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Investing

Rules for a Health Savings Account (HSA)

Health Savings Account (HSA)
Health Savings Account (HSA)

I remember the excitement of starting my career fresh out of school.  My employer went through all of our benefits, and briefly mentioned the high deductible health plan.  I should have paid more attention to the details of my health coverage.  The focus was on my salary, 401(k) match, and paid time off.  More attention would have been made If I knew about the tax advantages of an health savings account (HSA).  Additionally, my employer made a $500 annual contribution, which I assumed to be enough to cover my health care costs.

A Health Savings Account (HSA) is a diversified savings and investing tool that can be used for medical expenses. Personally, it is one of my favorite savings and investing tools.  An HSA is a health coverage that incorporates a high deductible health plan (HDHP) with a savings account that allows an individual to save money.  The money is deposited before taxes.  It can be used to cover qualified medical expenses. It is also known as a triple tax-savings vehicle.

The intent of this post is to for two things.  The first, is to share the IRS laws for contributing to an HSA,  The second, is to share my approach in handling an HSA and my contributions.

Next, I will discuss how my HSA has affected my annual taxes.

How Does an HSA Impact my Taxes?

Health Savings Accounts (HSA's) are known as a triple tax savings vehicle. The intelligent investors use this as a mechanism to lower their yearly tax expense, accumulate capital gains (tax free), and pay for qualified medical expenses without being taxed or penalized.  Next, I will discuss the three tax savings advantages in more detail.

The first, your annual tax bill is lowered.  If possible, I always attempt to max out my annual HSA contribution.  It has an astonishing benefit of lowering an individual's adjusted gross income (AGI).  In other words, my employer deposits my specified contribution amount into my account.  This occurs without a reduction from taxes. This "above the line" reduction lowers my AGI. Consequently, this decreases my annual tax bill.  I am always trying to reduce costs.  That includes the pesky Federal Insurance Contributions Act (FICA) expense.  Indeed, taxes are costs too.

Tax Day!
Tax Day!

The second, investment gains will be tax free.  Upon reaching a specified amount, a health savings account balance can be invested. The money can be placed into index funds or bonds. The invested assets can accumulate more wealth, which will not be taxed. Do not forget about the eighth wonder of world, compound interest!  For this reason, I maximize my HSA contributions.

Lastly, my investment gains can pay for qualified medical expenses, tax free.  Indeed, I do not pay taxes on funds that are withdrawn to pay for qualified medical expenses.  This will be beneficial in retirement.  Undoubtedly, health care needs will arise in older age.

Next, I will review who can qualify for an HSA.

Who Qualifies for an HSA?

According to the IRS, an individual can qualify for an HSA if they:

  1.  Are covered under a high deductible health plan (HDHP), on the first day of the month.  The minimum annual deductible and maximum annual deductible and other out-of-pocket expenses for HDHPs are as followed:
    Minimum Annual HSA Deductible and Maximum Annual Deductible and Other Out-of-Pocket Expenses
    2020 Minimum Annual HSA Deductible and Maximum Annual Deductible and Other Out-of-Pocket Expenses (Source IRS)
  2.  An individual has no other health coverage except for what is allowed by the IRS.
    • Generally speaking, someone who has a HDHP and a FSA or an HRA that reimburses qualified medical expenses cannot contribute to an HSA.  However, there are certain arrangements that are allowed.  Consulting financial planner can aid in understanding these arrangements.
  3.   The individual is not enrolled in Medicare.
  4.   You are not eligible if you are claimed as a dependent on someone else’s tax return.

What is the Maximum Annual Contribution to an HSA?

There are a couple of answers to this question.  First, you must remain an eligible participant of an HSA. Secondly, contribution amounts are dependent upon who your insurance covers.  The contribution amount for a single individual (in 2020) is $3,550.

If the insurance covers a family, than the contribution limit is $7,100 for 2020.  In my opinion, this is a substantial reduction in a family's adjusted gross income (AGI).  Subsequently, this reduces the burden of the annual tax liability.

An individual should reduce their HSA contribution if their employer also contributes to it. This is important to consider when automatically depositing from your paycheck each month.

Again, medicare recipients are not allowed to place contributions into their HSA's.  This commences on the first day, of the first month an individual is enrolled in it. This rule applies to periods of retroactive coverage (backdated coverage).  However, upon reaching 65 an individual can withdraw money out of their HSA for non-qualified medical expenses without a penalty tax. Although, they will still be subject to pay income tax on that specific amount. This is not true for those younger than 65.  Unfortunately, they may be subject to a 20% penalty tax in addition to the income tax.

What are Qualified Medical Expenses?

There is a list on the IRS website that defines qualified medical expenses.  Generally, these would be some expenses listed on the IRS' website under the Publication 502.  For simplicity, I have listed some common items covered:

  1. Hearing aids
  2. Breast pumps
  3. Eyeglasses
  4. Prescription drugs
  5. Dental treatments
  6. Co-Pays
  7. Vaccines
  8. Wheelchair
  9. Vasectomy
  10. Flu shot
  11. Insulin
  12. Infertility Treatment
  13. Chiropractor
  14. Ambulance

It should be noted, that these change regularly. If unsure, review the documents on the IRS website.  It is important to review and stay on top of the changes to prevent a 20% penalty.

Who Uses my HSA?

Per the IRS' Publication 969, I can use my HSA funds on anyone that is listed on my income tax return.  This includes my spouse, my dependents, and myself.  Even if your family may not be covered by your insurance, they can still utilize your HSA funds.

What Happens to My HSA After My Death?

Again, there is not a single answer to this question.  It depends on who the beneficiary is.  Upon inheriting, a spouse can maintain the HSA as if it were their own.  They can keep using the HSA for qualified medical expenses.  They can even use the funds as income after the age of 65.  Although, they will still be obligated to pay income tax on money not used for qualified expenses.

If the HSA beneficiary is not a spouse, than the account will no long be recognized as a health savings account.  The assets in the account will be distributed to the designated beneficiary.  Subsequently, these funds will be considered on the beneficiary's annual income tax.  Also, the inheritance will not receive any additional taxes or penalties other than the income tax.

In Summary

In conclusion, a health savings account (HSA) is a great savings and investment vehicle.  This is a way for me to save money by reducing my annual tax liability.  Additionally, it allows for me to invest my money.  The tax-free gains can be used for future, qualified, medical expenses.  Moreover, this will be crucial during the retirement years.

The account provides me the ability to invest and carry over a balance from year to year.  If I do not use it, my children will be able to use it once I am gone. Most importantly, the health savings account will grow long-term, while saving us money in the short-term.

Why not have one?  Do you invest your HSA funds?

 

Retirement Portfolio: 401k Investment Strategy

The Financial Engineer: 401k Investment Strategy
The Financial Engineer: 401k Investment Strategy

Finding a good 401k investment strategy is an important decision that will impact you for numerous years. For most, their 401k's will be the mechanism used to reach their financial independence. Accordingly, proper allocation of investments into a 401k is crucial.

My friend and I were discussing 401k investments, when it struck me.  Most people think that investing takes a true Financial Engineer (pun intended).  At this point, I realized I wanted to share my simple, passive 401k investment strategy.

Please, do not take that out of context.  Investing can be complicated.  Some investor's strategies are extremely complex.  For example, hedge fund managers utilize engineers to analyze various financial instruments. They use stochastics, simulations and analytics as tools to asses an investment's risks and rewards.

Whoa, that is a fun word to say....stochastics.

As previously stated, my strategy of choosing investments for my 401k is not complex.  The approach I use provides 3 things.  First, it avoids actively managed funds. Second, it provides a broad market exposure. Lastly, it keeps costs low (low expense ratio).  Most importantly, I want to hold my 401k investments for the long-term.  In other words, play the long game.

In this post I will go through how I structured and planned my 401k by:

  1. The 4 major classes of funds
  2. The percentage of 4 classes in my portfolio
  3. Rebalancing the 4 classes by age
  4. Keep the 4 classes' costs low (low expense ratio)

Now, lets take a look at the 4 major classes of funds I invest in.

The 4 Major Classes of Funds

Simplicity is the name of my game.  Although there are numerous ways to structure a 401(k), my main focus is in 4 major classes.  They are as followed:

1.  U.S. Stock Index Funds

I remember first asking, what the heck is a U.S. Stock Index Fund and how does it work?  The best way I have found to answer this question is through simple pictures and metaphors.  For example, envision handing a single individual money to purchase a small share of every company listed on the S&P 500 index. This individual reaches out to every CEO that makes up the S&P 500 index.  They request each CEO place a share of their company in a box.  This box is a metaphor for the U.S. Stock Index Fund.  The individual that manages the box is a brokerage firm, like Vanguard.

The Financial Engineer: S&P 500 Index Funds
401k Investment Strategy with a S&P 500 Index Fund

You now own a small share of every company on the S&P 500 index, which lies within your box.  You will receive dividends from those companies that will automatically be used to purchase more shares of each company. The brokerage firm will place those additional shares back into your box.  This box will keep housing more and more shares until it is full (i.e. you reach your retirement goal), or you reallocate your money to a different investment type.

2.  U.S. Bond Index Funds

Envision purchasing debt from numerous municipal governments, companies, and the federal government through a single individual (the brokerage firm).  All of the varying entities' debts comes in the form of bond notes.

The individual will hold all of these notes in a box, similarly to the U.S. Stock Index Fund example. The box holds varying debt from numerous corporations or government branches. The individual will manage the box for you.  That person will ask each entity to repay you, with interest, until the debt is paid back in full.  The money returned to you can be reinvested or reallocated.

3.  International Stock Index Funds

Similarly to U.S. Stock Index Funds, international index funds allow an investor to own an entire box of international stocks that are not U.S. based. Instead of owning a portion of every S&P 500 company (or similar U.S. stock index), you own a small portion of international companies.

The individual will still reach out to every company for you.  Similarly to the U.S. Stock Index Funds, that individual will request every company place a share in the box (the International Stock Index Fund) that they will keep for you.  The individual that manages that box is still a brokerage firm, like Vanguard.

4. Real Estate Investment Trust (REIT's) Index Funds

Similarly to all of the previous index funds, the Real Estate Investment Trust (REIT) index funds seeks to follow an entire REIT Index.  The box will now hold numerous REIT's and companies that manage properties that collect rent.  This box will reflect a total REIT index that will be managed by a single individual who will reinvest your returns.

If you are not yet aware, I am a huge proponent of index funds.  This diversifies your portfolio at the cheapest cost (low expense ratio).  Rather than investing in a single sector, index funds allow you to own the entire markets in a box.

Next, I will share the current percentage that makes up my 401(k).

The Percentage of 4 Classes in My Portfolio

As most of you know, I am relatively early in my career.  As a 30(ish) year old father of 2, I still have a way to go before I retire.  Although I plan to be financially independent through passive income streams, I will not retire until my early 50's.  This is a strategic plan to better support my two daughters.

With that known, I am in a growth model of my 401k retirement plan.

The Financial Engineer: Current 401(k) Allocation to the 4 Classes
Current 401k Investment Strategy with the 4 Classes

Rebalancing the 4 Classes by Age

I currently plan to follow the 120 minus my age(ish) to allocate that portion of my 401k portfolio to stocks.  This would mean when I turn 40,  I would have 80% of my 401k in U.S. Stocks.

The Financial Engineer: Age of 40 401(k) Allocation to the 4 Classes
Age 40: 401k Investment Strategy with the 4 Classes

As I continue to gain grays in my hair, and get closer to my early retirement age I will decrease my risk exposure in stocks and place them into U.S. Bonds Index Funds.

The Financial Engineer: 401(k) Allocation at 50 years old
Age 50: 401k Investment Strategy with the 4 Classes

Once I reach the retirement age where I can take distributions without penalties, I will further lower my risk exposure and shift even more of my money into U.S. Bond Index Funds.

The Financial Engineer: 401(k) Allocation at 60 years old
Age 60: 401k Investment Strategy with the 4 Classes

Finally, I will share how I select index funds based upon their costs.

Keep the 4 Classes' Costs Low (Low Expense Ratio)

I keep preaching to keep costs low when selecting an index fund. This is an extremely important part of the 401k investment strategy.  In fact, I mostly evaluate two things before choosing a fund to invest in.  The first is what index the fund follows.  I place most of my money in funds that follow the S&P 500.  However, the S&P 500 isn’t the only index that funds follow. The second consideration is the cost (or expense ratio) of the fund.

Index funds are known for their low costs. Nevertheless, one should not assume that all index mutual funds have a low cost.  How do you know how much a fund costs?

Most 401(k) sponsors provide access to a document center.  This will allow you to download a fund's prospectus and each fund's investment fact sheet (similar to the image below).  Both provide information regarding the fund's fees and expenses.

The Financial Engineer: Finding How Much a Index Fund Costs
401k Investment Strategy:   How Much a Fund Costs on a Investment Fact Sheet

In particular, evaluate the expense ratio and operating expenses when comparing funds.

The Financial Engineer: Index Fund Expenses and Fees
The Financial Engineer: Index Fund Expenses and Fees

Even though the ratio seems minimal, the costs will add up over time.  For example, compare two funds with an assumed annual rate of return of 6%  The first, has an expense ratio of 0.04% (as shown above). The second has an expense ratio of 0.50%. What do you think the difference in costs would be on an initial investment of $30,000 with an annual additional contribution of $5,000 over 30 years?  A whopping $51,180 in cost difference!

A small percentage can add up over the years.  It is important to drive costs down so the investor can keep their hard earned money.  This will enable an investor to further increase their net worth.

In Summary

My 401k investment strategy is known as indexing.  It involves holding an index that is sponsored by a brokerage firm (e.g. Vanguard). I have invested most of my money into an index that is made up of large U.S. corporations. It is an attempt to mirror the performance of the target index, and not individual companies.

The thought is to buy and hold for the long-term.  There will be only two instances when my portfolio is adjusted.  The first, when an index sponsor rebalances the index on a pre determined schedule. The second, when I reallocate by investment percentages by a pre-determined age.  I have a plan in place for reallocating my 401(k) funds when I reach 40, 50, and 60 years old.  This will ensure I reflect on the macro gains and not short-term volatility. This is important because people do stupid things when they are emotional and/or drunk.

Drunk Decisions
Lowered Inhibitions and Bad Decisions

Finally, be sure to evaluate the expense ratios.  It is important to keep your own money, and keep the costs low.

"The greatest enemies of the equity investor are expenses and emotions." - Warren Buffett

What are your favorite index funds?  Please feel free share your 401k investment strategy.

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