Monthly Archives: July 2017

Focus On: DCSD Retirement Plans (401k/403b/457 Plans)

by in PERA, retirement and tagged , , , , | Leave a comment

Summary: Choose the PERA 401k plan and invest as much as you can.

 

dcsdretirement

The first part of this post repeats the information in the LPS Retirement Plans post, then the rest of it is specific to the choices you have in DCSD.

The idea of retirement is a fairly new one. It wasn’t until early in the 20th century that the concept of retiring from work and “living a life of leisure” was even a concept. Many employers started offering pension plans and then Social Security came along in 1937. Then in 1978, the idea of a tax-deferred savings plan (401k) was created, although it’s original intent was not the way we’ve ended up using it.

Social Security was really designed to be part of a “3-legged stool” concept of retirement, that retirees would draw from their company pension, from social security and from their personal savings. As pension plans have gone out of favor and 401ks have taken their place (particularly in the private sector), it has really become a two-legged stool (which is somewhat problematic). For public school employees in Colorado, PERA is a social security replacement plan, so basically covers those two legs, leaving the personal savings leg for you to figure out on your own. That’s where employer-offered tax-deferred savings plans come in.

All PERA employers offer the PERA 401k plan to their employees, and some employers also offer access to the PERA 457 and the newly created PERA Roth 401k/457 plans. Many school districts also offer additional, non-PERA options for tax-deferred accounts. This post will focus on what’s offered in Douglas County School District, but you should check with your employer to see what options they offer.

DCSD allows you to choose between PERA and MetLife for retirement savings vehicles, offering the PERA 401k and the MetLife 403b, 457, and Roth 403b plans. There are subtle differences between 401k, 403b and 457 plans that can be important but, for the purposes of this discussion, we’ll treat them as roughly the same, with the important exception that you have separate contribution limits for 401k/403b and 457 plans which gives you the ability to save more if you have the cash flow to do that.

This post is not intended to be an in-depth explanation of 401k/403b/457 plans (or their Roth versions), but let me try to briefly describe them (if you decide to work with me we can dive deeper if need be). The idea behind 401k/403b/457 plans is to save money in a tax-deferred account, which means that you are not taxed on your income that you place into those accounts now, nor are you taxed on the earnings in those accounts as they accumulate, but you are only taxed when you make withdrawals which will hopefully be when you are retired. The traditional thinking is that most folks will be in a lower tax bracket when they are retired, so not only do you reap the benefits of saving “extra” all those years by not paying taxes up front, but when you do pay taxes upon withdrawal you will pay a smaller amount.

More recently Roth 401k/403b/457 plans have been created (along with Roth IRAs, which don’t flow through your employer) that take a different approach. For these plans you do pay taxes on any income you invest, but the earnings grow tax free and all withdrawals in retirement are tax free as well. In other words, pay the tax up front, never have to worry about taxes on this money again. For folks who think their tax bracket might actually be higher in retirement, this is a better option.

The obvious conundrum is how do you know for sure whether your tax bracket will be higher or lower in retirement? You don’t, which is why many folks choose to put money into both types of accounts to hedge their bets and give themselves more flexibility in retirement by giving them the option to withdraw from whichever account makes the most sense based on their current tax situation. (There are also some really nice benefits of a Roth if you are trying to leave an inheritance.)

Many employees, especially younger ones, kind of throw up their hands at all this. Retirement seems like a long way off, the choices can be complicated, and of course choosing not to spend money right now can be difficult for some folks. But the beauty and power of investing is compound interest, and it’s most effective the more time you give your money to grow, so the sooner you start, the better (and easier) it is to generate the retirement savings you want.

Many folks thinking about 401k/403b/457 plans also don’t take into account the effect on the tax-deferral on their current income. They think about putting say $100 a month into a 401k, but then worry they can’t do without that $100 a month. But they’re missing that their actual paycheck won’t go down by $100, but more like $70 (if you are in the 25% federal bracket, plus 4.65% for Colorado taxes). The government is basically saying, “invest $70 and we’ll give you $30” (always remembering that eventually they are going to tax you on that when you withdraw it). If you choose the Roth options, you don’t get that tax break up front, so your paycheck will decrease by $100 (but the potential for tax-free growth over time is tremendous).

So, with that overview, if you are a DCSD employee, should you choose PERA or MetLife? Well, again, that depends on your individual circumstances and I’d be happy to discuss those with you, but for most people PERA is the better choice because of lower fees.

PERA offers a choice of several funds or a self-directed brokerage account if you want more control. For most folks, the funds are the better choice. In 2011 PERA chose to go with a “white-label” approach to investments. Research has shown that many folks make poor investment choices when given too many choices so, instead, a “white-label” approach has you choose among asset allocation choices instead of picking individual funds.

whitelabel

I’ll write more in future posts, but there are basically three things you can control when saving for retirement:

  1. How much you save.
  2. What asset allocation you choose.
  3. How much in fees you pay.

By going with a white-label approach and trying to keep fees low, PERA has tried to simplify the second and third choices for you. For each of their asset classes, PERA has typically gone with a combination of a passive (index) approach and an active (managed) approach. This combination gives you lower fees than a fully active approach, but higher fees than a strictly indexed approach. PERA thinks that they can achieve higher returns than the index this way. I’m a big fan of index funds, so I’m not totally convinced of this approach but, so far in their short lifespan (since 2011), they have mostly achieved this to a small extent.

perafees

PERA does also give you a self-directed brokerage option (for an additional fee), which allows you almost unlimited choices in investments. For most folks, the additional complication of choices and fees make this sub-optimal, but it’s there if you want it.

selfdirected

For some reason, DCSD and/or MetLife have made it extremely difficult to get information about the plan. It took me three weeks of emails and calls to finally get the information we needed. (The way they currently have it set up, you can only find out information about investment choices and fees after signing up and giving them money, which is less than ideal. They are working on fixing that.)

MetLife gives you access to a small set of individual mutual funds, which is one of the reasons the fees tend to be a bit higher (0.34% administrative fee plus the underlying fund fees, some of which are pretty high). Here’s a comparison of fees for a large-cap investment in the PERA white-label fund, the PERA self-directed brokerage option invested in a large-cap index fund (they require you to keep $500 in PERAdvantage funds), and the MetLife option invested in the same index fund. (You can view comparisons for other asset classes here.)

metlife

 

If you look carefully, you’ll notice that the cheapest option is the PERA self-directed brokerage option (as soon as you pass about $20,000 in your account), with the PERAdvantage funds coming in second, and MetLife coming in last. Since the middle and third columns are essentially the same choice in terms of what you’re investing in, there’s no reason to choose the higher fee MetLife option over the PERA option. If you are investing a lot, you can save in fees by going the self-directed brokerage option, but this is where PERA would argue that they think they will outperform the index and make up those fee differences. The differences are small enough between the first two columns that, for most folks, it’s probably best to stick with the PERAdvantage options.

Importantly, this fee difference gets much more extreme if you choose anything other than the three Vanguard choices in MetLife. The MetLife Target funds have a total fee of 1% (compared to 0.18% for PERA), and the International Fund is 1.48% (compared to 0.52% for PERA). This is really, really bad, and you should avoid these at all cost (pun intended). The only reason to choose MetLife is if you’ve maxed out your 401k and want to contribute additional money to a 457 (since their contribution limits are separate, and DCSD has chosen not to allow contributions to the PERA 457 plan). I hope that DCSD considers adding the PERA 457 option in the future as an alternative to the high-priced MetLife.

In future posts I’ll write more regarding possible asset allocations (which fund(s) should you choose), contribution limits (and the fact that you get separate limits for 401k/403b vs. 457, allowing you to save much more if you can), and the power of compounding. But, for now, this gives you an idea of where to start. The key thing is to start now and put as much as you can into one or more of these vehicles so that your “stool” will be sturdy enough to support you in retirement.

Saving for College: 529 Plans

by in college, investing, taxes and tagged , , , | 2 Comments

Summary: If you want to save for college, there’s probably no better choice for Coloradans than the College Invest 529 plan.

collegeinvest

We live in an interesting time. There’s no question that, right now, having a college degree is really helpful both in getting and staying employed and in earning more while employed. But that doesn’t mean that college is the right choice for everyone, and some folks are beginning to wonder if the traditional college degree will retain it’s place of prominence for much longer.

Of course the purpose of an education is more than just preparation for employment, but certainly that’s a big part of why many folks choose to go to college, so this poses a dilemma. We don’t know if college will continue to be the “path” to career success, yet it is so expensive that most folks with children will need to save up some money ahead of time to help pay for it. My crystal ball is way too cloudy to definitively answer this but, should you choose to at least hedge your bets and try to save up some money in advance, I can give you some good advice on how best to do that.

The short answer is, especially in Colorado: a 529 plan. Like 401k and Section 125 plans, it’s named after a section in the tax code. It allows you to invest money for your child(ren) and the investment grows tax free, and then any qualified withdrawals (used for higher education expenses) are also tax free. It’s similar to a Roth IRA in the sense that you put after-tax dollars into it and then earnings and withdrawals are tax free, except the purpose for the money is different and the timeline is shorter.

While you can choose any 529 plan, in many states (including Colorado) it makes sense to choose your state’s plan because they offer additional incentives. In Colorado’s case, your contributions are tax deductible which, in effect, means you earn an automatic 4.63% return on your money when you deposit it. (You don’t actually get that money until you file taxes for that year, at that point it reduces the taxes you owe Colorado so that you either pay less or get a larger refund.)

They are way too many nuances to 529 plans to cover in one blog post (this site has lots of information), but here are the basics of what Coloradans needs to know:

  1. College Invest is the Colorado state plan
  2. Choose the Direct Portfolio
  3. Decide what your total goal is by the time your child(ren) graduate from high school and contribute accordingly
  4. Get started now

There’s much more to it, of course, including choosing how to invest the money, but those are the basics. We started ours for our daughter as soon as she had a social security number, because that’s required to open a 529 plan. (Because she was adopted at 9 months, and then had to go through the citizenship process, this was a little later for us than for many of you.) But you can even begin to save before they are born, either by putting away money that you will eventually transfer into a 529 plan after they are born, or by opening up a 529 plan and then changing the beneficiary once your child is born.

Once the account is opened, you can invest lump sums whenever you want, or set up automatic investments from a checking or savings account that occur every month. We did both, plus for a while we had a rewards credit card where the rewards went directly into the 529 account. You then choose your investment options, choosing between an age-based option (similar to target-date funds) that automatically shift to more conservative investments as your child approaches age 18, or by choosing a particular portfolio. The portfolios changed a bit in 2004, but since that change we’ve been in the “Growth Portfolio“, which is 75% stock/25% bond.

That might be too aggressive for some folks (especially as our daughter is about to begin her senior year in high school which means we’re close to the withdrawing phase), but because of our overall financial security, and because of the bond-like nature of our PERA pension, it was a good fit for us. For reference, here are the actual returns our account has earned (your account will always be somewhat different than the generic portfolio return because of the timing of your contributions).

ci

Note that the 10-year return currently includes 2008, which is pretty remarkable that it’s still so high. Going back to October of 2004 (when the portfolio changes occurred), our total annualized return has been 6.7%. At this point we are debating whether to shift the portfolio to a bit more conservative choice but, because the conservative portion of these portfolios are in bonds and that segment of the market has its own issues right now, we’re not sure. Given we still have 5 years left (senior year plus at least four years of college), equities are still likely to outperform bonds over that period.

Either way, this account has been incredibly successful for us (more on that below). Which brings up a big concern that some folks have – what if you don’t need the money? The reasons to not need the money can vary from your child ends up not going to college, to your child earns scholarships, to you actually saving and earning more than you need. Thankfully, there are options for dealing with each one of these.

    1. Your child doesn’t go to college: First, there are a variety of post-secondary options other than college that sill qualify. If none of those apply, you can always change the beneficiary to another child or even to yourself or eventually a grandchild, or you can withdraw the money for non-qualified expenses. If you do the latter you pay federal and state taxes plus a 10% penalty on any of the earnings that you withdraw (not on the contribution portion). For any of the contribution portion you withdraw that you took a Colorado tax deduction at the time of contribution, you would have to make Colorado “whole” on those taxes. While this may sound bad, it’s really not. In the end it’s “extra” money that you wouldn’t have had otherwise (because it would have gone to the college).
       
    2. Your child earns scholarships: For whatever dollar amount in scholarships they get, you can withdraw that amount of money for other purposes. Similar to #1 above, you would have to pay federal and state taxes on any of that that was from the earnings portion (not contributions, as you already paid tax on those), but you would not have to pay the 10% penalty. You can of course still pay for expenses not covered by the scholarship, and you can leave the money in for future use (or for a future beneficiary).
       
    3. You end up with more money than you need: Your options are the same as #1 above.

For us, we may actually end up being in the position of having more than we need. Because we did a good job of contributing (especially a fair amount in the early years so it could compound), and because the returns have also been pretty good (recently the earnings portion of our portfolio exceeded how much we’ve contributed), it’s likely Abby’s total expenses will be less than what we currently have in the 529 plan (barring a severe market downturn in the next couple of years, or she decides to go to med school). (Make no mistake, this is a good position to be in.)

We can’t really tell yet, because we don’t know for sure which college Abby is going to, how much it will cost, what if any scholarships she might receive, how many years it might take her to finish, or whether she chooses to pursue anything beyond a bachelor’s degree. Plus there are other factors, including the American Opportunity Tax Credit, which means that at a minimum we’re going to want to spend $2000 a year from outside of the 529 plan (and perhaps as much as $4000) in order to claim that credit. But at this point my best prediction is that when she finishes her college work, we’ll have to decide whether to withdraw what’s left or leave it for possible future use by us or Abby’s possible children. Again, a good problem to have, and definitely not a potential reason to shy away from using a 529 plan.

If you live in Colorado and want to save some money for your child(ren)’s higher education, you should definitely be looking at a 529 plan as part of your larger financial plan. If you choose to work with me, this would certainly be part of our discussions. And keep in mind that while it’s better to start right after they are born to maximize the compound investment earnings potential, it’s never too late. Even if your child is in college now it makes sense to funnel your payments through the 529 plan. Even though they might not be in there long enough to really benefit from the tax-free investment growth, you will still get the 4.63% Colorado state tax rebate. When most folks are paying $20,000 and up (sometimes way up) a year, 4.63% isn’t nothing ($926 if it was $20,000).

Credit Cards: Evil or Good?

by in spending, Uncategorized and tagged , | 1 Comment

Summary: When used wisely, credit cards are an excellent financial tool and can actually pay you to use them.

cc

Credit cards have a bad reputation in financial circles, and for good reason. Lots of folks have used them to spend more than they can afford, and then end up paying exorbitant amounts of interest because they carry a balance. The problem, of course, is not with the credit cards themselves, but with the behavior of the person. If – and this is a big if – you have self-discipline and only buy what you truly need and can afford, then using credit cards is actually a very smart financial move. The rest of this post assumes that you can use them responsibly – if that’s not true, then stop reading now. If it is, then it turns out that the credit card companies will even pay you to use them.

There are many posts you can read that will dive into this much deeper than I will, particularly if you want to use credit cards to “travel hack.” I will just briefly describe the somewhat haphazard way I’ve gone about this to demonstrate that you don’t have to be an expert to take advantage of this (while acknowledging that it can be done better if you take the time to become an expert).

Until fairly recently we were a one credit card family. We’ve always been disciplined about our spending and we started using a credit card early on and pretty much charged everything we could simply for convenience reasons. Then credit card companies slowly started introducing “rewards” credit cards in different flavors, and we went ahead and changed our one credit card to a credit card that earned us 1% cash back that went directly into the 529 college savings plan we had started for our daughter (more on 529 plans in a future post). We still just stuck with one credit card and didn’t really see the need for more than one. Flash forward a few years and suddenly reward credit cards are everywhere, and we also happen to be financially secure, including owing no debt, so didn’t have to worry about possible impact on our credit score (if you do it right, opening multiple credit cards isn’t that much of a concern anyway).

Since some of the new reward credit cards offered more enticing deals than simply 1% back into the 529 plan, I started researching them a bit. I discovered that not only did many of them offer more than 1% cash back (at least on certain items), but they also frequently offered bonuses for signing up. At first that seemed too good to be true (I mean, really, they are going to pay me to get their credit card?), but after investigating it turns out that it was legitimate. Credit card companies make their money from merchants (who pay a fee for each transaction), and from credit card users who don’t pay off their balances each month. (Part of me feels ethically conflicted about this, so that might be a reason not to do this if you feel that same conflict strongly enough.)

For a while we were pretty content with just that one, but then in 2012 we added in a Chase Freedom Card (*referral link). This card also offers 1% back on everything, but then 5% off on categories that Chase chooses each quarter. Those categories can change from year to year, but for 2017 look like this (fourth quarter has often included Amazon):

chase

This then became our primary card and we eventually cancelled our earlier card. While it was a bit annoying that the categories changed each quarter, it was still better because we still got the 1% on everything and then got the 5% on some things each quarter. I don’t have an easy way to tell how much we earned with this card then, but it would’ve definitely been more than with the earlier card. Especially because this was also the first time we got a “sign-up bonus” and I’m pretty sure it was $200 (it’s currently $150 after a minimum spend).

We stuck with this card for quite a while, but then in 2014 we added in a second card, the U.S. Bank Cash Plus Card. At the time we still had our checking account at US Bank (more about our switch to Ally Bank in a future post) so it was nice and convenient, plus in addition to offering 1% cash back on everything, it offered 5% cash back in two categories and 2% in one other category that you can choose each quarter. While it’s a bit of a hassle to choose those categories each quarter, it only takes a minute or two and can definitely add up. Here are the current 2% and 5% categories you can choose from:

usbankcashplus

Because we also had (pre-defined) categories for our Chase Card, each quarter I check for what those categories are and then choose complementary categories for the US Bank card. For example, I usually choose the 2% for the US Bank card to be for groceries, except for the quarter that Chase offers 5%, then I’d switch it to restaurants. For the two 5% categories, we really only take full advantage of one of them – cell phones. We have a family plan that includes myself, my wife and my daughter, but also my sister, my mother-in-law and my father-in-law. We pay the bill and then they reimburse us, so the bill is somewhat significant each month. By charging it to this credit card, we get 5% back each month on that. Because we really don’t buy that much, the other 5% category isn’t that important, but we usually choose department stores for when we occasionally buy some clothes. Over the life of this card (since July 2014), we’ve earned more than $1800 cash back. I think the sign-up bonus for this one was only $25 once we redeemed $100 in cash back, but I think that for a while it was a $25 bonus every time we redeemed at least $100 (that’s ended now). The sign-up bonus right now ups the 5% categories to 5.5%, 2% to 2.5%, and 1% to 1.5%, all for the first year, then it drops back down to the normal levels.

It was nice having two cards in case there was a problem with one, and it was nice being able to juice our cash back a bit, and of course we always paid off the balance each month. We were content for quite a while with just those two, but then I kept reading more and decided to add in a third card – the American Express Blue Cash Preferred Card (*referral link) in December of 2016. This is a card that I honestly thought we would never get because it has a $95 annual fee. With all the no-annual fee cards, why would you choose to pay a fee? Well, it turns out the cash back on this card is more than enough to cover the annual fee and still earn us more than some other cards.

amex

First, the sign-up bonus included $150 cash back after a minimum spend, so that more than took care of the $95 annual fee the first year. If we decide it isn’t worth it, we can always cancel the card before the year is up and avoid the $95 fee for the next year. An additional sign-up bonus was 10% back on Amazon purchases for the first 6 months. We got this card right before Christmas, and we also have quite a few family birthdays in the first 5 months of the year, so we took good advantage of this. The on-going rewards include 6% back on groceries (this is where we come out ahead even with the $95 annual fee, which is why at the moment we don’t intend to cancel it), 3% back on gas and department stores, and then 1% on everything else. There is a $6,000 annual limit on the groceries, but conveniently one quarter we can use the Chase Card and get 5% back on groceries and then use the Am Ex for the other three quarters of groceries and stay within that limit. We now put restaurants for the 2% category for the US Bank card instead of groceries (although during the 3rd quarter we use Chase for restaurants because it’s 5%).

Now that we had three cards, I was feeling that was plenty. But then I needed to book an airplane flight to visit my parents this summer and ended up on a different airline than usual. When I was about to book the flights, up popped an offer for a branded credit card that would give me $100 cash back on that very flight. The rest of the benefits weren’t that great, but I went ahead and got the credit card simply to pay for that one flight. Now that the flight has been completed, I’ll cancel the credit card. (Haven’t yet just in case I need to book an emergency flight on this carrier in the next few months.)

Then, funny enough, because we got that credit card (which happened to be offered by Citi), Citi then tried to upsell us on another credit card, the Citi ThankYou Premier Card. It also has a $95 yearly annual fee, but it’s waived for the first year, and you can earn $500 in bonus points with a minimum spend, plus additional points for travel purchases.

citi

As it so happened, we need to book several flights for later this year and those, combined with paying our annual house insurance on this card, met the minimum spend. So we got this card, put the flights and the yearly house insurance on it, and got slightly over $575 in points between the bonus and the 3% bonus on travel expenditures. The only thing I didn’t really like with this one is that if you wanted to use those points for cash back, they were only worth 50% of the value. If you booked travel through their site, they were actually worth more than 100%, but I didn’t want to deal with that going forward, so instead we converted them into $475 in Target gift cards plus $100 at Red Robin. It will take us a while, but we do eat at Red Robin and shop at Target occasionally, so again it was basically free money. We’ll keep this card until our travel is completed, then cancel before we have to pay the annual fee.

After this one I was ready to take a break for while (although still planning in about 12 months to explore options again for additional reward and sign-up bonus opportunities), but then for our next Amazon order an offer popped up to get an Amazon Credit Card. This was something I had been planning on eventually doing because it gives you 5% back on Amazon purchases (had to wait until after the 10% cash back from the Am Ex card was done), so went ahead and did it now because they also offered a bonus of $70 cash back.

Now, at this point, this may sound a bit crazy to you, but it’s all pretty straightforward. As I mentioned previously, I’m not an expert on this, and there are many blog posts that explain how you can systematically go about this to optimize your rewards (especially if you want to use them for travel). But even just doing it haphazardly like we have can easily earn you more than $1000 in bonuses, plus probably several thousand a year in cash back. (There are enough cards out there, and you can even get the same card again after not having it for a while, that you can probably keep rotating through them and continue to get bonuses for quite some time.)

This only works if you’re fairly secure financially (helps you qualify for all these cards), and if you don’t succumb to temptation and use these cards to spend money you otherwise wouldn’t. It really does end up being pretty much free money at the cost of a very small amount of time, for items you would be buying anyway. Even if you don’t want to get multiple cards at the same time, make sure the one card you do have is the optimal one for your spending habits, then periodically see if it makes sense to switch to a new one that also works for your spending and allows you to earn the bonus.

Now, what should you do with all this free money? Well, it depends on your circumstances, but most of the good options involve investing it. I’d be happy to work with you to figure out the best way to do that.

photo credit

Working Teens and Roth IRAs

by in investing, retirement, Roth IRA and tagged , , , , | 1 Comment

Summary: If you have a teenager with a job, opening a Roth IRA for them is really good idea from both a learning and a financial perspective.

roth

Our daughter is 17 and has had a part-time job for a little over a year. She makes minimum wage and probably works about 8 hours a week on average during the school year, and a bit more during breaks if we are in town. (Ironically, this summer she’s interning at a summer camp, which means she’s working full-time but making less.) While I think it’s safe to say that not many 17-year-olds are thinking much about retirement, ours is (well, at least she is when I make her :-).

As a result, as soon as she received her first paycheck, she opened a Roth IRA via Vanguard (since she’s not yet 18, it’s a custodial account, but will become completely hers once she turns 18). Why in the world would we do that? Simple, because it’s a fantastic opportunity for her to learn about finances and planning ahead, and also because it’s an incredibly smart move financially for her to do this now.

If you aren’t familiar with Roth IRAs, they allow you to put money (earned income up to $5500 per year for those under 50) in post-tax (so you don’t get an immediate tax deduction like regular IRAs or 401ks). That money then grows tax-free (like a regular IRA or 401k) but then, and this is key, upon withdrawal is also tax free. That means for my daughter, and most teens working part-time like her, this money is never, ever taxed because she doesn’t make enough in a year right now to owe state or federal taxes.

In 2016 she earned a total of $1651 and contributed the same amount to her Roth IRA. In 2017 so far she has earned $2133 and contributed that to her Roth IRA. With some investment gains, her current balance is about $4000. She’s invested in a low-cost Vanguard Index ETF because since she started with $0 she didn’t meet the $3000 minimum for the index mutual fund, and the ETF allows you to buy individual shares at whatever the current cost is. We’ll wait until she surpasses $10,000 so that she qualifies for the low-cost admiral fund and then probably move it over into the mutual fund version (same expense ratio as the ETF, but a little less hassle on our part to invest).

So why is this an “incredibly smart move financially”? In a word (okay, two words): compound interest. If she continues to work about the same amount between now and August 2018 (she graduates in May 2018 and will probably be going to college in the fall), she will have invested somewhere around $7,500 in her Roth IRA. Including the investment gains she’s had so far and assuming a bit of a gain in the next year, let’s call it $8,000 at the point she starts college.

Now she’s likely to work part-time in college, and eventually she will begin full-time work, at which point she will most likely add a 401k to her retirement savings plan and she may or may not continue to contribute to a Roth IRA depending on the circumstances. For the moment, let’s assume she never contributed another dollar to her Roth IRA for the rest of her life, let’s explore what happens.

Well, predictions are just that, predictions, but we can do some decent estimates based on historical results. The stock market has typically returned over 10% a year on average for a long time (and small-cap value, what our daughter is invested in, is even a bit higher), but most folks think that at least in the short term (the next 10 years or so), those returns will be muted a bit. So for demonstration purposes, we’ll use 8% returns (feel free to substitute in a lower or higher amount if you want). So if she has $8,000 invested in her Roth IRA at age 18, doesn’t invest another dollar for the the rest of her life, and “retires” (whatever that will mean at that point) at age 68, how much money will she have? Over $375,000.

That’s fantastic, considering it’s totally tax free and it came simply from the part-time jobs she worked while in high school. But it also overstates it a bit, as those are not today’s dollars, but 2068 dollars, which means you have to take into account inflation. We’ll assume inflation of 3%. Historically inflation has averaged 3.5%, but it’s been lower lately, and governments try harder now to manage that rate, so lots of folks think it will be lower going forward (that’s also part of the reason that the expectation is that stocks will earn lower than 10% going forward as well). So, in reality, what we’re calculating here is a 5% real return after inflation (8% nominal return minus 3% inflation). That amounts to over $91,000 in today’s dollars. That may not sound quite as impressive, but keep in mind that’s assuming no additional investments after she graduates from high school, and that money is completely tax free. (That’s also likely more than a lot of the adults reading this post currently have saved in their retirement account.)

This entire scenario assumes, of course, that the teen can afford to invest this money. Many teens have to work to help support their family day-to-day, so this unfortunately isn’t an option for them. Ours doesn’t have to help support the family, so this is another advantage of us being financially secure – we can not only help our daughter learn about saving, investing, financial planning and retirement planning, but we can give her a head-start on her savings and investing. If your family is in a similar position, I highly recommend you consider this option and, if you choose to work with me, this is something we will investigate.

photo credit

PERA Transition Year (aka, 93/93 or 110/110)

by in PERA, retirement, Uncategorized and tagged , , , | Leave a comment

Summary: For many public school employees, a transition year is a fantastic benefit that can make a huge difference in your retirement finances. It’s definitely worth finding out if your school district offers it, under what conditions, and then investigating whether it might be right for you.

transition

The working after retirement rules for PERA specify that retires can work up to 110 days in a calendar year for a PERA-covered employer after they retire (there’s no limit on non-PERA covered employment). While any PERA-covered employee can possibly take advantage of this, it works especially well for public school employees because our contract year naturally occurs half in one calendar year and half in the next, meaning you won’t exceed the 110-day limit in either year. Some – but not all – school districts offer this transition year benefit (sometimes referred to as 93/93 or 110/110), but often with special conditions. For example, in Littleton Public Schools you must have been continuously employed by the district for the previous 10 years in order to qualify, and the district does not pay benefits during the transition year. Check with your district to see if it’s offered and what conditions there may be. (In Douglas County Public Schools it is also working in the district the previous 10 years plus the permission of your supervisor.)

Despite this being around for a while, lots of folks are a bit unclear on the details (or unaware of it altogether), so I thought I’d use my experience as an example. I officially retired on June 1, 2017 and am now working a transition year with LPS. I currently have 29 years of teaching experience under PERA, plus I purchased 6 years of service credit, giving me 35 years of service credit that my retirement benefit is based on. Thirty-five years translates to 87.5% of my Highest Average Salary (HAS) if I choose option 1 under PERA (full benefit comes to me, but when I die the benefit stops). Since I chose option 3 (I get a reduced benefit, but when I die my spouse gets the exact same benefit until she dies), I’m getting about 91.5% of that which comes out to about 80.1% of my HAS. It’s important to understand that the factor that determines that reduction percentage changes, both according to your age and your spouse’s age and due to PERA’s current actuarial assumptions, but the changes are relatively small from year to year.

What this means is that during this transition year, I’m effectively getting 180% of the pay I would normally get, minus the amount I have to pay for my own insurance coverage. I’m adding on to my wife’s insurance (as is our daughter) so that comes out to approximately 5% of my salary, so I’m making about 175% of what I normally would. (Also, in LPS your pay for the transition year is “frozen” at what you made the previous year, so I do not receive the small cost-of-living raise I would’ve normally received.)

The other thing to keep in mind is that in addition to losing benefits, I’m “giving up” the service credit I would earn with PERA by working this transition year. I (and LPS) still contribute to PERA during this year, but I do not earn any service credit, which is effectively giving up 2.5% of my HAS. Because I’m 75% “ahead” from getting the benefit during my transition year, that’s equivalent to roughly 30 years of retirement. (Not exactly because of the time-weighted value of money, it is actually much longer than that because I can earn money by investing that 75% over those thirty years, but good enough for our purposes). So, with that back-of-the-envelope calculation, the “break-even” point is 30 years. If I live longer than that (which I have decent chance of), then theoretically not taking the transition year would work out better. In reality, because of the compounded investment returns that I can make on that 75%, it’s likely to be 40 years to break-even or perhaps a lot more, so for me the (financial) decision was pretty easy. (The fewer years of service credit you have, however, the closer you need to look at that calculation.)

There are other things to consider in addition to the “break-even” point when looking at the transition year option.

  • Because you have to retire from PERA and keep working for your employer, you have to know you are going to retire (and commit to it) about 16 months before you will actually stop working for your current employer. For some folks, that’s difficult to do.
  • As mentioned above, in many districts you’ll lose your benefits, which includes not only health, dental and vision, but things like life insurance and sick days (in LPS you get 5 sicks days for use during the transition year). So you have to figure out where you are going to get coverage (from a spouse, from LPS via COBRA where you pay the full premium, from PERACare, or on the individual market).
  • During the two calendar years that the transition year affects, your taxable income will increase (both your regular income and your PERA distribution are taxable), and there’s a decent chance it will move you into a higher tax bracket. (In LPS you get two “paychecks” – one from LPS, one from PERA – for a total of 14 months, 7 in each calendar year.) This is especially true in LPS if you have a lot of accrued sick days, as LPS gives you a payout on those as well, for me that’s over $9000 additional taxable dollars for 2017 (this is not PERA-includable salary). This is why many folks increase their contributions to 401k/403b/457 plans during these two years.
  • And it depends a lot, of course, on your personal financial circumstances and needs. There’s no one-size-fits-all when it comes to retirement planning.

So, should you take a transition year (assuming your district offers it and you’re eligible)? It depends, and if you choose to work with me we will look at this very carefully, but it’s definitely something to know about, investigate, and perhaps even make some financial decisions prior to retiring based on the knowledge that you will be receiving this benefit.

photo credit

Your Next Car Should Be Electric

by in spending, sustainability and tagged , , | 1 Comment

Summary: While there are a plethora of environmental and climate change reasons to go electric, your next car should be electric because it will save you money and time, and will make your life better.

 

model3

As I indicated in the Why You Should Go Solar post, I believe climate change is a huge issue and so I’m not exactly unbiased in this discussion. Having said that, I would be writing this post even without the environmental impacts of choosing an electric car. You should choose an electric car because it’s just a better choice of car for most people. (By the way, if you really want to build wealth, health and fight climate change, consider replacing one of your cars with a bicycle.)

There are lots of reasons to go electric, this guy lists 30 (only a few of them are a bit tongue-in-cheek). Let me (briefly) give you my top three:

  1. The most important non-renewable resource you have is time. Getting an electric car will give you more of it. No more gas stations (you start every day with a full “tank”). No more oil changes. Practically no more maintenance, rotating and changing the tires is about it – by one estimate there are about 18 moving parts in an electric car, compared to over 20,000 in a typical ICE (internal combustion engine) car.
  2. You will enjoy driving more. Electric cars drive like sports cars, let you merge into traffic much easier, and are incredibly quiet. If you like to drive and think, it will be so much quieter. If you like to talk or listen to podcasts, it will be easier. If you like to listen to music, it will be higher quality.
  3. You will save money. Right now, with current incentives, you will save money up front. Over time you will save money on fuel costs (depending on current gas prices, the electricity you use costs only half as much as the equivalent amount of gas), maintenance, and a longer usable life of your car (if you so choose).

I can happily go on for a long time, going more in-depth on the above reasons or discussing many others, but since you have access to Google and can readily find that on your own, I’ll spare you (at least in this post, in person…be ready :-). For the rest of this post let me (again, reasonably briefly) go through a few of the vehicle choices you have right now and some of the pros and cons of each.

Tesla Model 3: Full disclosure (or confession), we’re first-day reservation holders on a Model 3, so I’m definitely biased (and excited to get ours later this year or perhaps early next year). Tesla is the reason I can write this post. Because of their incredible work over the last decade or so, electric cars are going mainstream. While you have several good choices today, every auto maker will be coming out with compelling electric cars in the next 2-5 years because Tesla has shown that you can make a compelling car that people will want to buy (at least 400,000 people have reserved a Model 3 and put a $1000 deposit down a year in advance, including yours truly).

Up until now Tesla has been the leader, but their offerings have only been in the luxury car segment (Model S and X cost $70,000 to $150,000-ish). That was part of Elon Musk’s master plan (here’s part deux), to generate revenue to fund the development of a mass-market car. With a base price of $35,000, I would still consider a Model 3 to be on the upper end of that mass market, but certainly within the range of what many middle-class Americans pay for their cars. (We’ve never paid more than $21,000 for a car, so this is definitely a change for us.)

The Model 3 is designed not only to be a great electric car, but to be a great car, directly competing with the BMW 3-series and the Mercedes Benz C-class. (This post does compare total cost of ownership to a Camry, but mainly from an evaluating Tesla as a company perspective.) The reveal event is scheduled for July 28th, so at that point we’ll know all the details about the car and hopefully the pricing on the available options. (Once we know the pricing on the options, I will write a follow-up post on the details of our Model 3 purchase.)

The main points to know about the Model 3 at this point for comparison purposes is a $35,000 base price, at least 215 miles of range on a charge, access to Tesla’s Supercharger Network, and all the hardware included to enable fully autonomous driving in the near future should you want that (and enhanced autopilot driving right now). The other thing, unfortunately for most of you reading this, is that if you aren’t currently on the wait list, if you sign up for one today it will likely be early 2019 before you can get one. It qualifies for the $7500 federal tax credit (although if you aren’t already on the list, you will likely be in the phase-out period by the time you can get one, so might only be $3750 or $1875) as well as the $5000 Colorado tax credit.

Tesla Model 3 Net Base Price after tax incentives: $22,500

2017 Chevy Bolt: The only non-Tesla long-range fully electric car currently on the market, the $37,500 base price Chevy Bolt is a good car. It was named North American Car of the Year for 2017 as well as Motor Trend’s Car of the Year for 2017. It gets 238 miles on a charge, is a reasonably roomy hatchback, and is a pleasure to drive. To be clear, the Model 3 is anticipated to be in a different class than the Bolt. The Model 3 is targeted at the low-end luxury market, the Chevy Bolt at the “regular” market.

There are probably three main drawbacks to the Bolt right now:

  1. Chevy is constraining production, so there is somewhat limited availability (although definitely more available than the Model 3 🙂
  2. Some people feel it is a little “small”. From what I know, I don’t think so, but if you’re used to an SUV, I imagine it will feel small.
  3. The Bolt does not have the advantage of the Supercharger network. This is only an issue for long road trips. On a long road trip, the fast-charging capabilities of the Supercharger network is a huge advantage for Teslas. There are plenty of charging stations available for the Bolt, they just won’t charge as quickly as the Superchargers will. (And, of course, you can plug into any electrical outlet.) As the charging infrastructure is built out, and faster chargers are deployed, this will become less of an issue (although it’s unclear whether today’s Bolt will be able to take advantage of those faster charging speeds).

The Bolt qualifies for the $7500 Federal Tax credit and the $5000 Colorado tax credit, so the base price in Colorado is effectively $25,000 (Chevy is still a long way away from selling enough electric cars for the Federal incentive to phase out for them.)

2017 Chevy Bolt Net Base Price after tax incentives: $25,000

2017 Nissan Leaf: Next to Tesla, Nissan has had the most impact on the EV market with the Leaf. With a base price of $30,680 and a range of just over 100 miles, it’s a great car for what it was designed for. As a “daily commuter” car, it’s great, and has all the electric advantages. The main downside is total range and the fact that Nissan did not build thermal management into the battery, so the battery degrades more over time than batteries from Tesla or Chevrolet.

Everyone is eagerly anticipating the release of the next generation Leaf (2018 model year) in early September. This is expected to be in the same range category as the Model 3 and the Bolt and hopefully will be thermally managed. Nissan has kept a tight lid on the features and pricing of this car, but I would anticipate it will be in the 230 mile range on a charge and around $33,000 base price before incentives, so $20,500 in Colorado after incentives, but I could be very wrong. (Nissan is closer than Chevy to phase out, but since they don’t have 400,000 reservations like the Model 3 does, it shouldn’t be an issue if you are buying now.)

Because the next generation Leaf is on the way, however, there is a window of opportunity to get a great deal on 2017 Leafs. If you are okay with the range limitation and the battery degradation, you can get 2017 Leafs for $25,000 or less before incentives, which means around $12,500 or less after incentives in Colorado (and currently you can even get 0% financing for 60 months). That’s a pretty good deal and worth considering. As we get closer to September, you can probably even deal and save a bit more (for any that are left in inventory).

2017 Nissan Leaf Net Base Price after tax incentives: $12,500
2018 Nissan Leaf Net Base Price after tax incentives: Guessing $20,500

2017 Chevy Volt: This is a plug-in hybrid, not a pure electric vehicle, but is a great choice for many folks, especially if you aren’t quite comfortable yet going pure electric. It gets about 50 miles on pure electric, and then switches over to the gas engine to extend the range to 420 miles. Since most people’s daily driving is less than 50 miles, it functions like a pure electric vehicle most of the time, but gives you the comfort level of knowing that the gas engine will kick in if you run out of charge (and you can fill up at gas stations instead of worrying about charging).

The base price is $34,095 but, after the Federal and Colorado tax credits, that drops to $21,595. That’s a really good price for a really great car that gets you almost all of the advantages of an electric car with the safety net of a range-extending gas engine.

2017 Chevy Volt (plug-in hybrid) Net Base Price after tax incentives: $21,595

There are other choices out there (and many more coming soon), but those give you a pretty good idea of some of the options available to you. For many of you, however, you might want to consider one more option, which is buying a used electric or plug-in electric car. Again, there are lots of options, but one of the best would be to look at used Chevy Volts, particularly 2013 models with average to low mileage.

I can speak directly to this because we ended up purchasing a used 2013 Chevy Volt at the end of December. We were not really looking at getting a new (new to us at least) car, since we had the Model 3 reservation. But we have a new driver in the household and, on occasion, having a third car would be nice (first world problem). Plus, our 1995 Honda Civic, which has been a great car, was starting to experience a few issues and we were worried it might not last until we got the Model 3 (our other car is a 2006 Toyota Prius).

So we originally explored both new and used Nissan Leafs, but finally decided that with the battery degradation issue we didn’t want to go with a somewhat compromised used Leaf, and with the Model 3 coming a new Leaf wasn’t quite as compelling for us. We had decided to live with two cars and hope the Civic held out until we got the Model 3, but then we ran across some good deals on 2013 Chevy Volts that were coming off lease with relatively low mileage. As we got closer to the end of the calendar year, the deals kept getting better, so we started investigating a bit more.

Eventually we found a base model 2013 Chevy Volt with about 21,000 miles on it for only $13,500 and decided that was too good to pass up. Especially because this car came from out of state, and at that time Colorado still offered a state tax break on any EV that had not been previously licensed in Colorado. That saved us an additional $2145, bringing the net price down to $11,355. (Unfortunately, Colorado discontinued the tax break for used cars at the end of 2016). This was also a Certified Pre-Owned vehicle, meaning we got a one year warranty and two free maintenance visits over the next two years (oil change and tire rotation).

The 2013 Chevy Volts typically get between 30 and 40 electric miles on a charge, and then the gas engine extends the total range to about 380 miles. But, again, for most folks’ daily commutes, that’s plenty. To give you an idea, we’ve driven the car about 3800 miles so far and have yet to put gas in it. We’ve used a total of 3.2 gallons of gas, and about half of that is because the car will force the gas engine on periodically if you haven’t had to use it just to keep the gas engine in good shape. I anticipate not having to put gas into it for another 12 months or so (perhaps more if our Model 3 arrives sooner rather than later).

Used 2013-ish Chevy Volt Base Price (no tax incentives): Neighborhood of $14,000

Buying a used car is often a much better financial decision than buying new (current EV incentives change that equation a bit for electric vehicles right now), so this is an excellent choice to consider for those who don’t want to spend so much, or who aren’t quite comfortable buying a fully electric car yet. It will provide a nice bridge vehicle to the near future when the charging infrastructure is built out, the range of pure EVs will likely be greater, and economies of scale will likely make the prices even more competitive. (I’d predict the “tipping point” is 3 to 5 years before buying an electric car will be the obvious choice for almost everyone – sooner if a carbon tax somehow gets passed in Washington.)

If you choose to work with me, part of our discussions will be around making good financial decisions around your transportation needs, so discussing electric would certainly be part of that. But, even if you don’t want to work with me on financial stuff, I’d be happy to discuss (cajole, harangue, hassle you about) electric vehicles. They will save you time and money (especially right now with the Federal and Colorado tax incentives), help save the planet and, oh yeah, are really fun to drive.

Focus On: LPS Retirement Plans (401k/403b/457 Plans)

by in investing, PERA, retirement and tagged , , , , , , | 3 Comments

Summary: Choose the PERA 401k plan and invest as much as you can.

lpsretirement

The idea of retirement is a fairly new one. It wasn’t until early in the 20th century that the concept of retiring from work and “living a life of leisure” was even a concept. Many employers started offering pension plans and then Social Security came along in 1937. Then in 1978, the idea of a tax-deferred savings plan (401k) was created, although it’s original intent was not the way we’ve ended up using it.

Social Security was really designed to be part of a “3-legged stool” concept of retirement, that retirees would draw from their company pension, from social security and from their personal savings. As pension plans have gone out of favor and 401ks have taken their place (particularly in the private sector), it has really become a two-legged stool (which is somewhat problematic). For public school employees in Colorado, PERA is a social security replacement plan, so basically covers those two legs, leaving the personal savings leg for you to figure out on your own. That’s where employer-offered tax-deferred savings plans come in.

All PERA employers offer the PERA 401k plan to their employees, and some employers also offer access to the PERA 457 and the newly created PERA Roth 401k/457 plans. Many school districts also offer additional, non-PERA options for tax-deferred accounts. This post will focus on what’s offered in Littleton Public Schools, but you should check with your employer to see what options they offer.

LPS allows you to choose between PERA and TIAA for retirement savings vehicles, offering the PERA 401k, 457, Roth 401k and Roth 457 plans, and the TIAA 403b, 457, Roth 403b and Roth 457 plans. There are subtle differences between 401k, 403b and 457 plans that can be important but, for the purposes of this discussion, we’ll treat them as roughly the same, with the important exception that you have separate contribution limits for 401k/403b and 457 plans which gives you the ability to save more if you have the cash flow to do that.

This post is not intended to be an in-depth explanation of 401k/403b/457 plans (or their Roth versions), but let me try to briefly describe them (if you decide to work with me we can dive deeper if need be). The idea behind 401k/403b/457 plans is to save money in a tax-deferred account, which means that you are not taxed on your income that you place into those accounts now, nor are you taxed on the earnings in those accounts as they accumulate, but you are only taxed when you make withdrawals which will hopefully be when you are retired. The traditional thinking is that most folks will be in a lower tax bracket when they are retired, so not only do you reap the benefits of saving “extra” all those years by not paying taxes up front, but when you do pay taxes upon withdrawal you will pay a smaller amount.

More recently Roth 401k/403b/457 plans have been created (along with Roth IRAs, which don’t flow through your employer) that take a different approach. For these plans you do pay taxes on any income you invest, but the earnings grow tax free and all withdrawals in retirement are tax free as well. In other words, pay the tax up front, never have to worry about taxes on this money again. For folks who think their tax bracket might actually be higher in retirement, this is a better option.

The obvious conundrum is how do you know for sure whether your tax bracket will be higher or lower in retirement? You don’t, which is why many folks choose to put money into both types of accounts to hedge their bets and give themselves more flexibility in retirement by giving them the option to withdraw from whichever account makes the most sense based on their current tax situation. (There are also some really nice benefits of a Roth if you are trying to leave an inheritance.)

Many employees, especially younger ones, kind of throw up their hands at all this. Retirement seems like a long way off, the choices can be complicated, and of course choosing not to spend money right now can be difficult for some folks. But the beauty and power of investing is compound interest, and it’s most effective the more time you give your money to grow, so the sooner you start, the better (and easier) it is to generate the retirement savings you want.

Many folks thinking about 401k/403b/457 plans also don’t take into account the effect on the tax-deferral on their current income. They think about putting say $100 a month into a 401k, but then worry they can’t do without that $100 a month. But they’re missing that their actual paycheck won’t go down by $100, but more like $70 (if you are in the 25% federal bracket, plus 4.65% for Colorado taxes). The government is basically saying, “invest $70 and we’ll give you $30” (always remembering that eventually they are going to tax you on that when you withdraw it). If you choose the Roth options, you don’t get that tax break up front, so your paycheck will decrease by $100 (but the potential for tax-free growth over time is tremendous).

So, with that overview, if you are an LPS employee, should you choose PERA or TIAA? Well, again, that depends on your individual circumstances and I’d be happy to discuss those with you, but for most people PERA is the better choice because of lower fees.

PERA offers a choice of several funds or a self-directed brokerage account if you want more control. For most folks, the funds are the better choice. In 2011 PERA chose to go with a “white-label” approach to investments. Research has shown that many folks make poor investment choices when given too many choices so, instead, a “white-label” approach has you choose among asset allocation choices instead of picking individual funds.

whitelabel

I’ll write more in future posts, but there are basically three things you can control when saving for retirement:

  1. How much you save.
  2. What asset allocation you choose.
  3. How much in fees you pay.

By going with a white-label approach and trying to keep fees low, PERA has tried to simplify the second and third choices for you. For each of their asset classes, PERA has typically gone with a combination of a passive (index) approach and an active (managed) approach. This combination gives you lower fees than a fully active approach, but higher fees than a strictly indexed approach. PERA thinks that they can achieve higher returns than the index this way. I’m a big fan of index funds, so I’m not totally convinced of this approach but, so far in their short lifespan (since 2011), they have mostly achieved this to  a small extent.

perafees

PERA does also give you a self-directed brokerage option (for an additional fee), which allows you almost unlimited choices in investments. For most folks, the additional complication of choices and fees make this sub-optimal, but it’s there if you want it.

selfdirected

TIAA is more like the self-directed brokerage option, which is one of the reasons the fees tend to be a bit higher (although still not bad compared to many other companies, 0.42% plus the underlying fund fees). Here’s a comparison of fees for a large-cap investment in the PERA white-label fund, the PERA self-directed brokerage option invested in a large-cap index fund (they require you to keep $500 in PERAdvantage funds), and the TIAA option invested in the same index fund. (You can view comparisons for other asset classes here.)

401kfees

If you look carefully, you’ll notice that the cheapest option is the PERA self-directed brokerage option (as soon as you pass about $20,000 in your account), with the PERAdvantage funds coming in second, and TIAA coming in last. Since the middle and third columns are essentially the same choice in terms of what you’re investing in, there’s no reason to choose the higher fee TIAA option over the PERA option. If you are investing a lot, you can save in fees by going the self-directed brokerage option, but this is where PERA would argue that they think they will outperform the index and make up those fee differences. The differences are small enough between the first two columns that, for most folks, it’s probably best to stick with the PERAdvantage options.

In future posts I’ll write more regarding possible asset allocations (which fund(s) should you choose), contribution limits (and the fact that you get separate limits for 401k/403b vs. 457, allowing you to save much more if you can), and the power of compounding. But, for now, this gives you an idea of where to start. The key thing is to start now and put as much as you can into one or more of these vehicles so that your “stool” will be sturdy enough to support you in retirement.

Section 125 Plans

by in benefits, taxes and tagged , , | 1 Comment

Summary: If you aren’t taking full advantage of Section 125 plans, you’re giving money away.

125

Most school districts (and most employers in general) give you access to Section 125 plans which, much like the better known 401k plan, is named after a section of the federal tax code. Despite these being around for a while, many folks don’t completely understand them or take full advantage of them. While the specifics of what your employer offers may vary a little, most are pretty similar. I’ll use Littleton Public Schools as my example, but most likely your employer will be very, very similar.

The reason Section 125 plans are so useful for you is that they allow you to pay for various things pre-tax. How beneficial that is for you depends on what tax bracket you’re in, the more money you make, the more beneficial it is. Most educators are typically in the 25% or 28% federal tax bracket, and everyone in Colorado pays 4.63% in state income tax , so that means you’re typically saving between 29.63% and 32.63% in income taxes for every dollar you can put into a Section 125 plan. But, as an educator paying into Colorado PERA, you save an additional 8% because your Section 125 contributions also come out pre-PERA deduction, which brings your total savings to 37.63% to 40.63% (FYI – this also saves your school district money, as they don’t have to pay contributions on that amount either.)

So, what are these Section 125 plans? There are typically five components:

  1. Paying insurance premiums pre-tax (Premium Only Plan, or POP)
  2. Health Savings Accounts (HSA, goes with High-Deductible Plans)
  3. Health Flexible Spending Account (FSA). If you don’t have an HSA, can be used to pay for out-of-pocket medical expenses.
  4. Limited Purpose Flexible Spending Account (Limited Purpose FSA). Can be used in addition to an HSA to pay for out-of-pocket dental or vision expenses only.
  5. Dependent Care Flexible Spending Account (Dependent Care FSA). Can be used to pay for child care expenses.

Let’s look at each one briefly. (Note: this is not an in-depth look, just an overview, we can delve into much more detail in person.)

Premium Only Plan: Unless you are within 3 to 5 years of PERA retirement*, this one is a must. It takes whatever you pay in health, dental and vision insurance premiums and exempts those amounts from both income taxes and your PERA contribution. It’s basically free money – take it.

Health Savings Accounts: There’s a lot to say about High Deductible Plans and HSA’s but, to keep this brief, if you have a high-deductible plan an HSA is perhaps the best tax-advantaged option out there. It’s often referred to as a “triple-advantaged” plan, because contributions, earnings and withdrawals (for eligible expenses) are all tax free (as a bonus, your employer often contributes to this as well – more free money). Essentially, you never pay taxes on this money. Many folks just use it to pay their healthcare expenses on a yearly basis but, if you can afford to pay those expenses with other money, letting it accumulate and grow over time (invested in low-cost index funds) can be an incredible wealth builder. (2017 Contribution Limits: $3400 individual/$6750 family, additional $1000 if over 55, balance rolls over year to year.)

Health Flexible Spending Account: This existed before HSA’s and, for those folks who don’t have a high-deductible, this is still a great option. The money you put in and then use for eligible expenses is never taxed but, unlike the HSA, this is “use it or lose it” so you don’t want to put more in here than you can spend in a year. (2017 Contribution Limits: $2600)

Limited Purpose Flexible Spending Account: When paired with an HSA, this money can be used for dental or vision expenses. It’s a great way to put additional money aside tax free but, unlike the HSA, it is also use it or lose it (some employers allow you to carry over up to $500 from one year to the next). (2017 Contribution Limits: $2600)

Dependent Care Flexible Spending Account: If you have young children in day care, this is a great option to pay at least some of those expenses pre-tax. Again, it’s use it or lose it, so plan the amount wisely. Many years ago I had a conversation with someone who said they didn’t bother with this because they just deducted it when they filed their income taxes. This is not optimal, as if you do that you lose the 8% PERA savings and, depending on your itemized deductions, you may not get to claim the entire $5000. (2017 Contribution Limits: $5000).

So, let’s put some example numbers with this. How much savings you realize varies tremendously, not only based on your tax bracket, but based on the size of your family and what expenses you have, but I’ll try to pick a “typical” educator family (even though there is no such thing). For this example, I’m going to have the educator be married with two children, one of whom is in day care. The educator will cover themselves and their children (but not their spouse) for health and dental, and be employee-only for vision. They will choose the Kaiser High-Deductible Plan and the Low Cigna Dental Plan. They will max out the Dependent Care Flexible Spending Account with $5000, contribute $100 a month to their HSA (plus the district contribution), and pay for all insurance premiums pre-tax. (Their spouse would probably realize additional savings by utilizing some of these at their employer for their coverage.)

  1. Kaiser HDHP Employee Premium: $391.29/month
  2. Cigna Low Option Dental Employee Premium: $34.76/month
  3. VSP Employee Only Employee Premium: $11.29/month
  4. Dependent Care Flexible Spending Account: $416.66/month
  5. HSA Contribution: $100 month (district adds $85/month)
  6. No Limited Purpose contributions

That totals $954 a month, or $11,448 a year (not including the $1020 the district contributes toward the HSA). Assuming the family is the 25% federal tax bracket, that equates to a savings of $4308 in a year in taxes and PERA contributions. Keep in mind that you also have $2220 in your HSA to either spend or preferably rollover from year to year, for a total “savings” of $6528. Again, it could be a lot less than that if you’re doing employee only coverage (although still worth it), or a whole lot more if you’re doing family coverage, using Cigna for health care, and/or contributing more to your HSA and the Limited Purpose FSA.

As with everything financial, the specifics of your situation matters, so if you choose to work with me, we’ll work through all the permutations. In a future post, I’ll talk more about retirement accounts (401k/403b/457 plans) and how, when you combine them with Section 125 plans, you can dramatically lower your taxes.

*Very Important: If you are within 3 to 5 years of PERA retirement, you want to opt-out of all Section 125 deductions because it will lower your retirement benefit (lowers your HAS). I think there is probably at least a 40% chance that this rule will change in the 2018 Colorado Legislative session, in which case you would no longer opt-out when near retirement, but you also would “lose” the 8% PERA savings each year prior to that. Still very much worth doing because of the federal and state income tax savings.

Photo credit: reynermedia via Foter.com / CC BY