2021 was another year that was outside the norm for market returns and the more risk you took the more you were rewarded. Currently, the top-10 stocks in the S&P 500 index comprise more than 1/3rd of the entire index. In other words, a 1% gain in the top-10 stocks is the same as a 1% gain in the bottom 90%. Had it not been for the enormous returns in companies like Apple (AAPL), Google (GOOG), Microsoft (MSFT), Tesla (TSLA), and Nvidia (NVDA), the return for the year would be much different.
We all want to make above average returns but historical valuation levels in the U.S. are at levels that are not sustainable from here over the next 5 years. All stocks eventually revert to a mean level of return. International and Emerging Market stocks continue to trade at the lowest valuation levels in 10+ years. These stocks should outperform the S&P 500 over the next 5 years on average. That is why our portfolios have a healthy allocation to these areas. Part of our job as an objective advisor is to invest where we are going and not where we have been.
We also are preparing for GDP to slow in the coming months from the mid 6s and approach high 4s by the second half of this year. We anticipate yield curve volatility to become minimal. Bonds will flatten if markets slow down. Notably the 2yr-10yr yield spread has gone from 1.5 in middle of 2021 to 80bp today. Also notable is manufacturing supplier deliveries which peaked during 2021 at 80 and now is heading in decline to 64. This is the lowest we have seen since 2018. The bulk of the fiscal spending was in March of 2021 to the tune of 1.4 trillion. That too is at the tail end.
Inflation continued to expand in 2021 because of supply constraints and governments around the world stimulating their economies to battle the Covid-19 virus. This has produced the fastest pace of asset price inflation (including the stock market and real estate) in decades. While absolute levels of inflation will remain high for some time, we anticipate seeing the beginning of disinflationary pressures emerging over the course of 2022. The current consensus is that the Federal Reserve will raise rates up to 4 times in 2022. The danger is that they will over tighten which will be very bad for the markets and our economy.
To prepare for disinflation pressures, we cut our exposure to commodities and energy and shifted into traditional bonds and gold. We anticipate further increasing our gold holdings and have become more conservative with our bond holdings. We have moved away from some alternative bonds and into more stable core positions. Since markets are dynamic, we reassess our allocations continuously and make changes in order to take advantage of assets that outperform in a slowing economy. Happy New Year and we look forward to serving you in 2022! Please contact us if you would like to meet to discuss your portfolio, and we will help guide you with objective sound advice.
First, I’ve got to clear the air as I’ve already misled you on the title of this article. To begin with, I don’t even know if I’m a financial advisor. I mean, that term is used so loosely that anyone and their mom could call themselves a financial advisor. I do know that I am a partner in a wealth management and financial advisory firm, and I talk to people about financial planning and optimizing savings strategies all the time. I also know that my background is a retirement actuary, and I passed every exam they threw at me to earn my Fellow of the Society of Actuaries. As such, I feel credible enough to give my son, and the internet, some free financial advice. But there’s the second item I misled you on. It’s true that I have a son, but I also have three daughters, and I even have two more sons. And my wife is carrying another unborn child of mine. And while the fact still hasn’t hit me that I effectively have 7 children, the point is that this ‘financial advice’ is equally applicable to each of them…sons and daughters alike…and even your children.
Alright, now that I’ve got that off my chest about misleading you in the title of this article, I’m ready to share three things that I’m already talking about with my son (and my daughter, and the other when they age a bit more, but for the sake of this article…let’s just stick to “son”). Before I jump in though, let me just say that I’ve already covered the basics and this article is not focusing on those basics: Save early. Save often. Don’t overspend. Get the maximum match in your 401k from the company from which you’re employed. Have liquidity. Protect your income…it’s your greatest asset. Diversify, not just investments, but also tax strategies across pre-tax, Roth, HSA. Yes. Yes. Yes. You know all these things as you’ve read some of my other articles.
Today I’m talking beyond the basics, and I’m talking about the stuff that I really want my kids to know and execute upon to give them a leg up.
Number 1: Contribute to your Roth IRA and do it now. Sure, this is in the basics, but there’s more here. I love Roth IRAs because of the tax-free earnings and the flexibility to withdraw contribution basis at anytime. Anyone early in career or at low marginal tax rates should be contributing to a Roth IRA. But the earlier the better, and getting my son to understand the value and build the habit of using this tool…the better. How early? Well he’s 9. So now. We’re already getting him earned income so that he can make contributions. We’re hiring him to do some work around the house and to help out with my wife’s furniture business. He’s a great wood waxer. He’ll get a paycheck from us and a 1099. And then he’ll get a lesson on why he needs to put 100% of it into his Roth IRA. The beauty of creating this understanding now is that as he generates his own income in a few years, he’s got the habit down. We’ll even give him some matching incentive in the future. If he earns $7,500 in the future as an example, we’ll ensure $6,000 gets into his Roth IRA. We’ll match him $1 for $1 on his own contributions. Put in $3k son, and we’ll put in $3k too; and you still have $4,500 to spend. He’ll do it. What we’re really encouraging here is getting him a very healthy Roth IRA balance out of the gate when he’s young. No 529 or checking or savings account necessary…just get that Roth IRA rocking.
Number 2: Plan to move every 2 years. One of the best ways to build tax-free net worth is sweat equity in real estate. If you live in your home as your primary residence for 2 years, then the gain on the sale is exempt from taxes up to $250,000 as a single filer and $500,000 married. When you’re young, there’s no better time to put in some sweat equity and do some home improvements. You’ve got the time. So my advice is to buy the cheapest house on the block, renovate over 2 years, then list it, take the cash, and repeat. Do it as many times as possible until you’re married and have children and just don’t have the time to allocate anymore.
Number 3: Gig it and gig it from home. Even if you have a corporate job, you should have a lifestyle business that you’re running out of the house. Step one is to figure out what passions or hobbies can be monetized. Step two is to run a business with the passion or hobby and start using every day expenses as business expenses as applicable. I’m not talking about doing anything sketchy. I’m talking about cell phone bills, and internet bills, and other utility bills, etc. Basically, stuff that you’re otherwise paying a bill for because it’s basically become a necessity of life, but it just so happens it’s a necessary expense to run the business and gig it. You’re shifting more of your life into a tax-free lifestyle and that’s what we’re going for here. An added benefit is that if you do start making significant cash, you’ve got the ability to open a self-employed 401(k) plan and reduce taxes even further. There are a lot of benefits on the self-employed 401(k) alone, like being able to decide how much of your income your sheltering as you’re figuring out your tax bill for the prior year, but a full discussion is warranted elsewhere.
So there you have it. When it comes to my son, in addition to the financial basics, I’m telling him to start his Roth IRA early, to buy and sell a house every 2 years, and to find a fun way to hustle on the side.
If you want me to give your son some financial advice as well, stop on by and introduce him!
As we head into the fourth quarter of 2021, the domestic economic backdrop has vacillated between a strong reflationary trend and muted growth coupled with high inflation. Quite a range we do admit. Despite the feds pacifying depictions of transitory inflation, we have seen container shipping up over 300% year over year, home prices up 20% for the year and the 19 commodities on the CRB index are at all-time highs. We are seeing inflation broadening across multiple venues. Wheat is up 30% and coal is up 35% for the past month alone. Oil is at its highest level since 2014. In turn, 7 of the 11 S&P 500 sectors are positive for the quarter and all 11 sectors are positive for the year. The 10-year yield bottomed around 1% in February and has trended towards the positive from July thru September. All the while the 10-year has moved from an early quarter 1.4% to 1.48% near quarter-end. High yield spreads have widened slightly from 3.05 to 3.20 at the end of the quarter, and the steepening of the yield curve remains for the most part unchanged. The bond market is a great foreteller of the economy and the equity markets. Given the recent metrics and the unwavering of spreads during the recent bouts of episodic volatility, we maintain that we are still in a growth-oriented market. Bitcoin is currently around $47,000/coin as the dollar fails to maintain strength and interest rates and inflation remain unabated.
During mid-3rd quarter, the 10-year depressed and with it came some concerns that the market was expressing a slow-down. In response, we harvested some energy and industrials sector gains. We used this cash to incrementally add gold and utilities as well as add to our existing REIT exposure. Shortly after, bull market trends became clearer and our stagnant market fears quickly dissipated. We exited those positions in order to increase our energy, real estate investment trust (over weighted in public storage and apartment rentals) and commodity exposures. We do anticipate adding gold and utilities again and with significant weights. However, timing is very important. Gold needs more than inflation to appreciate. Specifically, it doesn’t like rising interest rates like we are seeing with an increasing 10-year treasury. Utilities usually perform well during depressed growth and moderate inflationary environments. We anticipate adding those positions sometime 2nd quarter of 2022.
As we speak, the longest shipping regatta in history is waiting to set sail in Long Beach California. Currently there are 60 ships backed up in the West Coast harbor. This is a good illustration of increased demand and continued supply chain bottlenecks. We think that these supply chain issues will continue thru the beginning of next year and help to maintain upward pressure on inflation, CPI (Consumer Pricing Index) and PPI (Producer Pricing Index).
Please remember we are not in the game of timing the markets, but we can adjust and look to ride the areas where the volatility is manageable and the opportunities for growth seem best positioned. To time the market, would require us to be precisely correct when to sell and it would also require us to be precisely correct when to buy. Rarely are both done with precision. Portfolio rebalancing and reallocating our gains to opportunities that haven’t appreciated is the most efficient way to protect the portfolio. We look forward to discussing more with you at our next meeting or over the phone when it is convenient for you. And with that, we are going to get back at it. Cheers to another strong quarter.
As we head into the third quarter of 2021, the domestic economic backdrop remains in a reflationary environment. This past quarter has produced 15 all-time highs on the S&P 500 and an all-time high in high-yield bonds. This acceleration is seen in a host of markets abroad too. Germany, Poland, Spain, South Korea, Pakistan, and Australia (which reached all-time highs) have all seen lower volatility and higher equity trends. As of Friday July 2nd, 66 of 103 S&P 500 companies that issued earnings per share guidance for the second quarter offered a positive outlook that exceeded consensus estimates, according to FactSet data. This would mark the highest number of S&P 500 companies offering estimate-topping outlooks ever recorded in data going back over 15 years. Treasury yields sank across the curve, with the benchmark 10-year Treasury yield dipping below 1.48%. Major cryptocurrencies steadied after sliding approximately 50% from their all-time high in May. Bitcoin is currently around $35,000/coin.
We are not complacent. Many have asked us what would happen if? We are preparing for some potential market shifts and deceleration. These market shifts allow us to remove position gains and reallocate to where new opportunities lie. Within our fixed income allocations, we have added, and subsequently removed our quadratic spread between the 2-10 year treasury (IVOL), added a corporate bond position (LQD) and added a pre-merger SPAC (SPAX). This was done with the intent of collecting yield where possible, taking some bond term-risk and removing the 2-10 year spread that was being interfered with from the Federal Reserve. We have added equity positions into energy (XLE) and Real Estate Investment Trusts (CWRE). These assets were positioned to take advantage of the inflation that affects commodities and real assets that are appreciating from inflation, the devaluing dollar and housing supply constraints.
On the inflationary front, both pandemic dynamics and historic Fed-Fiscal policy support led to massive supply and demand imbalances. We see this flowing from the Goods to Services sectors. This is encouraging the Fed’s “transitory” stance and leading us to anticipate longer and higher-than-usual inflation in the coming quarters. Third quarter is primed for deceleration on a global basis. We believe nearly every G20 country will fall into stagflation or deflationary environments. China spent the second quarter in stagflation, as they were the first to emerge from COVID’s shadow. We believe that China will continue on this trajectory thru the beginning of next year. We want to remind everyone that we are discussing market environments in regard to trends developing and NOT the 2-3 year outlook. We are not entirely pessimistic on our global outlook. Europe is set to be a region with accelerating growth thru the beginning of 2022. Europe has lagged by 6 months in comparison to the U.S. and is following a similar trajectory that the U.S. has already traversed.
Your job as an investor is to remain patient amidst the volatility and know that we are positioning for market changes and managing the portfolios effectively and incrementally. As we stated before, we continue to see growth and inflation, we just need to be aware that some shifts may occur. We would be happy to chat with you at any time and we look forward to the conversation.
As we begin the second quarter of 2021, we are excited to share that we have moved into a new office, located at 1331 Lake Dr. SE, Suite 100 – in Eastown. We are proud of our new office and look forward to having you visit. Now to the market. Let’s start with some market indicators and data. This will provide an overall sense of what the markets have done and what we believe they will continue to do in the next quarter and into the remainder of 2021.
The 1st quarter ended with some episodic and non-trending volatility. At the same time, we have seen significant appreciation and increased trading volume in multiple markets areas. We continue to see an uptick in inflation and economic growth. Consumer confidence increased according to the University of Michigan Current Conditions Report and Expectations Report (up 7 and 9% respectively for the month). Unemployment is at 6%, and GDP is up 4.3% for the year. Real GDP year over year is up 11%+. All 11 sectors of the S&P 500 are up in the first quarter of 2021! Energy, Financials and Industrials have been the leading sectors with returns of 30.34%, 16.38% and 11.54% respectively. Year to date, the S&P 500, foreign and emerging markets are all positive, to the tune of 7.4%, 4.3% and 4%. In the U.S., the leading asset class has been in the small cap space, up 14.4%. Another notable event in the first quarter is the disparity in growth and value names down the market spectrum from large to small companies, illustrated in the chart below. Lastly, the Barclays Aggregate Bond Index is -3.4%
First Quarter Disparity in Growth by Sector
So, what does this all mean? We believe we are in a growth and reflationary environment. To put it neatly, we have a massive easing of money and pent-up global demand. In the U.S., we are expeditiously breaking free of the virus’ constraints as more people are vaccinated. In the U.S. over 20% of the population have been vaccinated and approximately 100 million American’s have received the first dose. Locally speaking, DeVos Hall has the ability to vaccinate 20,000 people a day. These vaccinations locally, nationally, and eventually globally, will significantly improve commerce. We believe that Europe and the rest of the world will lag by about 5 months. As the U.S. and the world finds their footing, so too will investment capital markets. We believe that in the next several months we will see global supply chain issues resolve and that there will be a massive increase in inventory levels. This is a market, that Wallstreet likes to call “risk on”. Depending on their risk tolerance this is a period of time when an investor should strategically allocate their portfolio to more risk where they can.
This growth and reflationary environment started the last half of 2020 and continues. This is a relatively short period of time where commodities, equities, credit, and foreign currencies will appreciate. We believe that during this reflationary trade, technology (even though expensive), consumer discretionary, industrials, financials and energy will appreciate. We also believe this is a short period to avoid utilities, REITS, Consumer Staples and Healthcare.
While we don’t have a crystal ball, we maintain our conviction that value and emerging markets should outperform over the next 3-5 years. Markets overall are trading at the highest valuations in decades which is concerning. These high valuations are countered by unprecedented involvement by the US congress with fiscal stimulus and changes to monetary policy by the federal reserve that are driving markets higher which may continue for some time. We are living through an unprecedented time in our country, and we are honored to guide you through this period.
Happy New Year! We are thankful for this year’s opportunities and for making it thru a very challenging chapter. We are optimistic for the anticipated vaccine. We look forward to returning to a life and community that is more open, and we are excited to rebuild. We all hope 2021 is that new beginning.
In the world of financial planning, there is a calendar year reset that occurs as well. It’s a new tax year. Health care deductibles reset, and it is time for new contributions to IRAs, 401ks, and HSAs. We look back on the returns for 2020 and strategize for the year ahead.
By investment standards, 2020 was a rollercoaster of change and volatility. COVID-19 brought a swift decline in the financial markets. The Fed produced trillions of dollars in stimulus and markets ultimately recovered. By year end, most indexes ended the year in positive territory.
Facebook, Amazon, Nvidia, Google and Tesla led the U.S. stock market into a manic exuberance. Investment professionals and individuals alike were excited by these tech giants and about their prospects of market dominance. Let’s face it, the world has changed expeditiously in the past few years. Tech companies are positioned to propel us into the future. The question becomes, how much are you willing to pay for these future hopefuls. Prices of these stocks are expensive. In fact, all other investments, globally and domestically paled in comparison. Even the other 490 stocks that make up the broad U.S. large cap market haven’t compared. Take a look at the following chart.
YTD Tesla has risen 657% and approximately 1100% in the past 18 months. Here are a couple of numbers to stew on. Tesla market cap has increased by $500 billion in 2020. According to the market, Tesla’s value has surpassed that of the nine largest car companies globally. This includes Volkswagen, Toyota, Nissan, Hyundai, GM, Ford, Honda, Fiat Chrysler, and Peugeot. To bring these numbers into context, Tesla only made ~1% of the total vehicle sales in 2020 or approximately 500,000 vehicles. We are of the firm belief that those returns won’t continue along the same upward trajectory forever.
We have recently been asked, “Why do we need bonds in a portfolio, especially now?” Prevailing thought is that if interest rates go up, the price of bonds will surely go down. Interest rates are almost at zero and inevitably they will go up. We have had low interest rates for a decade and near zero rates for a year. Stocks have beaten bonds by 90+% over the rolling average of the past 100 years. Given where interest rates were, 30-year treasury bonds still produced a total return of 18.88% for 2020. However, bonds play an important role in a portfolio’s stability. When equities are bullish, the case for bonds is challenging, but when markets selloff, it is conceivable to experience a 60+% drop in a portfolio without bonds. We like to think of bonds as an insurance policy. This insurance policy also allows us to buy equities when markets sell off.
A few salient points that we like to remind folks: we can’t time the market and there isn’t a correlation between GDP and Equity returns. Earnings look back and stock prices are an anticipation of what the stock earnings and company growth will look like in the future. If we were to try and time the market this year, many investors would have taken money out when their portfolios plummeted and would have resisted putting money to work when the pandemic was saddling the world with depression like statistics.
So where is the opportunity today? We see an opportunity in emerging market equities that have been underperformers for several years. Specifically, we are focused on value categorized companies. For the past 10 years, we have seen a stark disparity between the returns of value and growth companies. Value names have experienced their worst decade in history and to further the pain they have just experienced their worst 12 months in history. We see this underperformance as an opportunity to reallocate portfolios that were in favoring domestic growth equities and shift them towards more international and value-oriented names. In regard to fixed income, we are favoring some credit risk in exchange for term risk. Currently, inflation remains tepid. Although current spreads between conventional treasuries and TIPS have widened to 1.8% in the later part of 2020, this is well below the 2% fed target. If inflation does increase, term risk will weigh more on the fixed income portfolio.
Current portfolio changes for 2021
In order to best position our portfolios and to take advantage of where we forecast returns to come from in the near future, we have made the following adjustments for the first quarter 2021. We exchanged our passive positions in MSCI EAFE Growth and Value for an active position in Oakmark International Value fund. We added positions to the Sharepost 100, a late-stage private equity fund and the Columbia Dividend Income Fund. We also increased our positions in Robinson Municipal Bond fund and the ATAC Rotation fund and decreased our positions in Fidelity Conservative Income.
The markets remained resilient through the end of September. Following four straight weeks of losses, all major market indexes are positive year-to-date. Specifically, the S&P 500 remains at a positive 3.5% through the 3rd quarter. The following sectors, Technology (26%), Consumer Discretionary (21%), and Consumer Services (7%), have all generated positive YTD returns. Current unemployment has fallen to just below 8%. The economy has returned approximately half of the payrolls lost at the start of the pandemic. Certain economic indicators such as consumer spending, manufacturing demand and durable-goods growth point toward an economy that is recovering.
The quarter was not without its challenges. The Billy Joel song “We Didn’t Start the Fire” rings in our heads. Government stimulus, Supreme Court nominations, elections, coupled with the COVID calamity continue to create commotion and noise. One concern is that while some economic indicators are improving, they are experiencing it at a slower pace than we would like to see. Although stock market indexes are positive, some sectors, Energy (-48%), Financials (-22%), and Real Estate (-8%), have suffered year-to-date. Disney announced that 28,000 furloughed workers would permanently lose their jobs. American and United Airlines cut more than 35,000 jobs. Positive sentiments in the housing sector have waned. Housing starts slowed to 0.9% below the July 2019 numbers and 0.01% below the August 2019 numbers. Furthering the concern, lumber prices have slipped into backwardation pricing, where future bundles are being priced at discounts to current prices. This may foretell weaker demand. All the economic stimulus and early access to retirement accounts pushed CPI upward. This data lends itself to the growing concern that inflation will rear its sleepy head.
Continuing coronavirus challenges persist as well. The coronavirus has claimed more than 200,000 lives in the U.S. Although the number of reported cases in the U.S. has leveled off, hotspots are reemerging in the Midwest and even in New York City. The U.K. is planning for a second shutdown. France recently reported its highest number of daily cases. Many are still fearing winter flu season is upon us and the dreaded “second wave” will be inevitable.
Interest rates remain at historic lows and the dollar continues to weaken. As we write this newsletter, the current 30-year mortgage rate is at meager 2.25%! The debt markets are so starved for yield that investors have been willing to accept a 30-year bond with a paltry yield of 1.3%. The demand is further illustrated by the +25% total return of the long bond.
We do believe there are pockets of the market that continue to signal opportunity. We believe value-oriented companies, specifically in the international value sector, look to be positioned for strong positive future returns. Antithetical to this, growth companies, globally, continue to price at historically high multiples. It is our belief that returns will be more pronounced in the value sector in the near term. Our investment portfolios currently reflect these sentiments. Please feel free to reach out to us to review this unique situation. Stay safe
Allow me to clarify the title right off the bat…I generally
don’t think you can save too much. But I
do think you can save too much in your 401k plan and not enough in other
tax-favored accounts, like your HSA or Roth IRA.
As Americans, we generally don’t receive enough financial coaching
in our youth, adolescence, nor early adulthood.
Yet in that absence, there are two false financial truths we hold to be
self-evident: 1) You should save into your 401(k) plan for your future, and 2) You
should save into a 529 college account for your child’s future.
I’m here to tell you that you’ve been misinformed…err…not
informed…err…developed misconceptions on your own. In any matter, let me set the record straight
here. I’ll be focusing on the first false ‘truth’ in this article, and I’ll hit
those 529s next time.
First, let’s develop a brief understanding of how 401(k) plans
became the default. In 1978, Section
401(k) was added to the Internal Revenue Code, allowing employees to avoid
being taxed if they ‘deferred’ their income.
A few years later, the IRS provided guidance allowing employees to defer
their income via payroll deductions and have their company set aside that money
for them into a 401(k) account. Companies
realized they could offer a matching contribution and retirement benefit through
a 401(k) plan to employees far cheaper and far risker than through pension
plans. 401(k) plans spiked in popularity.
The term “401(k)” has now become synonymous with “retirement plan”, much
like “Kleenex” is to “tissue” or “Rollerblade” is to “in-line skate”. Seriously, did you even know the term “in-line-skate”
existed? That synonymousness gave birth to the false self-evident truth that you
should save into your 401(k) plan for your future (retirement).
The truth is that any savings strategy you have for your future should involve a combination of your 401(k), Health Savings Account (HSA), and Roth IRA. And it’s a lot less in your 401(k) than you think.
**End Spoiler Alert**
A Quick 401(k) Discussion
The key benefit to the 401(k) is that there is a tax-favored
element to it. Specifically, when you save
money into your 401(k), you don’t claim income on that savings in the year you
earn it (for clarity, I’m talking about the “pre-tax” source in 401(k) plans,
albeit you could also save on a Roth basis – but table that digression for now…),
so you pay less in taxes that year. In addition, all investment earnings on
your ‘deferred income’ in the 401(k) plan also grow tax-deferred. You won’t claim any income nor pay taxes
until you take a withdrawal from the 401(k) plan.
A key disadvantage to saving into the 401(k) plan is that your
money is tied up in the plan for a long time.
You have less liquidity. In fact,
that money is basically tied up until you turn age 59 ½. Generally, if you take
money out of your 401(k) plan prior to age 59 ½, then not only are you going to
claim it as income and pay your ordinary income taxes, but you’ll also pay an
early withdrawal penalty of 10%! So roughly 30-50% of your withdrawal will
vanish to taxes given the current tax brackets for most folks. Sure, you may be
able to access some of that 401(k) money via a loan or hardship distribution
instead, but those will usually require you to pay processing fees to the
recordkeeper. Ain’t no free lunch here.
A Quick HSA Discussion
Health Savings Accounts are also tax-favored, and most
people will recognize the ‘triple-tax-advantage’ term that describes their
tax-favored-ness. Concisely, the ‘triple-tax-advantage’
means that the HSA is the most tax-favored account under the Internal Revenue
Code in the great US of A. Utilizing
an HSA is basically the only way that one can actually build tax-free wealth. Similar
to deferring income into your 401(k), you won’t pay income taxes on any income
deferred into your HSA in the year you earn it. And similar to the 401(k), all
investment earnings in the HSA also grow tax-deferred. But a key difference is that when you take
money out of the HSA you will not pay any taxes, assuming that withdrawal is
used to pay or reimburse yourself for a prior qualified medical expense. That sounds like a big assumption and a
potential limitation of Health Savings Accounts, but it’s really not.
Consider that some studies estimate that an age 65 couple
retiring this year are likely to face approximately $300k of medical expenses from
the day they retire to the day they die. Wow, that got morbid fast. Most of
those expenses can be paid from tax-free withdrawals from your HSA. Plus, consider all the medical expenses you’ll
have from now until you reach age 65…it’s a lot, especially if you have a kid
every 20 months over your 30’s (personal zinger there). The punch line here is
that the HSA is more tax-favored than a 401(k), and as such it should be used
instead of a 401(k) to generate more tax-favored wealth for your future. Of course, another key limitation is that you
must be covered by a High-Deductible Health Plan to even contribute to an HSA,
but most people are these days.
A Quick Roth IRA Discussion
A Roth IRA is yet another tax-favored account, but slightly
different than the two we covered already.
In the year that you contribute to your Roth IRA, you still claim that money
as income and pay taxes on it. But once
invested within the Roth IRA, all earnings grow tax free. When you eventually take a distribution from your
Roth IRA after the age of 59 ½, it all comes out tax-free. Yes, this Roth IRA thing also has that darn
59 ½ limitation just like the 401(k), lest you want to pay an early withdrawal
But here’s one of the most important advantages of the Roth
IRA…so do not miss this. The early
withdrawal limitation prior to age 59 ½ only applies to the investment earnings
of your Roth IRA. You can withdraw any of your contribution basis from your
Roth IRA penalty-free and tax-free at any time. This increases your liquidity,
serving as both an emergency fund and also as a funding mechanism for large
expenses prior to retirement – such as college expenses for your children or
Before moving on, let me simply explain this ‘contribution basis’ concept. Let’s say you contribute $6,000 to your Roth IRA for 10 years straight, for a total of $60,000. At the end of 10 years with investment earnings, your Roth IRA is worth $120,000. Of that $120,000, $60,000 is considered contribution basis and available at your disposal. If you’ve got some Roth IRA contribution basis, then you likely don’t need to tap into early withdrawals, loans, or hardships from your 401(k) plan.
A Quick Summary for Completeness
Some Quick Advice
So, what’s the optimal savings allocation across the 401(k),
HSA, and Roth IRA? It depends on your situation. Yup, you knew I had to say that, right? Alright
fine, I hear you cursing at me in your head, and this entire article would
simply be a waste if I didn’t provide some high-level guidance…right?
First, if your company provides a matching contribution in
either the 401(k) or the HSA, then contribute to those accounts the minimum
amount necessary to get the free matching dollars from your company. Free money is free money after all.
Second, fill that HSA bucket with as many Benjamins as you
can. Tax-efficiency is tax-efficiency
Third, if your income is only putting you into the 12%
marginal bracket…then load up that Roth IRA.
If your income is putting you into the 32% marginal bracket…then load up
that Pre-tax 401(k). You probably could use a tax-deduction more than increased
liquidity, and you probably have enough money to fill up your Roth IRA bucket every
year anyway as well. If your income is
putting you into the 22% or 24% marginal bracket, then you probably need to
figure out if liquidity or tax-deductions are more important to you right now
while considering your short-to-medium-term expense needs (like college or cars
or vacations or homes).
Fourth, fill up the bucket that’s still available, whether
the Roth IRA or the 401(k) depending on what you did on step number three. Candidly, most people will never get to this
point in any year as it’s a significant amount of annual savings.
On the record, I would simply like to state that this is generally
good advice and most people can follow the above four step process. I did caveat,
however, that it depends on your situation and there are some really good reasons
why one would want to deviate from the advice above.
At a minimum, hopefully you’ve realized the self-evident financial truth about 401(k)s is…well…it’s just not the whole truth.
So, you’re finally on the HSA bandwagon. You now realize it’s the only account within which
to build tax-free wealth. It’s the new
401(k). You now realize that you need to
actually invest the money in your HSA if want to build tax-free wealth and get
the triple-tax advantage. You now have taken the extra step of simply paying
your medical costs out of pocket and delaying reimbursements from your HSA…until…well,
a long time from now, because you want to maximize the tax-free investment
And now you have a problem. You need to keep track of all
those receipts for future tax-free distributions from your HSA. OR DO YOU!?!? [enter twilight zone sound effects]
Ok, yes, you do. But seriously,
don’t get strung out about this. It’s
not as hard as you think, nor do you need to keep some amazingly detailed and
up-to-date spreadsheet; nor do you need to take a picture of every receipt and upload
it into the cloud somewhere – but you can if that’s your thing.
One of the pushbacks we receive quite often when talking
about the magical* essence of HSAs, and how to maximize that magic*, is that
people don’t want to do all the recordkeeping of keeping track of their medical
receipts. It’s just such a burden.
I get it. But I don’t.
Here’s the thing to keep in mind. The only reason you actually need documentation
of your receipt (or documentation of your qualified HSA-reimbursable medical
expense) is if you need to prove it to the IRS, which would only happen if the
IRS audited your tax return. See,
everything is self-reported on Form 8889 as a part of your IRS tax package. Line
14a basically asks, “how much did you take out of your HSA?” and then Line 15
asks, “and of the amount you took out of your HSA…how much was for qualified medical
expenses?”. Line 16 then asks, “so how much was NOT for qualified medical
expenses?” because “you’re going to pay us taxes on that amount son!”. Of course, Line 16 will always be $0, right?
I sure hope so. And that’s it. You don’t
need to submit any documentation to the IRS.
You don’t need to prove anything to the IRS about what you noted on line
15…unless they ask you to through an audit.
Now, don’t get me wrong.
I’m not saying pull out money that is NOT for qualified medical
expenses, nor am I saying not to have the backup to prove it to the IRS.
Rather, I’m simply suggesting to minimize the chances of
getting audited and also to minimize your recordkeeping efforts unless you
actually get audited. Like, don’t do the
work unless you need to, ok?
Now, I don’t work for the IRS and I’m not suggesting I know
all their flags to start an audit. But I
have thought of the types of flags I would create if I did work at the
IRS. As an example, if someone took a
$150,000 distribution from their HSA (reporting $150,000 on Line 14a of their
Form 8889) and then reported $0 as taxable income ($0 on Line 16)…I’d be like, “wait
a minute, how is that possible. Johnny,
go check out this guy reporting $150,000 as tax-free distribution from his HSA,
because that is unlikely!” But if someone reported $5,000 as a tax-free distribution,
I’d be like “oh yeah, that makes sense.
Nothing to find here Johnny.”
So where’s the line? I’d look at what the IRS considers to
be a High-Deductible Health Plan in the first place. For 2020, the IRS defines
a high deductible health plan as any plan with a deductible of at least $1,400
for an individual or $2,800 for a family. An HDHP’s total yearly out-of-pocket
expenses (including deductibles, copayments, and coinsurance) can’t be more
than $6,900 for an individual or $13,800 for a family. (This limit doesn’t
apply to out-of-network services.)
Given those figures, I would then cap my annual HSA reimbursement
at $13,800 (or, if you reported being able to only contribute the “single”
limit of $3,550 on the top part of the Form 8889, then I’d cap my reimbursement
at $6,900). The IRS is likely only looking at things on an annual basis. And if
you took a distribution of $13,800 in any single year, they’d be like, “Oh
yeah, makes sense. That person hit their
out-of-pocket max this year on their health plan. Bummer.
But there’s nothing to see here Johnny.”
Of course, you savvy financial folk on the HSA bandwagon
know that there is no time limit to seek a reimbursement from your HSA for a
qualified medical expense. And yes, you
may have accumulated $150,000 of unreimbursed medical expenses over the past 25
years while banking those tax-free investment earnings, but I still think it’s
a good idea to cap your annual reimbursement at the $13,800 – or whatever the
IRS max out-of-pocket number is indexed to in a future calendar year.
So, what if you do get audited? Either because the IRS got
trigger-happy or because you decided that $150,000 HSA reimbursement was a good
Don’t worry, you’ve kept all your receipts. Because I didn’t tell you not to keep them. I
mean, keep them! But don’t waste your time keeping them. Here’s how I would do
it. In fact, here’s how I actually do
keep my receipts. Are you ready for
Every time I pay a bill, I just write down “paid date”
on the bill and stash that bill in a box in my furnace room. It’s becoming a big box, but it only takes me
3 seconds to do it. I’m not spending the
time keeping detailed records or tidy records or a detailed log of every expense
in excel or in some cloud somewhere. It’s
just a box of papers, and I haven’t wasted any time keeping track. Yes, I have a rough idea in my head of how
much I can reimburse myself, but I’m also not planning on any HSA distribution
until a very long time from now…like retirement. I’m also not planning on
getting audited, so I have no plans to sift through that box of papers
either. I don’t ever actually want to do
any work on this. I just want to build
up some tax-free wealth. So that’s what I’m doing. But I also know that if I ever do get
audited, I have the ability to spend some time sifting through papers and proving
my tax-free money really is tax-free. If I ever actually get to that bridge…then
I’ll cross it. But no point in trying to
cross a bridge over miles and miles of perfectly mowed pasture grass.
Are you looking to retire?
Need income? Investors are often
concerned with how much yield or income an investment can generate. Retirees
want to invest money and be able to live off of the income that their
investments generate. Often as investors
reach retirement age, they want less risk and don’t want to ride the volatility
wave of the stock market, particularly with the recent experience and pain of
the 2008 recession. That pain is so memorable
that it still plays a role in people’s willingness to take risk. How does this impact a portfolio? “Less risk” becomes synonymous with income-generating
Here’s the problem with focusing purely on income-generating investments…Prevailing interest rates will drive the current rates of respective investments. Note that prevailing rates are quite low today. During yield starved market environments investors become so desperate for yield that they will chase the very thing that they are trying to avoid…risk. When demand grows for market starved investments, the prices of these investments appreciate, which leads to further price appreciation. Investors are forced to chase even riskier investments than before. The result: risky investments with more potential volatility.
The problem is that retirees are overly concerned with the income or yield opportunity of a portfolio rather than looking at the total return opportunity. Consider two portfolios.
Portfolio A: Generates 3%
income/yield; and a total return of 5%
Portfolio B: Generates 1%
income/yield; and a total return of 7%
The income-focused investor will choose Portfolio A due to
an annual income that is three times larger than Portfolio B. Here’s the problem with this choice. Not only
did the investor make 2% less on an absolute basis, but the investor made
considerably less after taxes.
Income doesn’t matter. It is a marketing tool. We shouldn’t care about yield or income. We should only care about our bottom line; or what actually hits our pocket book.