Want to be the scariest house on the block this year? Instead of handing out candy, try reminding parents to check the selections for their employer benefits and watch the horror wash over their faces. That’s right, ‘tis the season to groan as it is the scariest time for employees all around the country, open enrollment. When everyday Americans are forced with making personal financial decisions to benefit themselves. It’s a horrifying tale and if you take the time to read on, you might be surprised at the opportunities buried in these documents.
Today we share with you the story of two couples making their way through the maze of choices. Meet the Intentional family, Ingrid and Ian who as you might guess, call Logic Lane their home. Their best friends, the Default family, Diana and Derek, are around the corner on Disregard Drive. Each couple has returned home today with the employer handbook and an array of new benefit choices. Long term disability optional buy ups, group life insurance, dental and vision plans, HSAs, FSAs, Dependent Care FSAs and optional retirement savings accounts to name a few. The Intentionals can’t wait to dig in and see how they can save on taxes, build their wealth, and strengthen their financial house. Ian can’t wait to see if the 401(k) contribution limit increased for 2022 (it is increasing, by $1,000 to $20,500 but the catch up at $6,500 stays the same.) The Defaults are also thrilled because they realize the employer handbook is the perfect thickness to stabilize the wobbly leg of their kids’ craft table, or at 540 pages, could also make an excellent door stop.
THE RESIDENTS OF LOGIC LANE AND DISREGARD DRIVE
The Intentionals and the Defaults, while best friends, as you can imagine have little in common when it comes to what they are looking to accomplish with their financial lives. Diana and Derek Default are not inclined to plan and prefer to enjoy the present to the fullest. Their family motto is, “We are not here for a long time, we are here for a good time.” Ingrid and Ian Intentional are disciplined with their earnings, tax planning, saving for retirement and college, reducing debt aggressively and protecting their wealth.
Ingrid Intentional and Diana Default are both surgeons at the same hospital and carry most of the traditional employer benefits for their families. Their husbands, Ian and Derek, run their own consulting companies and have more flexibility in their schedules to manage each family’s three children’s schedules. Like most neighbors, they don’t talk much about their personal finances, but once a year when open enrollment comes about, and the texts and screenshots start flying around, even the Defaults take a second to pull up their retirement accounts and at least check on how things are going. Let’s look at the choices they are making.
GROUP DISABILITY COVERAGE – 50% or 60%? DON’T LET THE DIFFERENCE COME BACK TO HAUNT YOU
First up is how to protect each family’s largest asset, Ingrid and Diana’s income. As surgeons they realize the importance of their hands, their brains, and how a finger crushed in the minivan door could compromise 12 years of very expensive medical training. Neither has purchased their own disability policy and instead rely on their employer’s coverage. Ingrid chooses to pay $300 per month for the optional buy up to 60% after-tax long term disability coverage. Ms. Default doesn’t select and therefore is defaulted into the employer paid (aka free) 50% taxable long term disability coverage. Who can interpret what “optional after-tax buy up for long term disability” is? And paying for an optional benefit that that she may never need? Sounds silly, according to Diana.
While no one wants to use their disability coverage, how different could 50% pre-tax or 60% after-tax be? Diana and Ingrid’s income is $350,000 and assuming a 25% average tax rate, a disability would put Diana Default at $11,000 per month of after-tax income. Her after-tax monthly income today is about $22,000. If Ingrid were to become disabled, she would receive $17,500 after-tax per month with her selection to do the optional coverage, 60% more monthly after-tax income than Diana.
Wait a minute, I thought it was only a 10% difference? How does Diana get 60% more? The devil, or in this case, the money, is in the details.
The default option is that the employer will pay you 50% of your income, and then it is taxed. Her annual salary shrinks from $350,000 to $175,000 and then is taxed, in this example at 25% to land at $131,000 take home. The optional buy up means Ingrid receives 60% of her income and it is tax free. This means her income decreases to $210,000 take home. $210,000 is 60% more than $131,000.
$17,500 per month to support your family or $11,000? Depending on where you live and how many people rely on your income, and how much of your money you spend vs. save, it could work out OK or spell financial ruin. Most Americans build their lives, their home purchases, their children’s schooling, their savings around their income, and a 50% decrease can be devastating. Would the Defaults figure it out if this happened and adjust their lives by potentially Diana going into teaching, hospital administration, moving somewhere less expensive, or Derek going back to work full time? Of course. They are a resilient, resourceful, and intelligent couple. Their lack of planning will probably, playing the odds, never come back to haunt them.
But, if they knew the tradeoff they were making, would they make a different choice?
This is an example of one employer’s potential benefits and yours will most likely be different. Maybe your employer doesn’t offer an after-tax option, maybe the employer caps the monthly benefit at $10,000, maybe the employer changes the definition of disability from own occupation to any occupation after 24 months, maybe they limit benefits for mental illness, or maybe you purchased your own disability policy and are more than adequately covered. The point is that for most individuals in their working and earning years, the biggest asset is not your car, your home, or your retirement account balance, it is your ability to go out and earn a living for the next 20 years. The present value of earning $22,000 after-tax per month for the next 20 years, assuming the income grows at 3% is an asset today of approximately $4,000,000. It is a productive use of time to understand how the most relied upon asset in your household is protected. And with all insurance, it is a tradeoff of money today for protection you may never need. In which case I recommend you ask yourself the question of, “What problem do I want?” We prefer tradeoffs that can’t come back to haunt you.
HEALTH SAVINGS ACOUNT – THREE TIMES THE FRIGHT
Ingrid and Diana are both enrolled in the high deductible health insurance plan for their families. Ingrid chose this plan because she and Ian may not have a favorite child, but they do have a favorite strategy to save on taxes. The HSA is the only vehicle which allows triple tax advantages and they max it out every year. They get a deduction for their $7,200 contribution, tax free growth, and if used for qualified medical expenses, tax-free withdrawals. Triple tax advantages! Oh, and they can invest the balance as well and let it grow! Once they are 65 years old they can use the HSA as another retirement vehicle and don’t have to spend it on medical expenses. If they don’t use it for qualified medical expenses after 65 they will owe taxes on it (like a traditional IRA) but in the meantime they will have had over two decades of tax-deferred growth. We can tell why it is their favorite. They project in 25 years, assuming a hypothetical 7% rate of return, by their age 65 that they could have $455,000 in that account alone to pay for out-of-pocket medical expenses in retirement.
The Defaults sign up for the high deductible health insurance plan but contributing to the HSA is not a default, so they pass on it. They have tried to use the HSA before, or was it the FSA? They never knew which one they had to use by the end of the year, never had the right credit card on them when they were at the orthodontist, and it was just one more project to manage. They realize they are giving up a tax advantage, but they are gaining three other resources, time spent, lower stress, and $5,400 of additional after- tax spending back today.
RETIREMENT – A (MEGA) DECISION OF GHOSTLY PROPORTIONS
While Ingrid and Diana both love their jobs, they love the idea of not having to work at some point in the future as well. Even Diana can get on board with this level of thinking about the future when it involves spending her time as she wants instead of the demanding hours of the OR. Diana defaults to contributing $19,500 to her pre-tax 403(b) a saving rate of 5.50% based on her income of $350,000 and receives her full employer contribution of 10% of eligible IRS earnings of $290,000 for a total savings to retirement of $48,500. An important thing to know for high earners with 403(b) or 401(k) plans is that the IRS caps the amount of income on which an employer can make a matching contribution, $290,000 in 2021, hence why the match is not on $350,000 and why many employers offer additional or alternative retirement plans for high income individuals.
Diana sees on her retirement plan something called an optional after-tax contribution to a non-deductible retirement account and an optional non qualified deferred compensation plan. Besides having to read it three times to comprehend the confusing language, she thinks, aren’t we saving enough for retirement through the 403(b) with how much my employer kicks in? Why put money into something I don’t understand?
Ingrid realizes that while she has a good income, saving 5% of it toward retirement isn’t going to make her dreams of financial freedom happen soon enough. She and Ian are looking for every vehicle to save in the most tax efficient manner. Ingrid also contributes $19,500 but instead puts this into her Roth 403(b). Her employer also puts the $29,000 into her account for a total of the same $48,500. But Ingrid knows the combined employee and employer IRS contribution limits are $58,000 and therefore she has $9,500 of tax advantaged headroom that is currently going unused ($58,000 - $48,500 = $9,500). Not on her watch she says and she clicks “yes” on the optional after-tax contributions to a non-deductible retirement account. What Ms. Intentional opted to do here was take advantage of something referred to as the Mega Roth which, depending on your company’s retirement plan, allows the employee to save additional funds to tax advantaged accounts. While Ingrid does not receive a deduction for the additional $9,500 contribution, her employer’s retirement plan also allows in service withdrawals. What this means is once a year Ingrid can go in and “roll” her after-tax contributions from her employer plan into her personal Roth IRA. The Intentionals don’t mess around when it comes to planning and while a relatively complicated concept, for them it is worth the extra step to maximize their wealth. All this means to Ingrid is either less taxes today, or less taxes in the future, both which sound great.
Ingrid also makes the optional selection to participate in the Non Qualified Deferred Compensation (NQDC) and contributes another $19,500 pre-tax to this plan. She understands there is potentially more risk to this option, but she is comfortable with it for the associated tax advantages. She figures between the $19,500 to the 403(b) plan the $9,500 to the “Mega Roth,” and the $19,500 to the NQDC she is personally saving 14% of her income for retirement. Add this to her employer’s $29,000 and her total annual retirement savings is $77,500 per year. Because she didn’t start working in her profession until close to age 40, she intends to work until at least age 60 so the fact that most of her wealth is in accounts with penalties for withdrawal before 59 ½ doesn’t bother her.
What’s the difference of saving $48,500 or $77,500 per year for 25 years, assuming the retirement accounts grow at 7% annually? Derek and Diana will have translated their income into $3,300,000 at their age 65. Ingrid and Ian will have translated their income into $5,200,000, 60% more than Diana and Derek. Is it better to have approximately $2,000 more per month today to spend or build more wealth? More importantly, does each family have a clear understanding of what trade offs they are making and are those tradeoffs aligned with the life they want to create?
A TAKEAWAY FROM LOGIC LANE AND DISREGARD DRIVE
If you find this overwhelming, you are not alone. As The Financial Planning Firm for Busy Families with Big Dreams® we understand most people don’t have the time, interest, or expertise to navigate these decisions. If you are like many Americans you didn’t love that tax form they made you fill out when you started your job. How many allowances do I want? I don’t know. What is an allowance? More allowances mean less withholdings? What exactly is a withholding? I also have rental income and investment income, does that matter? Oh, and if I don’t get this right, I could owe thousands when I file my taxes?
Can I just get my new employee badge? They didn’t teach this in my pre-med undergraduate degree.
We have only scratched the surface of what is offered through many employers, and the more you earn and the more sophisticated your employer’s benefits, the higher the stakes and the more questions you most likely have. Protecting your livelihood, having the IRS help you pay less for medical expenses, and saving for your future selves, are just a few of the choices millions of Americans are presented every year at open enrollment. The point is not to waste opportunities, take unknown risks, and spend more simply because you don’t have guidance you can trust. And in the big picture, the benefits from your employer should complement a personalized financial plan for your family, not be the cornerstone of what is relied upon for your financial security. Employers and benefits can change from year to year and if you value your family’s financial security you would be wise to build your own financial house first, and view any employer benefits as bonus, going along with the analogy, the furnishings of the home which can change from year to year. There are many resources available from hourly CFPs® for those looking for one off planning to highly customized, comprehensive planners who take the time to get to know your family and what matters who then design and build a plan to achieve your goals. There are also plenty of Google searches and uncles with random stock tips which can guide, or derail, your family’s goals.
We leave you with wisdom beyond Logic Lane about the value of taking the time to design a life on purpose, be that one of planning and intentional strategy or carpe diem, or somewhere in the middle. It is that of Jack London, given by M in his farewell to Daniel Craig in No Time To Die, “The proper function of man is to live, not to exist. I shall not waste my days in trying to prolong them. I shall use my time.”
Christy Raines CFP ®AIF®
(who may or may not be going as an Employee Handbook for Halloween)