Health Insurance and Using Your HSA as a Stealth Retirement Account

I’ve written a bit about health insurance before, going through the options for Littleton Public Schools (LPS) and Douglas County School District (DCSD). I was recently helping someone and thought I would update the numbers given LPS’s current insurance offerings, and also spend a bit more time talking about possibly using your HSA as an additional “stealth” retirement account.

First, a caveat: Health insurance is complicated and differences in individual circumstances as well as specific scenarios will vary. These are some “generic” examples that give you an idea of ways you can compare plans, but will not cover every circumstance.

LPS currently offers four choices for health insurance: CIGNA OAP, CIGNA CDHP, Kaiser DHMO, and Kaiser HDHP. The CIGNA CDHP and Kaiser HDHP both qualify as high-deductible plans, so you are eligible for an HSA, and the district contributes $1,250 a year into your HSA for employee only coverage, or $1,700 a year for any dependent care coverage. The following table summarizes the yearly premiums for each plan as well as the deductibles, coinsurance and maximum out-of-pocket expenses you could have.

The table below allows you to compare CIGNA OAP with CIGNA CDHP with HSA, and then Kaiser DHMO with Kaiser HDHP with HSA (and, of course, then CIGNA to Kaiser). The examples I chose for illustrative purposes are $2,000 a year in charges if you have individual coverage and $4,000 if you are covering any dependents. The total out of pocket listed in the tables is comprised of the total you pay in premiums, plus any out of pocket costs, minus the district contribution to your HSA if you choose one of the HDHP plans ($1,250/year for individual, $1,700 for any dependent coverage).

Note that these are rough estimates – for simplicity’s sake it just assumes you pay the 20% coinsurance after the deductible – but that totally depends on what services you need, so your exact total could differ (but it should be a pretty good estimate for comparison’s sake). You can do the math (or contact me and I’m happy to help) for amounts different from the $2,000/$4,000 examples. Also keep in mind that if you have expensive prescription drugs, that could change the calculations (because you typically pay for those out of your deductible in HDHP plans). Finally, keep in mind that you may – or may not – be having health care premiums taken out pre-tax (and pre-PERA), so that can impact your overall totals as well (but they are still directionally accurate).

In general, there are very few scenarios where the high deductible plans are going to cost you more (mostly involving expensive specialty prescription drugs). And even if in one given year it costs you more, you’ll likely more than make up for it in the “normal” or even “good” years where you spend less. Another important consideration to keep in mind with the HDHP plans is that if you don’t spend what is in your HSA (either contributed by the district or additional pre-tax dollars contributed by you), that money rolls over for future years (so you have the potential of $1,250/$1,700 from the district plus your own contributions to the HSA to rollover each year, plus any investment gains over time). So in years where you have lower expenses, the savings from an HDHP plan are even greater than shown above (because your premium costs are the same no matter how much care you get, but your out-of-pocket costs vary with how much you use the plan).

As you can see, for these examples ($2,000/$4,000 in costs), the high-deductible plans come out much better and, not surprisingly, Kaiser comes out better than CIGNA. (And, in years where you spend much less than $2,000/$4,000, the high deductible plans will come out even better.) In general, the only reason to go with CIGNA over Kaiser is if you already have an established relationship with a doctor with CIGNA and don’t want to lose that relationship. And there’s very few circumstances where it makes sense to go with the OAP or DHMO over the high-deductible plans.

If you do go with a high-deductible plan, then there’s a strategy to really supercharge your HSA. HSAs are designed to help you pay for health care costs with pre-tax dollars (not just pre-federal and state, but pre-FICA as well, but not pre-PERA). Similar to an FSA, they allow you to reimburse yourself for health care costs out of your HSA. Unlike an FSA, however, the entire balance in your HSA can rollover from year to year if you don’t spend it, the total amount you can contribute each year is higher, and you can invest the money in your HSA if you choose (typically there is a minimum threshold you have to keep in cash, but then you can invest any amounts above that).

So, while most folks use the HSA to reimburse themselves as they incur health care expenses, the ideal scenario is that you start with an HDHP with HSA when you are young (although this works for any age pre-Medicare), but do not reimburse yourself from the HSA (just pay from your checking account). Instead, invest the money in the HSA and use it like a stealth retirement account. This assumes, of course, that you can afford to contribute to your HSA while still paying any out-of-pocket health care costs out of your regular cash flow. (You can keep track of your health care expenses over time and reimburse yourself at any time, even for costs incurred in the past, as long as they occurred while you were enrolled in a high-deductible plan.)

The reason this is so powerful is that the money in your HSA never gets taxed (if you eventually use it for health care expenses), so it’s better than either a Traditional or a Roth 401k/403b/457/IRA. Ideally, you would max out your contributions to the HSA each year. For 2021, the limit is $3,600 for individuals or $7,200 for families (any dependent coverage), with a $1,000 catch-up contribution if you’re 55 or older. Keep in mind this includes the employer contribution, so subtract off $1,250 for individual or $1,700 for any dependent coverage to find out what you can contribute yearly (divide by 12 for monthly contribution). (And, if your spouse has their own HDHP with HSA through their employer, make sure to subtract off their employer contribution plus anything your spouse is contributing to the HSA.)

Then, once you’ve met the minimum that your HSA provider requires to be kept in cash (typically in the $100 – $2,000 range), you can set up an “automatic sweep” of any additional contributions into your investment account. You typically have a wide range of investment choices through someone like TD Ameritrade, so you can invest in low-cost, diversified index funds. Over time that money will grow and, again, will never be taxed. (Note that it is never taxed as long as you eventually use it for health care expenses. Once you turn 65, you can also use it for anything you want and pay taxes on it, but no penalty.)

In effect, you can use your HSA as another retirement account, in addition to your Traditional and/or Roth IRA, 401k, 403b or 457. But, unlike a traditional account (which is tax deferred, but you pay taxes when you withdraw), or a Roth account (which you pay taxes up front, but then withdrawals aren’t taxed), an HSA is never taxed (contributions are pre-tax, investment gains are tax free, and withdrawals are tax free). This is why HSAs should be near the top of your priority list for investing for retirement (second only to contributing to a 401k/403b/457 up to any employer match, and since most teachers don’t get an employer match, that makes HSAs your #1 priority).

So, let’s do a hypothetical to just give you an idea of what this could look like. Let’s take a 25-year old teacher just starting to contribute to their HSA. Let’s assume that in addition to the employer (district) contribution, they max out their HSA. Let’s also assume they have a spouse and therefore are able to contribute $7,200 per year into their HSA ($1,700 from the district, $5,500 from the teacher). For simplicity’s sake, we’ll ignore that the $7,200 will go up over time (and the current $1,000 catch-up provision once you and/or your spouse turn 55) and that they have to have a minimum amount kept in cash before they can invest (that will be more than made up for with the increases to the $7,200 limit in the future). We’ll assume they invest monthly in the Vanguard Total Stock Market Index Fund (VTSAX), and we’ll assume an 8% return per year. (Historically, the return would be higher than 8%, but going forward it may not be so going to be a bit conservative here.) We’ll assume they continue to invest $7,200 a year ($1,700 from their employer) for 40 years (until age 65, when they will be covered by Medicare), and then start withdrawing money for any accumulated or future health care expenses.

So, how much will they have at age 65? $1.8 million. Tax free (and the money has never been taxed). And it will continue to grow after that, since they are unlikely to pull the full $1.8 million right away. (And, at the historical return of closer to 10%, you’d have $3.2 million. Even at only 6%, you’d have over $1.1 million.)

Now, it may be unlikely that they’ll continue to teach until age 65, so they may lose the employer contribution before age 65. But, even if they do, they can still contribute up to the maximum with their own money, so the numbers still work. And given the fact that the $7,200 maximum per year goes up over time, and there’s the post-55 catch-up provisions, the final amount will likely be well over $2 million.

So, if you’re not currently using one of the high-deductible plans, consider switching. And consider maxing out your HSA each year and, to the best of your ability, paying for health care expenses out of your normal cash flow and let compound interest do its magic inside your HSA. This could end up being your best retirement account

Fees Matter: Vanguard, PERA, TIAA and MetLife Comparison

Inspired by some of the work Ben Johnson has been doing, I decided to revisit two posts I’ve previously done on the retirement plans (401k/403b/457) available through Littleton Public Schools and Douglas County Public Schools. (Note that the expense ratios are slightly lower now than when I wrote those posts.)

It’s probably worth reading at least one of those posts for context, but I basically compared the fees you would pay for investing in PERA’s 401k/457 plan with those you would pay in the other vendor offered (TIAA for LPS, MetLife for DCSD). In this post I thought I’d take that a step further by showing the compounded effects of those fees over time, as well as throw in a comparison to an IRA at Vanguard.

Important note: IRA’s have much lower contribution limits than 401k/403b/457 ($6,000 vs. $19,500 if you are under the age of 50), so you can invest much more each year into your workplace plans. And there are also income limitations on whether you can contribute to an IRA, whereas there are no income limitations on 401k/403b/457 plans. And don’t forget the behavioral aspect – some folks need to have the money taken directly from their paycheck otherwise they won’t ever end up investing it.

So I created this spreadsheet to illustrate the impact of fees over time. Like all spreadsheets of this nature, it is based on many assumptions and those assumptions may be incorrect. Feel free to make a copy of the spreadsheet and change any of the assumptions you wish. For example, for the return on different asset classes, I put in the long-term compounded average return, but many folks think those will be lower in the future, so feel free to adjust. You also can adjust your asset mix between the different asset classes (I kept it fairly simple by limiting to US Large Cap Stocks, US Small/Mid Cap Stocks, International Stocks, US Bonds, and a Target Date fund choice.) Make sure the asset allocation mix adds up to 100%!

You can also change the initial amount you have invested (currently $0 in my examples) and the amount you are adding to your investment each year (currently $6,000 in my examples). You should not change the fees charged by Vanguard, PERA, TIAA or MetLife (unless you are reading this enough in the future that those have changed as well), nor the columns that keep track of your running totals with each vendor. Note that the fees for each are based on the lowest-cost fund offered within each asset class with each vendor.

You can change any of the numbers that are in cells with a purple outline, leave the rest alone.

So, let’s look at some selected results. First, what if you had an aggressive, all-equity allocation of 40% Large Cap, 30% Small/Mid Cap and 30% International? This is what it look like after 10 years:

As you can see, investing at Vanguard is going to get you the best overall return, and investing with PERA is going to be a better choice than either TIAA (LPS) or MetLife (DCSD).

How about after 30 years?

Wow. You’d have over $110,000 more in Vanguard than with MetLife, and over $90,000 more if you choose PERA over MetLife. And if you take it out to 50 years (think starting when you are 22 and not withdrawing until age 72 when you have to start taking Required Minimum Distributions):

Almost $1.5 million more in Vanguard than in MetLife, $1.2 million more with PERA than MetLife. (Note that these numbers get even further apart with contributions that are greater than $6,000 per year, although the percentage differences will be the same.)

Okay, well what if you just chose a Target Date fund (which is the default option in your 401k/403b/457 plans, and a good, simple choice for lots of folks) and put 100% of your money into that? Here’s after 10 years:

Note that here PERA is actually ahead of Vanguard due to the lower expense ratios on their Target Date funds, but both Vanguard and PERA are still doing much better than TIAA or MetLife.

30 years?

50 years?

Play around with the assumptions in the spreadsheet, including the asset mix that most closely reflects your desired asset allocation. But no matter what mix you choose, Vanguard and PERA will come out the best (usually Vanguard as the best, with PERA only if you go with just a Target Date fund). TIAA will come in a distant third, and MetLife a very distant last place. (And keep in mind that the negotiated fees with TIAA and MetLife are actually pretty good compared to many folks’ 403b choices around the country.)

And yet many employees in LPS and DCSD choose TIAA and MetLife. Why? Perhaps because a sales rep contacted them and was kind, concerned, and “helpful”. Perhaps because they think they can choose investments and “beat the market”. Or perhaps they just chose without much knowledge.

So, now that you know a bit more, what changes might you make with your investments? In general, if your adjusted gross income is not too high (varies depending on Traditional vs. Roth, and increases slightly each year), opening up an IRA at Vanguard is going to be your best choice to fund first (this is assuming you are disciplined enough to invest the money when it doesn’t come directly out of your paycheck).

If you max that out (remember, IRA’s have much lower contribution limits each year), then fund your PERA 401k or 457 next. In LPS, I would choose the 457 over the 401k, as it’s a bit easier to access the money before age 59.5 (unfortunately, DCSD has not chosen to offer the PERA 457), but otherwise the 401k and 457 are essentially the same.

If you are able to max out your personal IRA and your 401k or 457, then you can invest in the one you haven’t yet, as the 401k and 457 are different “buckets” and they each have their own, separate contribution limit (note that the 401k and 403b draw from the same contribution “bucket”). This means that in 2021 if you are under the age of 50 (if your income isn’t so high that you can’t contribute to an IRA), you can contribute up to $6,000 to an IRA, $19,500 to a 457, and another $19,500 to a 401k, for a total of $45,000. If you are 50 or older, you get “catch up” contributions, which gives you an extra $1,000 for your IRA and $6,500 for both the 401k and 457, for a total of $59,000. (And, depending your plan, there may be special catch up contribution provisions in your last 3 years of work that can let you contribute even more.) Keep in mind that for all of these you have the option of doing a Traditional (pre-tax) contribution or a Roth (post-tax) contribution, which is a complicated and entirely different conversation.

As always, feel free to reach out with questions (or comment below).

PERA Votes to Switch from Voya to Empower

The PERA Board voted, pending final contract negotiations, to switch record keepers for the Defined Contribution plans (which includes the 401k/457b plans) from Voya to Empower. Voya came in second place in the RFP process, and it would’ve been “fine” to continue with them, but staff, the consultant, and the Board all thought Empower would provide a better experience to members.

The fee each proposed is essentially identical (Empower was slight higher in their bid). I would suspect that it won’t change the fee structure for the plan/funds at all, but I don’t know that for sure as I don’t know how the proposed fee compares to the current fee. (Since PERA has consistently focused on lowering the fees, I would be surprised to see them go up, but we’ll see.)

I’ve shared screenshots of the two slides below as reference for the pros and cons of each. But, essentially, Empower appears to offer better service, more customized offerings, and better technology. Interestingly, Empower purchased Personal Capital last year and will be integrating that into the platform by year’s end. I think that has huge potential if it’s done correctly.

I also think it’s significant that the PERA staff ranked Empower higher, considering that makes more work for them as part of the conversion. Note that there was going to be a fair amount of work no matter what, because as part of this RFP PERA is going to transition away from single sign on (meaning you will no longer have to sign on to PERA’s website in order to get to Voya – soon Empower), and they will be aggregating the contribution data before it goes to the vendor (right now each employer sends their data to Voya, after this transition it will all get sent to PERA and PERA will send one file to Empower). But, even with that, there will be a ton of work in order to convert the data over and, of course, in communication.

I do not know the timeline of when this transition would actually happen, but my sense would be by the end of this calendar year. I’ll have to see the final details, of course, but at the moment I’m cautiously optimistic about this change.

BlockFi: A Possible Alternative to Low Yield Savings Accounts

I’ve been debating for a while whether to post this here because I will be discussing a much riskier, alternative investment. As someone who argues you should pretty much invest in diversified index funds and forget it (other than rebalancing), this is a bit uncomfortable. But I finally decided to post because many people have been asking if there are any alternatives to the very low interest rates savings accounts and CDs are paying, and I figure you can all do your due diligence to see if this might be right for you. I will include multiple caveats along the way, starting with this: this is a potentially risky investment and there is definitely the potential to lose money (50%, 70%, maybe even 100%). So, hopefully this disclaimer is clear :-).

I learned about BlockFi through the Animal Spirits Podcast. Michael and Ben first had Zac Prince (BlockFi CEO) on last November in this episode. They first discuss Bitcoin (BTC) and cryptocurrencies in general and then start discussing BlockFi specifically at the 16:20 mark. While I will try to briefly describe BlockFi below, you should definitely listen to this entire episode before deciding whether you might want to invest with BlockFi.

Because of the intense interest (pun intended) from listeners, Michael and Ben had Zac back on for some Q & A as part of Episode 180. Zac is on from 35:57 to 47:45, answering questions that listeners had submitted (as well as some from Michael and Ben). Again, highly recommend you listen to this before deciding to invest.

Finally, they had Zac back again at the end of January where the discussion was more about Bitcoin and crypto in general, and less about BlockFi. Still worth your time, but not as important as the first two.

So, what is BlockFi? Briefly (and overly simplified), BlockFi is a “fintech” company providing financial services. They have a retail side and an institutional side. The retail side allows you to invest money and buy and trade cryptocurrencies (like Bitcoin, Ethereum, etc.) and – the main point of this post – allows you to earn interest on what you’ve invested. The institutional side (which is what allows them to pay interest on the retail side) serves as a prime broker to large institutions (companies, endowments, etc.) who want to play in the crypto space but traditional banks won’t currently provide any financing for it. They have also recently added an institutional trading product. (Listen to the episodes, it explains it much better.)

The interest they earn from the money they lend to institutions allows them to pay interest to the retail accounts and they make money on the spread. Currently they can charge very high interest rates to institutions because there isn’t much competition and this is the only way for institutions to borrow for crypto purposes. This, in turn, allows them to pay very high interest rates to retail investors. They fully expect those rates to come down over time, but it will be a relatively slow process as the industry scales up.

So, what kind of interest rates? Well, it depends on which cryptocurrency you invest in. See the chart in the image at the top of this post for the rates on each cryptocurrency, but let me highlight that you can earn 8.6% on GUSD (a “stablecoin”, more on this in a minute) and 6% on Bitcoin (up to 2.5 BTC, then 3% after that). That interest is paid monthly and you have full liquidity (you can buy, sell, or withdraw at any time, with a turnaround of one business day or less). How in the world can they pay that high of interest, when even the best savings accounts are paying 0.5%? It’s because they are able to charge around 10% to lend dollars to institutions, and around 7% to lend crypto to them.

So what’s the catch? There are (at least) two major ones. This is not a bank (they are regulated similar to companies like Square and SoFi), so your money is not FDIC insured. You can lose money – perhaps most or all of it. And (most) cryptocurrencies (like Bitcoin and Ethereum) are very volatile, so this is not for the faint of heart. But this is where GUSD, a “stablecoin”, comes in. Briefly, stablecoins are designed to be, well, relatively stable, with the value staying very close to $1. The best ones (like GUSD) are regulated and have the same number of US Dollars in an audited bank account as they have issued GUSD tokens. There is no guarantee that they will remain close to $1, but with the backing of actual dollars in an actual bank, the volatility should be relatively low (certainly compared to something like Bitcoin).

All of the above is a very brief, simplified explanation, so please listen to those podcasts to learn more (and perhaps do further research). And another reminder that this is not like a bank account – it is much riskier.

So now the main point of this post. After listening to these podcasts and exploring around a bit, I decided to invest a small amount (currently $2,000) in BlockFi, moving it from my savings account (in four batches over the last couple of months as I became more comfortable). While I may decide to invest more over time, at this point I didn’t want to invest any more than what I would be okay with if it should happen to go to $0. While I obviously wouldn’t be happy with losing $2,000, it wouldn’t be life changing, so I’m okay with the risk (and I don’t think it will go to $0). 

All $2,000 is invested in GUSD, so I feel like it is relatively “safe”, and unlikely to vary much from $2,000. BlockFi has a “flex interest” option where you can choose to have your interest invested in the same currency you earned it with, or in another currency. My current setting is that when I receive interest (8.6% annual rate on GUSD) at the end of each month, I have it invested in Bitcoin. (I am currently the proud owner of 0.00021612 BTC :-). I have earned a little over $7 in interest so far, and have accrued $6.81 so far this month that will be paid at the end of the month (recall that I did not invest the full $2,000 initially). The amount I have in Bitcoin earns 6% interest (which also gets reinvested in BTC), but of course the value of Bitcoin is anything but stable. My rationale (rationalization?) is that BTC could lose 90% of its value and I still would be ahead compared to earning 0.5% on my savings account (assuming GUSD stays stable). At this point I am not using BlockFi to actively purchase BTC (other than with interest), but they do appear to be a good platform to do that, as they do not charge any fees, which apparently other crypto platforms do (there is still some spread of 0.5 to 1% when you purchase, but that appears to be less than other platforms, plus no fees). They are also about to launch a rewards credit card, where you’ll get 1.5% back on purchases, but paid in BTC :-).

Since I started this, BTC has skyrocketed by about 70%, so I’m considering switching the flex interest option back to GUSD. While I generally don’t believe in “market timing”, Bitcoin is a bit different and compounding at 8.6% in GUSD seems like a pretty decent alternative (given the assumption that GUSD will be relatively stable). If BTC then drops a lot (which it will), perhaps I will switch back. (I’m not selling my current 0.00021612 of BTC.)

So, with a reminder of the caveat that this is much riskier and more volatile than a bank account and that you can lose money, what are your thoughts on this? For those of you looking for an alternative to very low interest bank accounts, would you consider putting some of your cash into BlockFi? If you do decide to invest, you might consider using my referral code. Please don’t feel compelled to, especially if you think this was all just an attempt to get you to use my referral code – it wasn’t (I promise). I just wanted to share in case anyone is interested, but if you do use the code and deposit at least $100, both you and I will get $10 in BTC as a bonus (you have to leave the balance in there until at least the first interest payment to earn the bonus). But you can also just choose to sign up without using the referral code if you have any concerns. I hope if nothing else this has helped educate you a bit (like it has me) about some of what is happening in the fintech space.

Edit: I forgot one important point for residents of New York State: New York residents can’t participate yet other than to get a loan and rewards card (interest products are not allowed yet in New York per regulations.)

Update 2-24-21: New features of the BlockFi Bitcoin Rewards Credit Card were just announced.

FI for Colorado Teachers Part 4: Tax Optimization

TL; DR: This is the fourth in a series of posts for Colorado teachers that looks at the tax code and discusses how you can optimize your financial decisions to take advantage of it. Hint: most people don’t take full advantage of the tax code.

Part 1 in this series describes the “what” and the “why” of Financial Independence. Part 2 discusses the process of “how.” Part 3 looked at the possible “what its” and “yeah, buts” objections to accomplishing FI. This post builds on part 2 and discusses how knowing the rules around taxes can allow you to optimize your finances and help you achieve Financial Independence.

Taxes are an interesting thing. Most folks will begrudgingly admit that they are necessary, but then often go on to complain about how much they have to pay or how unfair the system is for X reason. While there are certainly good arguments that can be made about the fairness of the system and how it could be improved, there are also ways that you can make decisions to address how much taxes you pay. To be clear, this is not cheating on your taxes, this is simply knowing the rules and making decisions to take advantage of those rules. If people would take the time to learn the rules and then adjust their decisions, they might not complain about how much they pay (or, more realistically, complain a bit less).

I am not a tax expert, nor can we go in-depth on all the various aspects of the tax code in this post. But there is some pretty basic information that you can use to your advantage, and some specific aspects that apply just to teachers, both of which you can use to optimize your finances. Spending just a little bit of time learning about the rules and then adjusting your decisions can have a big impact over time.

First, a quick reminder about how Federal taxes work (very simplified, but helpful for our purposes). You have a certain amount of income, some of it earned (your paycheck) and some of it is not (interest, dividends, capital gains, etc.). Some of that earned income you can “shelter” from taxes by investing in tax-deferred accounts, and some if it is automatically sheltered from taxes (your PERA contribution, your insurance premiums if you choose to take them pre-tax, your HSA contributions if you have them, dependent care expenses, etc.).

You then have some deductions to your income which, for the vast majority of taxpayers now, is going to be the standard deduction, with a few other deductions that might apply (for example, teachers also have the $250 teacher expenses deduction they can take).

You then end up with your taxable income, which is taxed using a progressive tax rate (that is adjusted for inflation each year), which means some of your taxable income is taxed at one rate, some of it at another, and perhaps some of it at yet other rates if you have a large taxable income. (Note that some of your unearned income, like qualified dividends and long-term capital gains are treated differently. This is important and we’ll talk about this eventually.) For example, in 2019 for a married couple, the first $19,400 in taxable income is taxed at 10% and any amount over $19,400 and up to $78,950 is then taxed at 12%. If you have taxable income above $78,950 but below $168,400, it gets taxed at 22% (and it continues above that, but most teachers won’t need to worry about that).

Many folks don’t completely understand how this progressive system works and think that all of their taxable income is taxed at whatever tax bracket they are currently in, which can lead not only to misunderstandings about tax policy, but sometimes some poor decisions around your taxes. For example, if your taxable income is $75,000, then the tax you would owe would be $8,612, which is an effective tax rate of 11.48%, not the 12% that many people think that $75,000 would be taxed at. ($19,400 at 10% is $1,940, the remaining $55,600 to get us up to $75,000 is taxed at 12%, which is $6,672 in taxes, for a total of $8,612.)

But it gets even better, because many people don’t actually owe that amount because they also get tax credits. Tax credits are different than tax deductions. Tax deductions get subtracted from your income to then determine your taxable income, but tax credits are dollar-for-dollar offsets to the tax you owe. The most common one for many people is the child tax credit, which is currently $2,000 per child (with up to $1,400 of that refundable). So, for the example above, if they had one child they would owe $6,612 in taxes, not $8,612. There are many other tax credits that could apply, so it’s important to investigate those based on your situation.

State taxes in Colorado are much simpler, as they take your federal taxable income, perhaps make a few adjustments, and then calculate your state tax at a flat (not progressive) rate of 4.63%. This means that all the ways you can lower your federal taxable income (deductions, tax-sheltering, etc.) also lowers your Colorado state tax owed, and then there are a few Colorado-specific tax credits you might be able to utilize (one of the most common is contributions to the Colorado 529 college savings plan are exempt from Colorado state taxes). Also, a quick plug (pun intended) for the Colorado Alternate Fuel Tax Credit, which is a $5,000 tax credit for an electric vehicle (and that’s refundable), which means if you have at least $7,500 in federal tax liability, then you can take a whopping $12,500 in total tax credits if you buy an electric vehicle (subject to phase out limits – Tesla and soon Chevrolet will begin ratcheting down).

Sorry if that was more (or less) than you needed, but we needed to set the stage for the next part of our discussion, which is about how best to take advantage of those rules on your path to financial independence. We’re going to focus on four areas: tax-sheltered accounts, Section 125 deductions, HSA contributions, and possibly optimizing to get the Savers Tax Credit.

Tax-sheltered accounts come in two main variants – pre-tax and post-tax. Pre-tax accounts are things like 401k/403b/457/Regular IRA accounts, where the money you contribute does not get taxed in the current year, but then gets taxed when you withdraw it during retirement (hopefully). Post-tax are the Roth variants of those, where the money you contribute is post-tax, meaning you do pay taxes on that money in the current year, but then any investment earnings you receive do not get taxed, so when you withdraw during retirement there is no tax liability.

For many folks, particularly if you are on the road to Financial Independence and will be considering retiring (work optional phase) early, the pre-tax accounts are the ones you want to focus on. (This post will not be able to go in-depth on why this is probably preferable to using Roths, but there are many resources on the web that discuss this.) This lowers your taxable income (both Federal and State, and often keeps you in the lower tax brackets), allows your investments to grow tax free, and sometimes helps you qualify for the Savers Tax Credit (more on that in a minute).

Every public school teacher in Colorado has access to PERA’s 401k plan (which is a good one). Most teachers then also have access to a 403b and a 457 plan. The 403b is going to be through a vendor other than PERA, but the 457 could be through PERA or that other vendor. Having access to that 457 is a huge advantage for teachers (and most public employees), because it not only allows you to shelter additional money, but also allows you to access that money when you are younger with no penalties (which is huge if you are planning on retiring/work optional at a younger age). (If your district does not offer you a 457 plan, talk to your Human Resources department ASAP. Even if they don’t want to deal with an outside vendor, setting it up with PERA is very easy for your district to do since they already are setup for the 401k.)

In 2019 you can contribute up to $19,000 to your 401k or your 403b – the limit applies to the combined amounts you can put into one or both of those accounts. (If you are over 50 you can contribute an additional $6,000, so up to $25,000). Note that this is per person, so if you are married your spouse can also contribute up to $19,000 (or $25,000 if over 50). But an important point to understand, particularly as your income increases as you grow older, is that you can also contribute up to $19,000 (or $25,000 if over 50) to your 457 plan. That’s in addition to the 401k/403b contribution. Essentially, public employees have double the amount they are able to shelter. (And, in fact, the 457 plan even has an additional “last-three-years” catch-up provision that can effectively allow you to contribute twice as much – $38,000 currently – each year for the last three years you are with with that employer.)

And the 457 is even better than the 401k/403b, because it’s considered “deferred compensation”, which means that you can access that money as soon as you leave that employer. This is different than a 401k/403b, where if you access the money before age 59.5 you may have to pay a penalty. (Note, there are ways to access a 401k/403b before age 59.5 without a penalty, but a 457 is so much easier if you have that option.) This means that if you do achieve Financial Independence and enter the “work optional” stage by quitting your teaching job, you can immediately access any money in your 457 to use as living expenses, even if you are way short of 59.5.

When we get to the case study posts (starting with part 5), we will go more in-depth on how to use this in the best possible way, but here are the two most important points to remember:

  1. Invest as much as you can in your 457 plan and increase it every year until you max it out.
  2. Once you max out the 457, invest as much additional as you can in the 401k/403b.

Many folks look at that and say, “That’s great, but I need money to live on.” That is certainly true, but keep in mind that since these contributions are coming out pre-tax, they don’t actually reduce your net pay by your total contribution. For example, if you contribute $19,000 in a year to your 457, and you normally would be in the 22% federal tax bracket (plus 4.63% Colorado tax bracket), your net pay “only” decreases by $13,940. Now, that’s still a fair amount of money, but it’s a lot less than $19,000. (And, as we’ll see, it might actually be even less than that if you can qualify for the Savers Tax Credit). As you’ll see in the case studies, if you can rein in your lifestyle expenses, most folks can actually save more than they think.

The second area to be aware of is Section 125 Plans. This refers to the part of the tax code that allows you to receive part of your income pre-tax if it is used for particular expenses. The added benefit for teachers is that it comes out pre-PERA contribution (although that will be changing for new hires hired after July 1, 2019). What are these particular expenses? They include insurance premiums (health, dental, vision, etc.), dependent care expenses (child care), and flexible spending account contributions (unless you have a high-deductible health plan, which we’ll discuss below).

All of these end up being expenses you can pay with pre-tax dollars (and pre-PERA dollars for current PERA employees), which can save you a significant amount of money. Again, if you were going to be in the 22% federal tax bracket, plus the 4.63% Colorado tax, you would save 26.63% of the total you spend on these areas. Plus, if you’re a PERA employee hired before July 1, 2019, you save an additional 8% on your PERA contribution (and that will be increasing over the next few years to at least 10% as part of the legislation passed in 2018). (Note that if it is coming out pre-PERA, you want to stop doing this in your last 3-5 years of employment in order to maximize your Highest Average Salary calculation. The amount you “lose” in tax savings during those years is more than made up for in pension income over time.)

If you have access to a High Deductible Health Plan (and most teachers do), then you also have the ability to contribute to a Health Savings Account (HSA). Employers also often kick in a small amount to your HSA in order to encourage you to sign up for the plan. Your contributions do not come out pre-PERA, but they do come out pre-tax and pre-FICA. HSA’s are known as “triple-tax-advantaged” accounts, because they are the only accounts that allow you to contribute pre-tax, earn pre-tax, and withdraw pre-tax. Basically, you never pay tax on this money (as long as you use it for medical expenses). And unlike an FSA, you don’t have to “use it or lose it” each year, can can carry over any balance for as long as you want.

You also have the option to invest this money, which can help it grow even more. From an FI perspective, this is an amazing account, especially if you can afford to not withdraw any money for medical expenses along the way and just let it grow tax free. As long as you save your receipts, you can always withdraw the money in the future when you need it, or you’ll likely have future medical expenses anyway. If you never have medical expenses (unlikely, but it could happen), then you can still withdraw it after age 65 and simply pay taxes on the withdrawals (but no penalty).

If you do have a High Deductible Plan, you can’t also contribute to an FSA (the HSA takes its place). But many district will have a Limited Purpose FSA that you can contribute to, and that money can be used for dental and vision expenses, but not health expenses. While this is “use it or lose it”, if you can estimate your out-of-pocket dental and vision expenses for the year, this is an extra tax strategy you should take advantage of.

Finally, as promised, we’ll talk about the Savers Tax Credit. In order to encourage folks to save for retirement, the Federal Tax code will actually give you money to help save, as long as your income is below a certain threshold. Because all of the previously discussed items (401k/403b/457/HSA/FSA/Section 125 plans) reduce your income threshold, if you can take advantage of enough of them you might also qualify for at least some of the Savers Credit. For example, in 2019 if you’re married and your adjusted gross income is below $64,000, you can claim 10% of your contributions to 401k/403b/457 plans as a tax credit, up to a total of $4,000. So, in our previous example where we discussed that contributing $19,000 to your 401k only reduced your net pay by $13,940, it may actually only reduce your net pay by $12,040, because you might get $1,900 from the Savers Tax Credit (assuming your income is adjusted gross income is low enough to qualify for the 10% Savers Credit). For many teachers, this is possible in your first few years of teaching, as you’ll see in the case studies posts.

There are more tax strategies we could consider, and we certainly will when we discuss the withdrawal stage of Financial Independence, but this gives you the overall approach. By understanding the tax rules and adjusting some of your decisions based on them, most folks can actually save (and invest) much more than they thought. While you can still complain about your taxes, you’ll have actively made some moves to reduce what those taxes were, which will help you on your path to Financial Independence.

  • Part 1: The Concept
  • Part 2: The Process
  • Part 3: The “What Ifs?” and the “Yeah, Buts”
  • Part 5: Case Study: Teacher Married to Another Teacher
  • Part 6: Case Study: Teacher Married to a Non-Teacher
  • Part 7: Single Teacher

 

Saving for College: 529 Plans

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).

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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).

Working Teens and Roth IRAs

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

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

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.

Why You Should Go Solar

Summary: Going solar, either rooftop or via a community solar farm, is not only the right thing to do for the environment and to combat climate change, but it will save you money.

Let me be clear up front, I’m passionate about sustainability, particularly the use of sustainable energy, and I believe climate change is a very serious threat. I think everyone should be concerned, not just for themselves, but for their children as well, so I of course think you should go solar. But, even if I didn’t believe all of those things, you should still consider going solar for financial reasons.

We put solar panels on our roof at the end of 2009. That’s only 8 years ago, but there’s been tremendous change in the solar energy industry since then. In 2009 solar panels were much more expensive than they are now (and the continue to get less expensive), and they weren’t as efficient as they are now (and still getting incrementally better each year). On the flip side, the incentives (at least in Colorado) were much better then than now.

roof

We purchased a 5.04 kW system from Standard Renewable Energy (SRE) and they installed it. (They’ve since been bought by GridPoint and no longer do solar installations, at least in Colorado.) The total cost was listed as $38,307, but then there was an “instant rebate” from SRE of $10,080, which took what I would consider the real cost down to $28,227. But we didn’t even have to pay that as, at the time, the combined utility and state rebate for that size installation was $17,020, which means our out-of-pocket cost (the check we had to write) was $11,207.

But it gets even better, because that doesn’t take into account the federal rebate, which turned out to be an $8,693 tax credit on our 2009 taxes, so we effectively paid $2,514. At the time SRE showed the break-even point to be between 3 and 4 years, but we estimated it at more like 5 (they had built in 10% electricity rate increases each year). We didn’t track it exactly, but we estimate the break even point was at about 4.5 years, which means that since mid-2014, our electricity has been close to free (not completely free, as we still pay a grid-access charge).

So what’s our “return on investment” on solar? Well, that’s a bit hard to tell, as the solar panels are still operating great and effectively generating income for us, and we don’t know how long that will continue or what electric rates will do. We spent $2514 at the end of 2009 and, so far, have “made” probably more than $4,000 in saved electricity bills. That’s currently around a 6% compounded yearly return (with no associated tax liability).

Plus keep in mind with all of the solar options I discuss in this post, these returns are tax-free, unlike the equivalent equity or bond investment so, depending on your tax bracket, that could significantly close the difference in returns between going solar and investing the money in the markets.

As part of the agreement with the utility company, solar systems are generally sized to generate approximately the same amount of electricity you use in a year, plus or minus a bit. (You can choose to install a smaller system and generate less, but they don’t like you to overshoot the mark.) Ours was sized at about 98% of our usage, although over the subsequent years we have actually used a bit less electricity (we installed new windows and replaced some appliances), so each year we typically have received a small rebate check from Xcel at the end of the year for the excess we’ve generated.

That was true until the beginning of this year, when we started again using more than we generated. This is because at the end of December we bought a used 2013 Chevy Volt, which is a plug-in hybrid. Much more on this in a future post, but basically because we are charging it each night, our electricity use has gone up and now surpasses what we generate. (To keep that “cost” in perspective, however, we still haven’t had to put gas in the car, having driven it more than 3,800 miles and only used 3.2 gallons of gas so far.)

Being the sustainability guy that I am, I of course wanted to figure out a way to make that new energy clean energy as well. We still had some room on our roof (perhaps not the ideal orientation, but still okay), but it turns out that most solar companies don’t want to add on to an existing system (I’m sure for liability/insurance reasons) and, since our system is still working great, we certainly didn’t want to tear it off the roof and put a whole new system on.

So we began looking at alternatives and ended up purchasing 4 panels at a community solar farm operated by Clean Energy Collective. Community solar farms are big arrays of solar panels, typically installed in big open fields, that generate electricity and feed it back into the grid. Individuals or businesses can then buy a portion of the array and get credit for the electricity generated to offset their own usage. It’s often called “roofless solar” and, in many ways, it’s better than solar on your roof. Solar farms are generally more efficient (they can align the panels perfectly) and cost effective (cheaper to install on the ground than on a roof, as well as economies of scale). I still prefer putting solar panels on roofs, as then I know for sure it’s new energy generation and it provided at the source, not simply purchasing already existing solar farm panels and feeding into the grid, although by purchasing those you are using up existing farms and therefore they are likely to build additional ones. But, because we couldn’t easily add any more to our roof, this was a great solution for us.

cec

The cost of this, of course, varies, but let me share the specifics in our case to give you an idea. Because we only needed to generate the additional amount of electricity we were using by charging the Volt, we only “purchased” 4 panels (which is the minimum) at the solar farm (located in Arapahoe County). We are effectively leasing the panels for 19 years (for initial customers it was 20, but because this farm has been in use for a little while, I guess we only have 19 years left). The cost for those panels was $3,050 out of pocket (ironically, more than our entire solar system after rebates in 2009).

Those 4 panels will generate 1.22kW. The way we get “paid” is that we get a credit on our utility bill from Xcel each month, currently 7.6 cents per kWh (that rises and falls with whatever the current rates are), as well as an 8 cent per kWh renewable energy credit (REC) that gets paid quarterly. The estimated yearly savings for 4 panels comes out to about $322. CEC then estimates that electricity rates will rise 4.8% per year. This is more realistic than the 10% SRE used back in 2009, but still perhaps a bit too high (unless a carbon tax is eventually passed, in which case it might be much too low). Using those assumptions they calculate a 9.5 year break-even point and a total return of “187%” after 19 years. Assuming no increase in electric rates, the return is about 4% per year compounded. Given that electricity rates will likely rise some, I’m going to guess it will turn out to be about 4.5% per year compounded.

Is that a great return on investment? Well, no, not compared to investing it in equities (but, again, keep in mind there’s no tax liability, so that boosts the return up some). If I was just trying to maximize my return, this would be a bad idea, investing $3,050 into an index fund would likely generate more return. But since I can generate clean energy, help combat climate change, and still earn a return that’s better than a money market account and probably pretty equivalent to what bonds would return, I think that’s a pretty good trade-off (as well as diversifies my investments a bit).

Now, if you don’t already have solar on your roof, you should definitely first investigate the cost and return on investment for that (more on that below). But, if you don’t own a house, or if you can’t or simply don’t want to put solar panels on your roof, then this is a great option. If you are interested, I’d recommend contacting Pete Stein at CEC (pete.stein@easycleanenergy.com or 720-623-0618), he was very thorough and helpful.

Full disclosure: If you mention my name and end up purchasing from CEC, I will receive a $200 referral fee. If you feel icky about that, don’t mention my name :-). But keep in mind that if you do, you also will receive a $200 check after completion of your purchase and $100 will be donated to charity, which is why I decided to go ahead and include it in this post.

Since we already had solar on our roof, I couldn’t get a quote for what it would cost to install solar now. Luckily, I have a friend who just installed solar in my neck of the woods in Colorado and he was willing to share his information. As I mentioned previously, much has changed in the solar industry since we installed in 2009. In addition to the changes in cost and efficiency, you now have many more choices of installers and many of them now offer solar leasing in addition to up-front purchasing.

My friend ended up going with Ion Solar and, so far at least, he’s been very happy with them. Let’s take a look at some of the details for his install. They installed a 4.85kW system, so roughly equivalent to the system on our roof. Their total system cost was $18,896, less the federal rebate of $5,669, for a net system cost of $13,227. There are no longer the huge state/utility rebates like when we installed ours, instead you now get a minimal REC from Xcel for the energy generated. (From the information shared with me, I can’t tell how much this is or exactly where it figures in the calculations, but I know it’s often less than 1 cent per kWh).

ion

My friend chose to finance the system, which is basically a solar lease. The amount financed is the full amount of $18,896 at 4.99%, and they’ll make payments of $79 per month for the first 16 months, then $91 a month thereafter for the remainder of the 20 years of the lease (this assumes that the $5,669 tax credit is then applied to the loan when it’s received). In their calculations Ion assumes a 4% yearly increase in electricity rates and, based on this information, after 25 years they will end up $20,667 ahead.

How does that work? Well, each month the (average) amount they save on their electric bill is more than their loan payment, so they come out ahead. Ion even does a calculation where if you apply that savings to the loan payments, the loan is paid off in 15 years and the 25 year accumulated savings is then $22,743.

So what’s the return on investment? Well, since there’s no money put down up front, it’s complicated. But for the sake of argument, let’s assume they had decided to purchase the system for the net cost after federal rebate of $13,227. Ion estimates that over 25 years (factoring in the estimated 4% yearly increase in electricity rates) they will save $42,280, which is about 4.8% per year compounded (again, tax-free). Again, compared to investing in equities, that’s not a great return. But given the good that you’re doing, along with diversifying your investments and earning a bond-like return, I think it’s more than worth it.

So what should you do? If you own a house, I’d suggest getting bids from several vendors for installed solar and compare, and perhaps also contact Pete at CEC to compare roofless solar as well. There are lots of vendors to choose from, but I would certainly include Tesla Energy (formerly Solar City), because I anticipate with their new Gigafactory 2 coming online shortly their prices will be very competitive. (In addition, if you happen to need a new roof sometime in the future, look into their new solar roof option. It’s more expensive because it’s tile, but when you factor in the electricity savings, it ends up being cheaper than an asphalt roof, plus it has an infinite warranty on the tiles themselves – you’ll never have to replace the roof again.) If you don’t own your own home, or for whatever reason don’t want to install solar panels on your roof, then definitely contact Pete at CEC and get all the details.

Any of these options will give you a decent, but not great, return on investment, as well as contribute to a better world. In future posts I will talk more about the used Chevy Volt we recently purchased, electric cars in general, and why your next car should be electric, as well as about the opportunity to invest in solar directly.

How Do You Measure Investment Risk?

risk

There are a lot of sophisticated measures in the investment business: P/E Ratios, Cash Flow Analysis, EBITDA, etc. The list goes on and on (and on). The one I find most interesting, however, is how most people measure risk. The generally agreed upon method is to measure volatility, which is how much the price of a particular asset (stock, bond, whatever) goes up and down, often in conjunction with looking at expected return of the particular asset. To simplify it a bit, the more the price of something changes, the riskier it is.

I find that fascinating and mostly wrong. If you are a long-term investor armed with self-control, measuring risk by measuring volatility is not very useful. This analogy is a bit of a stretch, but I’ll use temperature as an example. If a particular day starts at 60 degrees Fahrenheit and goes up to 80 then back down to 60, that would be considered “worse weather” than a day that starts at 100 degrees and stays there (or 40 degrees and stays there).

Now, if you are an investor who is actively trading, constantly moving in and out of different positions, volatility is important. Likewise, if you are an investor that is going to need to take money out of a particular investment in the near future, volatility could be important. But I prefer a different measure of risk: how likely are you to meet your goals?

To me, this is really the only measure of risk that matters. Will your investment portfolio/strategy achieve the goals you have set for it? If you are a long-term investor (and if you end up working with me you will be :-), you don’t care all that much about the daily ups and downs of your investment, as long as at the “end” your investment is up a sufficient amount that allows you to achieve your goal. Which means that if you construct your portfolio correctly, there is really only one sub-component of that risk that matters: you.

More specifically, do you have the self-control, the discipline, to follow your investment plan? When bad things happen (like the Great Recession in 2008, or the dot-com bubble in the early 2000’s, and the value of your investments drop, sometimes by a lot), will you be able to stay the course and not bail on your plans? One of the main reasons to hire a real financial planner (or even avail yourself of my services), is that they hopefully will help you to stick to the plan. While there are no guarantees, based on the entire history and theory of financial markets, if you invest for the long-term and don’t sabotage yourself by abandoning your investment plan at the worst possible times, you are (almost) guaranteed to be successful.

In fact, there is plenty of research that most investors earn less (often far less) than the mutual funds and other investments they invest in earn. How can that be? They buy high and sell low. They typically buy into a mutual fund (or stock, or whatever) after if has performed really well for a while (missing out on most of the gain), then lose heart and sell when it inevitably goes down. It’s the investor’s behavior that causes them to under-perform, and hence the riskiest part of investing isn’t typically what you choose to invest in, it’s you.

So what’s the secret?

  1. Spend less than you make.
  2. Regularly invest the difference in low-cost index funds.
  3. Don’t sell (unless you’ve achieved your long-term goal).

I’ll write several more posts exploring different aspects of this, but it pretty much is that simple. That’s one of the most frustrating aspects when I hear others talk about their finances. Either they are too afraid of “investing” because they are worried about losing their money (or somebody taking advantage of them), or they are constantly moving from investment to investment to try to outperform the market (generally with poor results, as that study indicated).

As I mentioned in one of the FAQs, about 90% of what you need to do is really pretty straightforward, and not all that hard to do, if you simply know a little bit and have that self-discipline. I’d be happy to get you started on that path.

Photo credit: Foter.com