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
investments.
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.
Illustration:
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.
Dear soon-to-be college graduate (or parents of a soon-to-be
college graduate),
You will soon enter a new era of salaried full-time
employment with broad benefits from a great employer. We’ve seen numerous offer letters and
countless benefit packages. This new era
will bring you new financial opportunity, but it also brings a few financial
traps to be aware of. That’s why we’ve
compiled this list of four common first-time-job financial mistakes, so that
you can be confident in the financial decisions and benefit choices you make on
day one of your new gig!
MISTAKE 1: LIVING ON 100% OF YOUR NEW PAYCHECK
You’ve got the offer letter. $60,000 salary. Nice! Quickly,
you do the math: just over $1,150/week.
Bazinga! You can have a lot of fun with $1,150/week! Sadly, that would be a mistake, because you
won’t have anywhere near $1,150/week of disposable income. Instead, you’ll
likely end up with about 20% of your pay as disposable income, which is more
like $230/week. A healthy way to think about
your paycheck would be as follows:
You won’t even see the first 25% of you pay as it will be deducted for taxes and premiums, including federal and state taxes, FICA, and employer benefit premiums. This may come as a shock in the first paycheck you receive!
Now that you’re on your own, you’ll need 40% for essential living expenses such as housing, food, utilities, and maybe even some student loans and debt payoff.
And don’t forget to pay yourself by setting aside 15%. Some will be siphoned off before you see it into your 401(k) and HSA, and some you’ll put into an IRA afterwards. Your future self will thank you for getting into good savings habits early.
Let’s do the math, and that leaves you with 20% as disposable income. Ouch!
MISTAKE 2: RIDING ON YOUR PARENTS’ HEALTH INSURANCE UNTIL YOU’RE 26
You’ve been covered by your parents health insurance for years, and it seems easy to maintain the status quo. But Just because your parent’s health insurance allows them to cover you until you’re 26 doesn’t mean it’s a good idea. It’s usually a pretty bad idea. Often, it means higher premiums paid by your parents and lost opportunity to get free HSA money from your employer. You have to review in detail both the insurance your new employee offers as well as the insurance your parents’ employer offers. Usually, premiums are higher for covered dependents (you would be a dependent on your parents’ insurance) than for the employee themselves. Your parents may be paying premiums that are 50-100% more than what you could pay for similar health coverage. Plus, as a young and healthy individual, it would probably be a wise decision to enroll in a low premium high-deductible health plan offered by your employer, which often comes with a nice contribution to your Health Savings Account. Bazinga!
MISTAKE 3: SAVING TOO MUCH IN THE 401(K) PLAN
Save…yes. But only in
the 401(k)…no. If you read the summary
of mistake #1, you’ll recall that we suggest saving a total of 15%. But generally, the most you want to save in
the 401(k) right of the college is enough to receive the maximum company match.
After that, you should be pumping the rest of that 15% in your Health Savings
Account (annually up to $3,500 individually or $7,000 if married) and your Roth
IRA (annually up to $6,000). Doing so will increase your Financial Agility, or
your ability to react to changes in your financial situation in the future. What
you need to know is that any money saved in the 401(k) is basically locked away
until the age of 59 ½ unless you’re willing to pay early withdrawal penalties
to the IRS. However, money saved into your HSA and Roth IRA may be accessed in
the short term and even right away without penalty. The gist is that you’re
going to use your Health Savings Account to actually accumulate or save money,
pay for medical expenses out of pocket, and those unreimbursed medical expenses
become future tax-free and penalty-free withdrawals. Relative to Roth IRAs,
your contribution basis (the money you contribute, not the investment earnings
portion of your Roth IRA account) is always available to you for withdrawal
tax-free and penalty-free in the future. The availability of these funds from
your HSA and Roth IRA on a tax-free and penalty-free basis provide you with Financial
Agility.…all while you’re still getting tax free investment earnings for the
future! Bazinga!
MISTAKE 4: ENROLLING IN UNNECESSARY VOLUNTARY BENEFITS
If your employer offers a nice suite of voluntary benefits, it can be tempting to go on a little shopping spree. After all, they’d only offer those benefits if they were a good deal – right? Not necessarily. Look, you don’t need pet insurance, or critical illness or accident insurance, and you probably don’t need to buy an extra two days of vacation. If you need life insurance due to debt or dependents, you’re likely better off applying for a term policy and being medically underwritten on your own versus buying one year of life insurance coverage through the company. Instead of siphoning off your income into these voluntary benefits, you should be setting up a little emergency fund (including your Roth contributions and unreimbursed medical expenses from your HSA) so that you’re able to self-insure those small-ish unexpected expenses as they arise. Save more into your HSA or increase your Roth IRA contributions to increase your Financial Agility. Bazinga!
So there you have it: four common first-time-job financial
mistakes that you can easily avoid to give your working career a lift. Just keep in mind that this article is
written in generalities, and every situation, every employer, every job offer,
and every benefits package is different.
While we’ve captured common mistakes in common situations,
you really should find a financially savvy advisor that will work with you in
your situation. Find an advisor that
will review your benefits package with you and provide enrollment
guidance. Find an advisor that will give
you a plan on how to allocate your income across living expenses, debt, and
savings. Find an advisor that will help you
understand all the savings vehicles (401(k), IRA, HSA, etc) available and how
and why to allocate dollars to them.
Find an advisor that’s willing to work with you for a small fee, even
though you likely don’t have investable assets yet. There may not be many advisors that fit that
pattern, but we may have a reference or two if you need one. 😊
The other day I was sitting with someone who just got their Total
Rewards Statement. “It’s such a joke” he
said, “We were all laughing at the stuff on the page. FICA taxes? Why would they take credit for taxes? I guess
they’re trying to make the number look as big as possible, right?”
It was clear these statements were met with skepticism. And I don’t think that’s uncommon when it comes to Total Rewards Statements. As an employee, it’s naturally to question a document that suggests you’re making $100k when you know your salary and bonus is only $70k, and yet you seem to only have $35k of disposable income to live on. You’re skeptical. You don’t want to be fed some bogus story on a piece of paper that you’re actually being paid $100k when you know you’re not.
Here’s the issue. Cash compensation, such as salaries and bonuses, generally only make up 70% ($70k above) of the cost of employment. The other 30% ($30k, for a total of $100k above) is provided as retirement contributions, health insurance, ancillary benefits, payroll taxes, etc. The employer knows it does actually cost $100k to pay someone a $70k salary. As an employer, you hope your employees have a true understanding of the full investment you’re pouring into them! You want them to know and appreciate that the benefits you provide, the culture you have, and the intangibles you offer are better than your talent competitor down the street!
So, Employer, how do we help your employees understand your
investment in them without getting a few chuckles and skeptical comments?
Well, I was just spit-balling on that same topic, so let me know throw some thoughts out there.
What if we turned that reactive end-of-year-look-back Total Rewards Statement into a proactive beginning-of-year-look-ahead Total Rewards Opportunity Statement? What if we focused on those elements of your organization that truly differentiate your employment brand and employment value proposition, rather than trying to get credit for every penny spent…like FICA taxes and unemployment insurance? What if we show the value of those financial opportunities (company contributions & match in 401(k)/HSA) not only in today’s dollars, but also as of the employee’s potential retirement age? What if you, or a trusted third party advisor, sat down with your employees to help them understand their Opportunity Statement and optimize their benefit elections and financial decisions so that they could increase their take-home value now and/or in the future? What if you added a review of one’s Opportunity Statement to the wellness program you already have in place, making it one possibility to earn the financial incentives of your wellness program? Or what if you had a mechanism to at least reach out talk directly to those employees that are not optimizing their rewards opportunities like wellness incentives, matching contributions, free gym memberships or EAP programs?
Think about all the value employees receive but don’t
understand. Think about all the value
that employees are leaving on the table.
Opportunity Statements may be one way to flip the script,
but that’s just the beginning. Let’s
figure it out!
Answer: probably not.
Don’t get me wrong, I’m with you on your intentions. And your logic is spot on if it’s anything like
that of a new (or experienced) parent, which probably goes something like this:
“We have children. We want the best for
our children. The best includes our
children going to college. We want our
children to be able to afford going to college.
Let’s open a 529 account and start saving, because a 529 account is for
college.”
That thought process is great. And it seems quite logical. But I believe there is one minor flaw. It assumes that a 529 account is the best tax
advantaged account to accumulate funds to pay for that college education. The reality is that 97%* of us probably
should never even consider a 529 account.
To explain why, let’s first remember that a 529 is
advantageous for saving for college because it allows us to avoid paying taxes
on the investment earnings in the 529 account.
It’s a tax advantaged account. But
what if there was a way to avoid paying taxes on investment earnings while
having flexibility to use your money…for things like a home purchase, a large
unexpected expense, or even college tuition when the time comes?
There actually is a way, and it doesn’t involve 529
accounts. Having your money set up in
this ‘way’ is what we define as Financial Agility: optimizing returns, taxes,
and flexibility so that you’re in the best position to financially react when
the future comes your way.
Instead of funding a 529 account, we would suggest first
funding your Health Savings Account and Roth IRAs. Both of these accounts are
tax advantaged like the 529, but they will provide you with some additional
financial agility. We’ve discussed
Health Savings accounts in our Thought Leadership series, so we won’t go into
detail here. The gist is that you’re
going to use your Health Savings Account to actually save money, pay for
medical expenses out of pocket, and those unreimbursed medical expenses become
future tax-free and penalty-free withdrawals – all while your money is still enjoying
tax free returns in the account. Relative
to Roth IRAs, your contribution basis (the money you contribute, not the
investment earnings portion of your Roth IRA account) is always available to
you for withdrawal tax-free and penalty-free in the future. The availability of these funds from your HSA
and Roth IRA on a tax-free and penalty-free basis provide you with flexibility. They can be used in the near-term future for
college expenses if you need it for that purpose. Not only that, these funds can really be used
as a source of near-term emergency funding for any need: home down payment,
broken furnace, etc. Of course, the hope
is that you don’t need these funds in the near term and you can use them to
help achieve your financial independence in the future; but the point is that
you’ll have these financial resources and financial agility to react at that
future point when it comes.
So unless you’re already contributing the maximum amount to
your HSA and Roth IRAs, which is $19,000 in 2019 ($7,000 HSA family maximum,
$6,000 for your IRA, and $6,000 for your spouse’s IRA), then it probably
doesn’t make much sense to set up a 529 account.
* No official study was performed to validate the “97% of
us” figure. 97% is a hyperbolized figure, kind of like a wet finger in the air,
although the magnitude is likely accurate.
Health Savings Accounts (HSAs) are the most tax-advantaged savings vehicles available in the United States tax code. As such, these accounts should be used as the primary savings account for one’s future. But the limited knowledge about how these accounts work has mitigated their popularity. It’s only a matter of time, however, until HSAs take over 401(k)s as the leading savings vehicle in America. That’s why we’ve compiled the following HSA fast facts.
HSAs have a triple tax advantage – meaning you contribute money pre-tax, investments grow tax free, and your withdrawals are tax free – assuming the withdrawals are used to pay for Qualified Medical Expenses
You must be covered by a high-deductible health plan to contribute to an HSA (but hey, aren’t we all these days?!)
You never ‘lose’ your HSA, similar to Flexible Spending Arrangements (FSAs) or other annual accounts
You can use your HSA in the future, even if you’re not covered by a high-deductible health plan at the time
There is no time limit as to when you need to reimburse yourself from the HSA for a qualified medical expense – meaning you may choose to pay for a qualified medical expense from your checking account and continue to have tax-free investment earnings rack up in your HSA – all while having the ability to take that reimbursement at any time in the future completely tax free
After becoming eligible for Medicare, you may withdraw from your HSA for any expense (including items that are not qualified medical expenses) without penalty…but you do have to claim the distribution as income and pay ordinary income taxes in that scenario – just like pre-tax 401(k) distributions
Fidelity Investments just made their individual HSA product available in late 2018 – so an open architecture HSA does exist
Now that you’ve got the facts, let’s talk practically about what it means to have an HSA and optimize the value. We generally suggest using your HSA as a wealth accumulation vehicle with callable tax and penalty free distributions to increase your Financial Agility. Alright, we threw some buzz words in there to gain some points, but we’ll explain it!
First, contribute as much as you can to your HSA and priortize your savings dollars into the HSA before your 401(k), IRA, and 529s (unless you can get free matching contributions in your 401(k)). Second, try not to use your HSA. Instead, pay for your medical expenses out of pocket. But don’t worry, you can always reimburse yourself for these medical expenses in the future when you truly need the cash flow. Hence, this gives you the flexibility to take future distributions without paying taxes or penalties. Think of it is emergency funds that have the ability to be invested and grow tax free. Third, invest your money within the HSA. Take advantage of that tax free growth! Maybe even set up your HSA on a open architecture platform so you have investment flexibility. And that’s pretty much it! Build your wealth with financial agility!
Contributed by Brian Riefepeters of Calder Consulting Group & Calder Investment Advisors.
We’ll admit it. The title of this article is intended to be provocative. Yet, we stand by our claim and will defend the fact that 401(k) matching contributions really are akin to dinosaurs in the modern employee rewards portfolio.
First, let’s recognize why matching contributions exist in the first place. As 401(k) plans began to surge and outnumber traditional pension plans, the responsibility and cost of creating an income stream in retirement shifted from employers to employees. Employers deemed it a shared responsibility with the employee to save for one’s retirement. To execute on that shared responsibility, employers offered matching contributions within the 401(k) plan, meaning that an employee would only receive the company contributions to their account as long as they made contributions from their own money as well. Matching contributions incent employees to save money in the 401(k).
Next, we need to realize that 401(k)s are simply one type of tax advantaged vehicle competing for the hard-earned dollars of employees. In addition, we’ve got IRAs, Health Savings Accounts (HSAs), Flexible Spending Arrangements (FSAs), 529 College accounts, and the list goes on. All of these ‘accounts’ provide a tax advantage to the person contributing to those accounts. Of particular importance is one of the newest allowed by the tax code: the HSA. Of even more importance is that HSAs are the most tax-advantaged of any of the accounts noted above. Many refer to this as the triple tax advantage, and a discussion of such advantage is beyond the scope of this discussion. Rather, we will simply summarize by saying HSAs are better than 401(k)s.
Lets summarize the facts so far. 1) Matching contributions incent employees to save money in the 401(k). 2) HSAs are better than 401(k)s. When summarized together, it’s easy to see how 401(k) matching contributions have become an archaic plan design. 401(k) matching contributions incent employees to save money in a sub-optimal manner, or in an account without the greatest tax advantages to the employees, or in an account that is inferior to another type of account. In the absence of any matching contributions, employees would be advised to put their money into the best account available – the HSA. This would provide the greatest benefit and advantage to the employee.
Fortunately, modifying and modernizing the rewards portfolios is relatively easy. Rather than creating the greatest incentive for employees to save into the 401(k), we might suggest creating the greatest incentive for employees to save into the HSA. Now, if you still want to have a matching contribution in the 401(k) at an even or lesser rate than the HSA match, we’re okay with that too!
Contributed by Brian Riefepeters of Calder Consulting Group
