The Retirement Gamble
Credits to PBS Frontline-The Retirement Gamble: for educational purposes only.
A retirement plan involves savings, investments, and distribution of that money to sustain oneself after retirement. It involves determining retirement income goals and what you’ll need to do to achieve those goals. It involves identifying income sources, assessing projected expenses, implementing a savings program and managing your assets and risk. Finally, future cash flows are estimated to gauge whether or not your retirement income goal is possible.
Studies of successful people (millionaires) teach that what’s wrong with what we’re doing is that we have debt. I’ve read that the number one process to building wealth, the number one thing to hit that goal, is to be debt-free. (For those who might argue this point, there IS an opposing school of thought on this). The number one key and your most powerful wealth-building tool is your income. Once you understand that, you realize that you’ve got to get your income back, that you can’t be giving it all away (ie. to banks, government, Wall Street).” The goal is to change one’s future/ one’s family’s future, to retire with dignity, and to be generous with those things that you care about. What do people build wealth for? “ They want to make sure their kids are taken care of, that they are taken care of, that they are not a burden on their family when they hit retirement, and that they can help other people (ie. with money, Church, causes they care about, etc.), and the more money one has, the more other people one can help (with money). Poor people can’t feed poor people. So get out of debt, so you can invest with more determination and intensity.
Disclaimer: This chapter is intended only as an outline of some of the common methods that an average person might have access to in preparing for retirement. I will be highlighting the major points of each method, looking at the great and the not so great, where applicable. Not intended as financial advice. In planning your retirement strategy, seek the counsel of a financial professional.
This next section will address common investment vehicles. They strike me as having their potential benefits, areas where they are lacking, and their place in a given portfolio, definitely not a one-size-fits-all solution. My intention isn’t to slam anything, but only to present accurate information here, garnered to the best of my ability, and to allow you to choose for yourself.
Pensions
Pensions, a “defined benefit (industrial-age pension plans),” are essentially, a guarantee from the employer to pay you a certain amount of monthly income when you retire for the rest of your life. Based on the number of years you’ve worked, age or salary, and other potential contributing factors, the employer is going to determine what kind of a benefit you’re going to receive. The amount you will receive likely won’t be what you were previously earning but it can be a big component of retirement income, when compared with someone’s personal savings accrued plus, perhaps, social security and can assist in maintaining one’s personal standard of living that they’d become accustomed to while in retirement. Considerations involve choosing when to begin collecting it as there are typically a range of ages at which one can choose to start collecting it. If one chooses to begin collecting sooner, one will typically receive a smaller benefit amount and this will continue for as long as you’re actually collecting it. The other consideration is what kind of pension option one might decide to choose. There are a variety of pension options that one can potentially choose from with varying degrees of survivor options offered in the event that pensioner were to pass away in some limited time period beyond the retirement date. One can choose to take more money now, thereby leaving less for a survivor, or one can take less money now, thereby leaving more for some designated beneficiary. Most pensions no longer exist and for a myriad of reasons, be it due to the economy, changing rules and regulations. A defined benefit by way of a pension essentially pays the employee for life (teachers, police, firefighters), but from a company’s perspective, it’s too expensive. Outside of the pension, once you leave a company, they are now able, fundamentally, to discontinue any relationship with you.
Problems with Pensions
Maximum pension age is typically after 30 years of service, and can be up to 40 years.
401K
The first option with which I’m personally acquainted is the 401k, a “defined contribution,” and into which we’ve generally transitioned, is now considered to be the “market leader” by which people typically prepare for retirement. The 401k is not an investment. It’s how the investment is treated under section 401, subsection (k) of the IRS code. Initiated by the revenue act of 1978, implemented on 1 January 1980, section 401k of that legislation, originally designed to supplement a pension (and as a tax dodge for the wealthy), has since come to replace a pension in most cases, and is considered to be the first of three ways that you can put money into a 401k, this first option as a “pre-tax /traditional 401k contribution.” I’ll touch on the second and third ways in the next couple paragraphs. The 401k transfers the burden of responsibility from the employer to the employee. Earnings grow tax deferred. This means that you pay taxes on the earnings only upon withdrawal. This is supposed to happen at age 59 1/2 or later. If you withdraw from it before this age, you’re hit with a tax penalty. The penalty is 10%. So any earnings that you’ve accumulated on your pre-tax investment into the 401k are penalized for early withdrawal. However, as of age 59 1/2 you are no longer subject to the 10% early withdrawal penalty. Next, investment into a 401k lowers your taxes by lowering your taxable income. The contribution amounts as listed by Google and effective for year 2022 and the annual elective deferral limit for 401k plan employee contributions is $20,500 for people under 50 years old with employees over 50 years old able to contribute an additional $6500 as Catch Up Contributions for a total of $27,000 for the tax year. It should be noted that these limits change regularly, almost every year, as set by the IRS for any given specific tax year.
There are 3 ways available that a company can use to calculate how much money they’re going to contribute into an employees 401k account. The first is, “salary based matching programs,” where you invest a percentage of your earnings into the program and the company will match it based on some given set of rules and limits. The average employer contributions to the 401k program is anywhere from 0% employer contributions (where you’re contributing but the employer is contributing nothing), and up to a 6% match (and greater) where the employer is matching you dollar for dollar for up to 6% of your contributions (or whatever it happens to be), also known as a 100% matching program. Or, it could be dollar for dollar up to some percent, then 50% of whatever you’re contributing (50 cents for every dollar you contribute) with the two of these combined totaling up to some maximum specified amount. The bottom line here is that whatever amount of money your company is willing to contribute into your 401k account, you should contribute this same amount at a minimum, because to do any less is like literally turning down free money. In other words, if the match is 3% then you should, at a minimum, contribute at least 3% of your earnings to your 401k. It would be comparable to your company offering you a raise and you, in effect, turning it down, and there are very few reasons in which you should not put that money into your 401k account in order to get the company match. Not every program available is dollar for dollar and is dependent upon the individual company. There is a distinction between 100% matching programs and another way known as a “partial match,” of say a 50% matching program in which the employer only contributes a different defined amount, in this case, 50% of your contribution. This also falls under the subheading of, “company defined matching limits.” In a study done by the Bureau of Labor Statistics, the median match contributed by employers to employees 401k accounts was 3%. The second way a company can use to calculate how much to contribute is, “company profit based matching programs,” where the company will put a certain amount of their profits into your 401k account, and usually with definitive limitations. However, this method isn’t very common. The third method used to calculate how much money an employer is going to contribute to an employees 401k account is based on specific dollar amount matching, where if you contribute a specific dollar amount to your 401k, the company will also contribute said amount but, in this case, the amount of your salary is irrelevant. Most companies have set limits on how much they will contribute to your account, so it is definitely not open-ended. For all intents and purposes, Salary Based Matching Programs are the most commonly used. It should also be noted that your employer’s contributions do not count towards YOUR limits for some given year. The maximum amount of combined employer plus employee contributions to a given 401k account for 2022 is $61,000, up from $58,000 in 2021. So what this means is that effective 2022, an employee under 50 years old can contribute up to $20,500 annually, an employee over 50 years old can contribute an additional $6500 by way of Catch Up Contributions for a total of $27,000 annually. Dependent upon whatever version of a given 401k program is offered by any employer, though matching contributions made by employers do not count towards an employees contribution limits, the IRS does place a limit on the total contribution to a 401k by both the employer and employee which cannot exceed the $61,000 imposed cap.
I had earlier mentioned that the first of three ways that you can put money into a 401k is as a “pre-tax /traditional 401k contribution,” and for most people, their 401k is their biggest asset, so it makes sense to try to max it out and deal with it strategically where possible. Continuing along this vein, the second general way to put money in is by way of a Roth “future tax-free” contribution. In addition to these first two, there is also a third way, with the caveat that the employer has to choose this and choose to make it available to you. It’s known as an “after-tax 401k option,” where one can elect to put in money on an after tax basis into your 401k. This is different than Roth. When you put in money after-tax, you’re taxed the same as if it were Roth contributions, but the difference is that your earnings don’t grow tax-free. The earnings grow in a tax-deferred manner but the government allows you to put in after-tax dollars. Once you get into this, “after-tax realm,” you’re no longer capped at $20,500 for under 50 years old or at $27,000 for persons over 50 years old. You can, at this point, use the funds for a Roth conversion with the potential for savings on future taxes although you must still pay levies on earnings upon transfer. If your plan has this special feature, you can use after-tax contributions to save up to $61,000 annually, including employer matching, profit-sharing and other applicable plan deposits, and this can become a major game-changer. You can now use the funds for a so-called “mega-backdoor Roth maneuver,” whereby you’ll pay levies on earnings and move the money to a Roth Individual Retirement Account for future tax-free growth. You don’t want to run the risk of reducing your employer’s ability to contribute the full match, but it presents an opportunity to contribute as much as $61,000 annually by rolling the after-tax dollars into the Roth account. Although this goes beyond the scope of the overall intention of this blog as well as beyond my pay-grade, in keeping with attempting to be thorough but concise, I included it because when I read about it, I was fascinated by the implications of using after-tax dollars as an asset earning interest. Judging by the way this particular topic has been treated by more than one source (both in videos and articles), it seems to carry a great deal of weight. I would strongly suggest that if you have the means to do so, this exclusive point (as well as everything in this particular chapter) is something that you might do well to bring up as a point of question/strategy with a financial advisor to see if this is something that you can attain to in planning your own retirement.
Moving forward, companies use something known as vesting, which is defined as the conveyance to an employee of unconditional entitlement to a share in a pension fund, and a vesting schedule as an incentive to hold on to an employee for as long as they can. In simplest terms, vesting means that you have to earn your shares over time. The vesting schedule allows a company to retain a certain amount of the contributions they made into your 401k. As an example, if you leave your company in under a year, you are 0% vested and are not entitled to take any of the employer contributions with you from your 401k. Between a year and 2 years, you are 20% vested, at 2 but less than 3 years, 40% vested, at 3 but less than 4 years, you’re 60% vested, at 4 but less than 5, you’re 80% vested, and at 5 years or more, you’re 100% vested and entitled to take 100% of employer contributions with you from your 401k. It should be noted that at any given point along this theoretical schema, that these percentage limitations only apply to employer contributions if you’re not fully vested. The employee is, however, always entitled to take 100% of their own contributions into their 401k with them at any time.
Hardship Distribution / Taking a loan out from your 401k prior to age 59 1/2: (ie. for disability, death, medical expenses). Withdrawal for purchase of a home or for educational use (ie. putting your kids through college) gets into a bit of a gray area. Congress has implemented rules whereby you can borrow money from your 401k plan for a limited period of time, put it back into the plan, and it won’t be treated as a taxable event and penalties won’t be applied. Limitations include only being able to borrow up to 50% of the plan balance or up to $50,000, Other than in the most extreme circumstances, withdrawal should be avoided. Check with a financial advisor.
You should receive an annual notice on your 401k. You should also receive a 408(b)(2) fee notice that discloses what all the services are, and all the fees that you’re paying in your plan. As a final addendum, it should be noted that retirement accounts set up under the Employee Retirement Income Security Act (ERISA) of 1974 are generally protected from seizure by creditors. ERISA covers most employer-sponsored retirement plans. This includes 401(k) plans, pension plans and some 403(b) plans.
Problems with the 401k
The crux of the problem here and with a 401k plan in particular, is that these plans place the burden on the participant to have an adequate retirement. The vast majority of regular people just don’t know how to do this or where to begin. They need to figure out: How much do they need to save for retirement? How do they invest that money? Once they retire and have a lump sum, how do they withdraw the money so they don’t outlive their assets?
For most people, there are several major forces with which they will deal throughout their lives that seek, in effect, to monetize us, and with which we will be in a constant tug-of-war for our money. These include banks (mortgages), the government (taxes), Wall Street (our retirement accounts). Companies/employers also seek to cut costs wherever and whenever possible. Employees are an expense and the less they have to pay by way of streamlining that expense, the more that will be left over for the bottom line as company profits, or perhaps, as investor profits (or increased share prices).
That’s one reason why they now offer 401k’s instead of pensions. Once the immediate working relationship is severed, the continued relationship by way of “benefits” is also severed. Your money earned from working, removed from your check weekly by way of automated contributions is put into a 401k, a financial container only and with a tax-advantaged status, but whose contents might contain a variety of different choices based on a pre-selected offering, based on high, medium or low risk. However, while these contributions do lower your taxable income, the actual financial instruments into which you’re contributing your money, and thus investing, are typically unknown by most people. They can have names designed to obfuscate their identity for the purposes of tracking performance and the fees being charged are often non-transparent. The net effect of this on the 401k as an instrument, a defined contribution plan, an investment paradigm, and a tool to adequately prepare for retirement, is that of having had its teeth removed.
The group that benefits from you having that 401k and from this model is Wall Street, but to most people this has no meaning. Wall Street benefits from your 401k because it’s their asset. The fees you pay out of that 401k are your expense, their income, but you never see it removed. You’re only aware of the fluctuations in value of your 401k over time. They take fees (points), be it 1% or 2% or greater, thereby demolishing your ability to utilize the effects of compounding interest on your nest-egg to any real or intrinsic advantage, turning it instead in their favor. The net effect is that it leaves the 401k holders with a nest egg at the end of their careers, to be sure, but that nest egg is only a fraction of what it could have been if not for the handling of that 401k account over the years. These handlers can include a company plan administrator, asset managers, fund managers, salespersons, brokers, and who typically work in their own interests rather than as a fiduciary, or in the interests of the individual 401k account holder. The typical and average American household has the net proceeds of their 401k account reduced by 1/3 or greater by utilizing these “managed accounts,” and will pay out approximately $155,000 and more in 401k fees over a working career. There is little to no evidence of a better outcome by using a 401k fund manager, and actually, there is ample evidence of index funds beating out professional investors in terms of performance.
The above scenario does not take into account the effects of the economy on the individual financial instruments that comprise those plan offerings based on risk tolerance. The economy is connected to business and influences the drive of business. Different factors affect the performance of the economy and on your 401k. These factors include interest rates, exchange rates, tax rates, inflation, labor, supply and demand, wages, laws and policies, government activity and recession.
Self-Directed 401k
A private pension fund that you’re the trustee of. It has its own bank account, it’s funded, you simply write a check. It’s been around since 1974.
Roth 401k
An after-tax investment, it is over 2/3 of all retirement plans that have a 401k. Money goes in after-taxes, grows tax-deferred, and comes out tax-free. You pay no taxes when you start taking withdrawals in retirement. If you’re under 50, as of 2022, you can contribute $20,500 to this account annually. If you’re over 50, you can contribute an additional $6500 by way of Catch-Up Contributions for a total of $27,000 annually. Both amounts are up by $1000 from their amounts for 2021. As a caveat, you cannot contribute $20,500 and $27,000 respectively to each of a 401k and a Roth 401k. These are obviously 2 separate accounts and although you can contribute to both accounts, the $20,500 and $27,000 amounts are aggregate amounts. What this means is that whatever you contribute to each of the two accounts, the combined amounts cannot exceed the prescribed caps for those under 50, and for those over 50 years old.
Problems with the Roth 401k
Individual Retirement Account (IRA)
The next option to consider is the Individual Retirement Account. It is a government-created program that was created in 1974 because Congress wanted people to begin preparing for their own retirement. Contribution limit remains unchanged for tax year 2022 from 2021 at $6,000 for those under 50, and if over 50, then at $7,000 with the additional $1,000 Catch Up Contribution. Unlike the 401k which can only be accessed through working for an employer, the IRA is not tied to a company and an individual can initiate it, without going through a job. The IRA was designed to incentivize individuals to save money for retirement, allowing them some control over their accumulating assets and to receive some tax benefits. There is a large selection of investment options available and you can choose individual stocks or choose from a substantial offering of mutual funds. The key here is to push off taxes when you’re at a higher tax rate. There aren’t any income limits for contributing to an IRA but if your income exceeds certain limits, it may no longer be tax-deductible. Withdrawal starts at 59 1/2 and one is required to take start taking out money no later than 70 1/2 years old, also known as a “Required Minimum Distribution (RMD).” Therefore, the age limit to contribute is at any point before 70 1/2 years old. In most cases, withdrawals are taxable. Rather than choosing from a narrow set of plan offerings, and through an employer, as in the case of the 401k(/403b), one has a wider choice of potential investments that can be included within the IRA as a financial instrument. These can include stocks, bonds, mutual funds, annuities, and even real estate, among others. Since it’s not being sponsored through an employer, in this case you would need to open it yourself. You would need to choose a broker (now online), pick an IRA (traditional or could be Roth), fund it, and choose your investments. The deadline for contributing to an IRA for tax year 2022 is on 15 April of 2022.
Problems with the Individual Retirement Account (IRA)
Roth Individual Retirement Account (Roth IRA)
Yet another well-known option is the Roth Individual Retirement Account. It is an Individual Retirement Account to which you will be investing after-tax dollars. The amount of your contributions and earnings on those contributions grow tax-free and can be withdrawn tax and penalty-free after 59 1/2. However, this account must have been in place for a minimum of 5 years to begin taking out the money. The IRA has a Required Minimum Distribution of the accumulated funds at no later than 70 1/2 years old and if you’re going to contribute to an IRA, it must be before this age. The Roth IRA has no such minimum age distribution. You can contribute to this account at any age but you’ll need a qualifying earned income. You can also leave it to your heirs as a part of your estate and they’ll pay no income tax on any withdrawals from the account. Contribution limits are $6,000 under 50 years old and, if over 50 years old, $7000 with the additional $1,000 Catch-Up Contribution. If one expects to be in a higher tax-bracket in the future, the Roth IRA is a good option. Due to income limitations to open a Roth IRA, not everyone qualifies for this type of a retirement account.
Problems with the Roth Individual Retirement Account (Roth IRA)
SEP IRA
A Simplified Employee Pension plan is an Individual Retirement Arrangement used by self-employed individuals, gives a small business owner a simplified means of contributing to both their employee’s retirement accounts, as well as to their own. It is, therefore, a business-tax deduction on an employer’s tax return, comparable to a 401k and the employee does not contribute to it. It grows tax-deferred, with taxes paid upon withdrawal. Can be converted to a Roth at a later time. Whatever is deposited into retirement via the SEP becomes a write-off. The employer contributions are set up for each participant in the SEP IRA plan and the contributions are flexible in that there is no set amount to be contributed by the employer. Contributions to an employee’s retirement account need only be implemented when said employee has been employed by the small business owner for a minimum of 2 years, and full time. If the small business owner has not set up a 401k for himself, he can still take advantage of the SEP. This account is sometimes implemented as a last minute tax deduction by the small business employer for purposes of qualifying for a write-off. There exists a certain amount of flexibility here and interesting tax implications as those funds can then be rolled into a 401k, rolled out to an IRA, or rolled out to an IRA and converted to Roth. Consult with a tax professional. Maximum contribution amounts to all defined contribution plans sponsored by the small business owner (ie. 401k, etc.), may not exceed 25% of net earnings, and is capped at $61,000 in 2022, up from $58,000 in 2021.
Problems with the SEP IRA
403b (TSA): Tax sheltered annuity
A public sector plan that works similar to a 401k in the business world but available to those who work in state or local government agencies. The two types of organizations who can have a 403(b) are Non-profits and school boards. Most people who have these are teachers, police officers, firefighters and those who work in hospitals. Works similar to a 401k, but has multiple providers (3, 4, 5, up to 25 providers), as opposed to a 401k which only has one provider. IRS maximum and contribution limit for current tax year 2022 is $20,500. 3rd party administrator (TPA) required if you want to take money out of 403(b). Typically used by those who work for a school board or a hospital and have a pension and for those with pensions, (also referred to as “4 buckets”), includes pension, social-security, retirement savings and unused sick leave and you need all 4 of these to equal your retirement benefit. As some may not be able to retire just on Social Security and their pension, they are encouraged to also contribute to their 403(b) which has the added benefit of potentially lowering their taxes also.
Problems with a 403b
These have high fees, and high fees can be ruinous to one’s retirement plan balances. A bad 403b can be expensive. Not accessible without penalty until 59 1/2.
457 Plan
There are essentially two types of 457 Plan available: the 457(b) and the 457(f) with the 457(b) plan being the most common.
The 457(b) is a State-based deferred compensation plan, applicable to state and local governments and provided by state and local governments and tax-exempt organizations. Plans eligible under 457(b) allow employees to defer income taxation on one’s retirement savings into future years. The 457(b) plan is similar to the 403(b) in that it serves those in the public sector. It is similar to a 401k in the business world. The contribution limit for the tax year 2022 is $20,500. Allows you to contribute money with lower fees. Can be accessed at any age you choose so long as you’ve separated service meaning that you’ve left your current job and this is a benefit that most employees don’t have access to.
The 457(f) falls under Supplemental Executive Retirement Plans (SERP). The SERP differs from regular retirement plans in that although it accumulates money on a tax-deferred basis, it is a “non-qualified” plan as opposed to say the 401k. Also unlike a 401k, it doesn’t have contribution limits or rules requiring it to be open to all employees. It falls outside of the Employee Retirement Income Security Act of 1974 (ERISA) guidelines. These “non-qualified plans” are specifically tailored both to meet the specialized retirement needs of executives, act as recruitment tools to attract top talent, and can assist in employee retention. These “non-qualified” plans are exempt from the “discriminatory and top heavy testing” that the otherwise “qualified” plans are subject to. Generally, “qualified” retirement plans, under which the vast majority of employees fall, are considered to have been designed to not favor key employees, corporate officers and owners. This retirement plan usually targets a percentage of final salary for the executive, and whereas 401(k)’s have strict contribution limits, a SERP is flexible with loose contribution limits, although according to Investopedia, SERPS do not have contribution limits and the SERP is funded by way of taking out a cash value life insurance policy on the executive. The employee can also contribute to the 457(f) in addition to the employer, but typically, the institution (employer) makes 100% of the contributions to the retirement account. Funding this plan is considered to be a “cost-neutral” event to the funding organization (such as a credit union for example) and with little or no impact to their bottom line. The account can provide tax-free income during retirement, if properly designed.
SERP’s contain a funding component and a legal document that addresses things like vesting schedule and payout stipulations. The SERP involves the money that is paid to some select group of employees at the time of retirement. It is very common to have some sort of vesting between plan inception and retirement and the account is taxed at vesting and not when it pays out. I would assume that this allows the funds in the account more time to mature. The plan allows non-profit employers (ie. Credit Unions, Educational Institutions and Hospitals) to contribute an unlimited amount of income to investment, unlike qualified plans such as the 401k which have strict caps on the amount that is allowed to be contributed to the account for retirement. The amounts contributed by the institution are later collectible by that institution (employer), and with interest, so no money is lost. This plan model is exclusively available to, and for, the future benefit of highly compensated employees such as the institutions key executives.
Problems with the 457 Plan
Regarding the 457(b), some states have higher quality plans than others.
As an addendum, there seems to be a dichotomy between the two distinct aspects of the 457 Plan, each falling under the innocuous subheadings of 457(b) and 457(f), respectively. However, the implications of, and tangible end-results, in terms of what is actually provided for in reality are, seemingly, not so subtle.
Thrift Savings Plan
A defined contribution plan, tax-advantaged retirement account for Federal government employees and members of the military. $20,500 annual contribution limit for those under 50 years old, a $1000 increase over 2021. If you’re older than 50, your plan may allow you to add $6500 in catch-up contributions for a total of $27,000. If separating before 20 years, while not being able to collect a pension and not being able to invest anymore into the TSP, funds can be left in the TSP where it will continue to grow. Alternately, it can be rolled into an IRA or another employer’s 401k plan. If rolling into another retirement account, not subject to taxation or penalty when following IRS rules. Military members are now enrolled automatically, and DOD contributes 1% of basic pay into TSP whether or not you contribute. However, when you add your own money in to the TSP, the government will match your contribution dollar for dollar up to 5% maximum of basic pay. A tax-deferred account, TSP contributions are a deduction. Pre-tax contributions into the TSP lowers one’s taxes owed. Required minimum distribution (RMD) is at age 72.
Problems with the TSP
Unlike the Roth TSP, traditional TSP withdrawals are subject to Federal and State taxes (if the participant is a resident of a state that charges income tax.
Roth TSP
Roth TSP can be funded with post-tax contributions and is known as a Roth Thrift Savings Account. The disbursements from this account are Federal and State income-tax free if participant is over 59 1/2 and the account has matured for a minimum of five years. All growth, all distributions are tax-free. Maximum contribution limit to a TSP $20,500 or $27,000 with catch-up contributions although this is determined by age, filing status and adjusted gross income. Can be beneficial in later life when one might have a lower income, but might also have less deductions thereby putting the taxpayer into a similar tax-bracket as when working earlier in their career. In order to be a qualified distribution, the account must be at least 5 years old, and can be withdrawn no earlier than 59 1/2. Required minimum distribution (RMD) is at age 72.
Problems with the Roth TSP.
Should not be invested into when income is high and you’re close to retirement.
Health Savings Account (HSA)
The HSA can be used as both a business owner or as a W-2 income wage earner. Can be thought of like an Individual Retirement Account (IRA) for health care, the HSA is the most universally used plan. HSA’s come with noteworthy tax benefits as there are no income limitations, so if you make too much money to contribute to a Roth IRA, you can still lower your taxable income by taking advantage of and implementing the HSA. As of 2022, deductibles must be $1400 for an individual or $2800 if married filing joint, to qualify as a high deductible. When you contribute pre-tax dollars for qualified medical expenses, you get a tax-deduction. It can grow tax free and it can be withdrawn tax-free at any age for a medical expense. It is not like a Flexible Spending Account, in which if you don’t use the funds by the end of the year that you may lose them. If you don’t use it, it rolls into the next year. It combines a health insurance plan with a health savings account, that includes a contribution or deposit from the employer. The combination of the HSA with the medical plan gives flexibility. In addition to the employer’s participation, one can contribute to the HSA up to the specified federal limits to save for medical costs. Helps to reduce tax liability and can double as an investment account. Maximum contribution limit for 2022 and for self only is $3650 and $7300 if filing jointly. Deadline is 15 April of the current year for a tax-deduction for the prior year.
Problems with an HSA
They can only be used with a high-deductible health plan (HDHP)
Flexible Spending Account (FSA)
A Flexible Spending Account is also known as a flexible spending arrangement. It is an account into which you will put money that you will use to cover a variety of out-of-pocket health care costs. You don’t pay taxes on the money in this account which means you will immediately save the dollar amount you would have paid in taxes if those taxes had been deducted on this amount. Unlike an HSA, an FSA can be used with most any type of health plan such as an HMO (Health Maintenance Organization), a PPO (Preferred Provider Organization), etc. An FSA is a health care fund for setting aside pre-tax dollars thereby decreasing one’s taxable income while increasing one’s take-home pay and is intended to be used only for out-of-pocket healthcare expenses. One caveat of the FSA is that whatever the amount you’ve chosen to contribute for the year, the employer will divide this amount into 12 monthly installments, deducting it from your gross pay to be set aside for the FSA. However, the full annual amount will be immediately available to the participant upon their first contribution. The current contribution limit for tax-year 2022 is $2850 (and up from $2750 for 2021). So let’s say you wanted to max it out for the current year. Dividing $2850 by 12 months results in 12 monthly installments of $237.50 being withdrawn from one’s gross amount earned for the month. But, the entire $2850 is available, as needed, on the first day the account becomes active for the plan year, even though only one payment has been made into the account. Medical expenses, doctor visit copays, vision expenses, and prescriptions can all be paid with this type of an account. Telehealth expenses, elective services such as LASIK surgery and other specialist health services, eyeglasses and contact lenses are also FSA eligible, as are breast-feeding supplies and baby-movement monitors and over-the-counter medicines. Hospital costs can be reimbursed to the participant from the account or the funds can be pre-loaded onto a debit card.
Problems with the FSA
If you don’t use the funds contributed into the account by the end of the plan year, you will lose them although the employer has an option allowing up to $570 to be carried over into the next plan year so the full amount isn’t lost. Finally, unlike the HSA in which the employer also contributes to the account, except for a small administration fee (like $5 per month) to outsource the handling of the FSA account, the employer does not contribute to the FSA account meaning that the FSA is employee funded.
Generally, one cannot have both an HSA and an FSA account. A partial exception to this is if the HSA holder also holds a limited-purpose FSA account that only covers dental, vision and preventative care costs.
**There are other options available as well such as the Health Reimbursement Arrangement (HRA) available to small business owners through which one can turn in a receipt and get reimbursed for up to $10,000. However, this is a potentially endless rabbit-hole and goes outside of the purview of my intended scope. I only originally included the HSA because it also has a tax-favored account status and is also one into which an employer contributes, like the 401k. If you happen to be interested in more information about an FSA or an encapsulated breakdown of the HRA or any other investment or health account, leave a reader comment and I’ll research it and include it here. Otherwise, for more information on the FSA or HRA or any other, see Google or YouTube.
Stocks
You own a company and you need money. One strategy is to break down your company and to sell part of it, retaining a majority share to stay in charge. Stocks are shares of ownership in publicly traded companies. Companies issue stock on stock exchanges to raise money. Investors buy and sell stocks based on their potential to increase in value, or to pay out dividends. Dividends are a distribution of a company’s earnings to its shareholders. Dividends are based on a company’s net income or net profit, divided by the number of outstanding shares of its common stock which gives you the earnings per share. This number serves as a barometer of the company’s profitability, and when reported, a company will typically report earnings per share (EPS) that is adjusted for potential share dilution or extraordinary items which are gains or losses from events that were unusual and infrequent in nature and that were disclosed separately on that company’s financial statements. With stocks, profits and losses are driven by market forces and are less predictable. Market forces are those economic factors that affect the price of, the demand for, and the availability of a commodity, for example, those factors that affect the price of oil, nationally and globally. To continue, the distribution to shareholders is determined by the company’s board of directors. Often, dividends are distributed quarterly and paid out as cash or in a form of reinvestment as additional stock. Stocks are subject to stock splits, which are a corporate action taken by the company’s board that increases the number of outstanding shares, by dividing each share into multiple fractions of that same share, thereby diminishing that individual stock’s procurable price. Its price now reduced into fractions of the original price, more people are able to afford the stock and to join the community of investors in that stock. However, though the number of shares has increased, there is no net effect on the company’s market capitalization, which is the total value of all of a company’s shares of stock. Stock can be common or preferred, preferred stockholders having no voting rights like holders of common stock, but dividends are paid on preferred stock before they’re paid on common stock. If part of an IRA or 401k, you’re not required to pay taxes on dividends or on stock sales (realized gains) so long as the investments remain in the account. You will, however, owe regular income taxes when you withdraw it during retirement for traditional IRA’s and 401k’s. An exception to this is that with the Roth IRA or 401k, there will be no income taxes levied against those gains nor are you taxed on the capital gains at withdrawal. However, traditional IRA disbursements are taxed as ordinary income. Roth disbursements are most likely to be free of any kind of tax burden if you’ve adhered to the 5 year rule and are 59 1/2 years old. Stocks are an important component of a retirement portfolio yielding higher returns, on average, than “safer” investments, though those returns come with more risk, up to and including loss. Younger investors have more time to recoup losses while those nearing retirement don’t. It should be noted that at least some degree of stock exposure (for older investors for example) can guard against other risks like inflation (the rise in consumer costs) as well as longevity, or living longer than expected.
Problems with Stocks
Volatility
Bonds
A bond is a loan given to a company or a government by an investor who receives interest back on the money he has loaned out. Bonds are viewed as a less risky alternative to stocks. They’re often used to diversify a portfolio. This means investing your money into different asset classes and securities in order to minimize the overall risk of the portfolio. An asset class is a grouping of investments that exhibits similar characteristics. Stocks, fixed income bonds, cash, real estate, commodities and currencies, are distinct examples of an asset class. Securities are tradable financial instruments used to raise capital (cash or liquid assets, ie. cash flow) which is held or obtained to be spent (expenditures). Continuing, the bond purchaser acquires the bond paying the face value for the bond (like paying for a $10 IOU with 10 one dollar bills out of your pocket), thereby submitting the actual cash that the bond seller is trying to acquire to fulfill their needs. In return, the bond seller pays the requisite and agreed upon interest on the bond’s face value, also known as its coupon rate. This amount is paid each year, and for the agreed upon number of years, when the bond is said to have reached maturity. At this point the original amount, purchase price of the bond, is given back to the bond purchaser, also known as redeeming the bond. So the investor has received regular and predictable interest payments as well as the return of the original investment. The characteristics of a bond are such that they’re viewed as both a predictable and typically stable arrangement, but they’re not a perfect investment. There are definite risks associated with bonds. The first is the potential for the issuer to default on paying back the principal amount or the bond’s face value. This is known as default risk. Bonds with higher risk of default also come with higher coupon rates, interest rates payable. The amount of risk is dependent upon the issuer’s financial stability. Governments are usually viewed as being more stable, thus offering a lower coupon rate. Corporations might be viewed less favorably and be required, of necessity, to pay a higher coupon rate in order to obtain the desired funds. Credit ranking agencies are implemented to quantify a potential investor’s level of exposure and to gauge a company’s financial stability. To do this, these credit agencies assign rankings to the various bonds. Another risk is that of interest rate risk. This is when an interest rate goes up, leaving the investor holding a bond that is now, essentially, worth less than when he purchased it. If he tries to sell it on the open market and before the maturity date, he will be required to sell it at a discount in order to make it worthwhile to another investor, as alternate investors are now allocating their funds to purchase bonds offering the new higher yield rate.
One should recognize that the aim here is to not only keep one’s money, but to earn more. Bonds typically do not move in the same direction as stocks, and they can increase or at least protect a given portfolio’s returns, so in this way bonds can be an advantageous addition to one’s portfolio.
Mutual Funds
Mutual: Something held in common by multiple parties. Fund: A pool of something whose basis is money. A mutual fund is, therefore, when multiple parties pool their money, thereby holding it in common. It’s a collective investment that assembles the funds of a grouping of investors to purchase securities like stocks and bonds or other different investment avenues, and the mutual fund will earn income out of that. Mutual funds generate two kinds of income: capital gains and dividends. Thus, the Income earned can be in the form of interest, or dividends, or in gain (the difference between cost price and sales price). Purchasing one share in a mutual fund is one small stake of all of the investments assembled within a collective “basket of funds,” and that are assembled so as to be unlike each other. They can be divided by different industries or classes and are thus called “diversified,” and are said to be balanced “defensively.” NAV stands for Net Asset Value. It’s the price of one share of one Mutual Fund Unit. You can also buy partial units of Mutual Funds, and it is easy to buy and redeem funds in Mutual Funds. When the prices of a majority of shares goes up, the NAV goes up, when the prices of a majority of the shares comprising the mutual fund go down, the NAV goes down.
This brought me to some information that was slightly different as presented by two different sources. One said there are three different categories of mutual funds while the other said there are 5 categories of mutual funds or investing schemes. The first source identified only three main categories, money market funds, bond funds (also called “fixed income” funds), and stock funds (also called “equity” funds), further, only saying that each type has different features and different risks and rewards.
The next source itemized 5 categories. First, Equity Mutual Funds, invest in commons stocks or equities rather than bonds. Second, Debt Mutual Funds invest in fixed income generating securities. Funds can be deposited into Certificates of Deposit, Commercial Paper, Government Bonds, and Treasury Bills. Generally, there is risk associated with these or other debt instruments, and the higher the return, the higher the risk. It should be noted that Commercial paper is a debt instrument, and being unsecured, if the company goes bankrupt, you will likely lose any funds you’ve invested. Third, Hybrid Mutual Funds invest in more than one asset class i.e. equity, debt and other asset classes. These funds invest in a mix of different asset classes to diversify the portfolio with an aim to minimize the risk involved. Fourth, Solution Oriented Mutual Funds, design their portfolio to achieve a specific goal like retirement planning and child’s education planning. Fifth, and as a class, there are Other Mutual Funds, and which might include Index Fund, as an example.
Mutual fund capital gain “distributions” are broken down into long-term capital gains which occur when a stock is sold after being held in the portfolio for longer than one year. Short-term capital gains occur when a stock is sold after a holding period of one year or less.
Mutual Funds are managed by practiced and seasoned handlers, or fund managers, who have successfully made their living in the finance industry for a great many years. Typically, and let’s say when gains are to be had, these fund managers will remove a portion, or percentage, of these gains for their own purposes, calling them management expenses. These removed funds are known as expense ratio and are typically 1-3% of your total investment. Whether speaking about fund managers or financial advisors, let’s not forget that nobody cares about your money the way that you do.
There are a variety of funds available and they allow investors to engage in a diversity of investment types which include Low risk, medium risk, or high risk. You can choose from Growth, Growth and Income, Aggressive growth, and International.
When you die, money that’s in your mutual fund is part of your estate.
Mutual funds: For educational and informational purposes only. (Credit: Office Of Investor Education And Advocacy)
Exchange Traded Funds
An investment fund that trades like a stock. Investor money is pooled together and used to purchase a basket of funds which usually includes stocks, bonds and other securities. ETF’s generally provide diversification to help balance risk. Bought and sold on the stock exchange. They incur commissions and other fees. Some ETF’s invest in a assortment of stocks and bonds. Some duplicate the performance of a stock index. Others track the performance of a given market sector, like pharmaceuticals or tech. ETF’s designed to follow a market sector offer less diversification than those designed to mirror an index. An investor in an ETF buys shares like he would for an individual stock. Returns are earned in two ways: a rising ETF market price and through dividends. Not all ETF’s pay dividends. Some reinvest earnings into the funds holdings. A dividend yield is a financial proportion that describes the percentage of a company’s share price that is paid out in dividends each year.
In the event of a price drop in the ETF market, a loss isn’t realized until you actually sell, and at that lower price. There is a lower minimum investment associated with an ETF. An ETF investor can only buy a single share, plus applicable commissions and any additional fees. Most ETF’s are not actively managed and typically have lower management fees than mutual funds.
Annuities
An annuity addresses an investor’s challenge of knowing how much of a nest egg to withdraw to cover their living expenses. They want to be comfortable but do not want to risk drawing out too much, too fast and to risk outliving that nest egg.
The annuity is a financial product that guarantees a steady stream of income for a lifetime. Offered through an insurance company, designed to provide regular payments for a pre-determined period of time whether that be a specified number of years or for a lifetime. Two ways to contribute into an annuity, the first being to hold the annuity for a period of time and to allowing funds to accumulate and grow tax deferred. The second way is to deposit a lump sum payment, allowing it to grow tax deferred. If paying by way of a lump sum, it is called an immediate annuity and that annuity is payable immediately. If investor ready to receive payments, it goes through annuitization. This is when an insurance company starts paying out a certain amount on the annuity, that amount depending on the terms of the contract.
Payments from that annuity are guaranteed by the insurance company. With a lifetime annuity, a person will receive payments for life, even if living longer than expected per the original contract/agreement.
There are immediate and deferred. The immediate annuity is funded by a single lump sum payment and is payable immediately. A deferred annuity is one that a person will contribute to over time. Attempts to allow it to grow in value before an annuitization. Money contributed in this way grows tax-deferred so no taxes are paid on the accumulating sum until the investor starts receiving payments. Deferred annuities grow their earnings at either a fixed rate or at a variable rate.
Fees are conditional and will not apply uniformly in every situation when comparing fixed and variable annuities. Four common fees are insurance charges, surrender charges, investment management fees and rider charges. Insurance charges, also known as mortality fees or expense fees, and these pay for the insurance that will guarantee the lifetime income in addition to administration costs. Surrender charges are a fee that will be enforced if the investor removes funds earlier than expected but these charges will diminish over time and according to a schedule. Next, investment management fees are associated with variable annuities. These fees pay for the management of underlying investment accounts. Lastly, there are rider fees. These will occur depending on additions made to the annuity such as the add-on of a death benefit paid to your beneficiaries upon your death, and for this add-on, you would pay extra, known as a rider’s fee. It’s not commonly known that an old annuity can be exchanged for a new annuity if the annuitization event has not taken place. This means that an investor has the option of finding a new higher-paying fixed or even a new variable rate annuity. With each new feature added to the annuity, there are also additional costs.
Index Funds
An index fund is a type of passively managed fund, a mutual fund that tracks the performance of a specific market bench-mark, or index such as the Dow Jones or the S&P 500. Made up of a wide assortment of investment options to include stocks and bonds.
Commodities
Agriculture, Energy, Livestock and Metals.
Cotton, gold, silver, oat, wheat, coffee, sugar, natural gas. Commodities can be added to smooth out one’s portfolio. One can invest directly or through futures contracts. This gives an investor exposure to commodity prices through the futures market. Futures contracts are financial contracts to buy specific quantities of a commodity at a specific price and delivered at a specific date in the future. These contracts fall into the derivatives category and are obligations to buy the underlying asset. Prices of these contracts are based on the underlying commodities and often used by speculators who believe the commodity price will move in a specific direction, and these small movements can result in substantial gains or losses. Another type of speculation is CFD trading or Contract For Differences, which is a legally binding agreement that creates, defines and governs mutual rights and obligations between 2 parties, typically described as buyer and seller. These two parties exchange the differences between the opening and closing price of a contract. Interest, commission and financing charges apply for transactions from the broker. Another way to participate in the commodities market, instead of investing directly, is to participate indirectly by investing in companies that are engaged in producing or extracting commodities such as oil companies or mining. Another option is a pooled investment club that manages trading in futures on behalf of its members, for a fee. They can also implement exchange traded funds or mutual funds that follow one or more commodities. The fund manager of these funds allocates funds to each commodity and buys future contracts.
Options
Mortgage-Backed Securities
RSU’s
RSA’s
Net Unrealized Appreciation
Avoid Capital Gains
Tax Credits
Based on an income range. You can get an idea of how much you need to put into the traditional side of the 401k, if you’re close to one of those ranges, and can contribute into that side of the plan, thereby lowering your taxable income, and thus, qualify for these different tax credits.
Tax Deductions
Saver’s Credit
Social Security
Typical ages to begin collecting Social Security are anywhere from 62 to about 70 years old. In principle, the longer you live, the better it is to take it later as you’ll get a larger check for a longer period of time. The later you start collecting it, with each additional year, you’ll receive more. You can run the calculations on the Social Security’s website.
When you die, money that was coming to you is NOT a part of your estate.
Every year, the Federal Government adjusts how much it gives to Social Security recipients, known as a Cost of Living Adjustment (COLA). This adjustment is tied closely to inflation. Annual increases are calculated using the Consumer Price Index (CPI). The CPI is the average change over time in prices paid by consumers for a “basket of goods and services.”
To be continued…
Interesting reading: Top 10 Ways To Prepare For Retirement (credit Dept of Labor, for educational use only)
