better creditor protection, says Brandon LaValley, co-founder of Targeted Wealth Solutions in Colorado Springs, Colorado.

Cash balance pension or defined benefit plan. Freelancers or independent workers that have strong cash flow and expect it to continue should consider adding a cash balance pension or a defined benefit plan, Purkat says. The closer in age to retirement, the larger the contributions that can be made for a given year – it's actuarially pre-determined, based on your age, compensation and IRS regulations.

They could use this in addition to an individual 401(k) that was maxed out and would not violate IRS rules, Purkat says. It's a little more complex to set up, but it's possible to contribute over $200,000 (And over $300,000 if 62 or older) combined with the 401(k) plan.

The plan is defined to be kept in perpetuity. Filing a Form 5500 is required and you may potentially need to file with the Pension Benefit Guaranty Corp. Providers of these plans are not widely available, and Purkat recommends working with an experienced advisor to coordinate with the multiple professionals typically involved, such as a third-party administrator, actuary, retirement plan advisor, accountant and record keeper).

When the owner is ready to retire, the cash balance plan can be converted to an IRA, LaValley says.

Roth IRA. After-tax contributions to a Roth IRA are possible up to $5,500 annually (and $6,500 if over 50). Your income must be below $118,000 for single filers and $186,000 for joint filers, Solomon says.

"The chances are good that right now, your income is lower than it will be at any other time in your life," says Adrian Nazari, founder and CEO of Credit Sesame. "Roth IRAs are beneficial because you pay taxes on the money going in now, but not when you take distributions in retirement. Hopefully, by the time you are in retirement, you'll be in a higher income tax bracket, so it's cheaper to pay the taxes now while you're taxed at a lower rate."