What to do after you maxed out all tax advantaged opportunities?

After I maxed out all tax advantaged options, there is nothing else left for me then to open a taxable investments account.

What taxes would I pay on investments in a taxable account?

A taxable account is funded with post-tax money.
The interest, dividends and capital gains are taxed every year. 

1. Interest
It is taxed at ordinary income tax rate according to you tax bracket.


2. Capital gains and Qualified Dividends (2018)
Ordinary dividends and short term capital gains are taxed at ordinary income tax rate.

Qualified dividends  and long term capital gains are taxed at reduced rates: 

There is an additional 3.8% Net Investment Income Tax (or Medical Surcharge Tax) for capital gains, and dividends.
It applies to modified adjusted gross incomes exceeding $200,000 for singles and $250,000 married filing jointly.  



I am thinking of opening a separate "challenge" account in which I will try to learn how with certainty to achieve more than 1% yearly returns on my own. In this account I will not use indexing. 
Majority of my investments is in index funds at this time. Indexing is supposed to make more than 1% returns per year with relatively high certainty. 
The "challenge" account will be for trying it on my own. I will add a link to it here as soon as I start with that.   

 

What is "Indexing"?

Indexing is a passive long term investment strategy.

Indexing can be achieved with mutual funds or exchange traded funds (ETFs) which closely tack the performance of the underlying index.


SPDR S&P 500 ETF (or SPY) is an example of an ETF which closely tracks S&P 500 index.
SPY holds 500 companies that make up S&P 500. 
People like indexing because with little effort this is a way to diversify. The 500 companies of the SPY are supposed to be approximately 80% of the overall US stock market.


With this method the investor will:
1. Achieve the same rate of return as the underlying index.
2. Will be exposed to the same risks as the underlying index.
3. Achieve a good degree of diversification.

Most of my investments are in index funds at this time. As mentioned above, it is easy, it is diversified and the return averages are acceptable. 

I have another post about how I do indexing for myself: Indexing simplified. 

How long is the list of tax advantaged retirement savings options?

The tax advantaged options are very few: 401k (and similar plans like 403(b), 457 and SEP), IRAs and HSA.

HSA is a special case: it is a health savings account but after age of 65 it can be used as an IRA.
401k and IRAs have 2 varieties: Roth and Traditional which means the contributions are post-tax or pre-tax. 

Here is this short list including contribution limits:

1. 401k (or Roth 401k) How to decide between regular 401k and Roth 401k 
    2018 limits: $18,500, catch up with 50 - additional $6,000


2. IRA (Traditional or Roth) How to use backdoor Roth IRA
    2018 limits: $5,500, at 50 - additional $1,000
      

3. HSA Why is it on this list
    2018 limits: 
    Individual $3,450, family: $6,900, 
    at age 55 - additional $1,000 (per person of age 55)


I am not counting the 529 college savings plan. Even if this account is in your name and theoretically it can be used as savings back up but the penalties are very high.



In the tables below are the maximum yearly contributions based on 2017 contribution limits. 
The first table is for a family with two working adults showing two 401k and IRA accounts and a family HSA.

You can see the added "catch-up" contributions at age 50 (401k and IRA) and at age 55 (HSA). 

The second table shows yearly contributions for a single person showing one 401k, IRA and single HSA.

The list is short and the contribution amounts are small. 
A high income professional will use up those options fairly soon. 
The rest of the savings will have to go into a taxable account. 

How does the "backdoor Roth IRA" work?

Assuming the taxes in retirement will be lower, then a Traditional IRA with tax-deductible contributions is a better choice.
 

However, not everyone qualifies for a traditional IRA with tax-deductible contributions. And not everyone qualifies for a Roth IRA either.

Still there is a way to have an IRA, which is called a "backdoor Roth IRA".

If you don't qualify for a Traditional IRA with tax deductible contributions, you still can open a Traditional IRA account. 
Your contributions will not be tax deductible but the money can be relocated from a Traditional IRA to a Roth IRA. After that the distributions will be tax-free. The money will grow tax-deferred. 

Here is how the conversion works step by step:

1. Open both, Traditional and Roth IRAs accounts with the same institurion.

2. First contribute to Traditional IRA.

3. As soon as the money comes into the Traditional IRA account convert the complete cash amount to Roth IRA (usually need to fill out a conversion form).

4. Repeat every year. 

It is convenient to contribute and convert the entire yearly contribution as lump sum due to paperwork. 
  

There are various options for IRAs accounts: from investments accounts which allow only mutual funds to brokerage accounts where you can buy stocks. 

Watch out for fees. Some offer no-fee accounts, and some have set-up, annual, termination or conversion fees. 


Contribution limit for both traditional and Roth IRA for 2017 is $5,500 ($5,600 if you 50 or older).  

In a Traditional IRA withdrawals are allowed starting age 59½ and the early withdrawal penalty is 10%. The required minimum distribution age is 70½.  

A Roth IRA is different - there is no age limit for early withdrawals. 
You can withdraw your contributions (contributions only, not earnings such as dividends, interest or capital gain) at any time without penalty.  
For the earnings there is a 5 year rule and the money have to be in the account for 5 years otherwise there will be a 10% penalty. 
Roth IRA also has no required minimum distribution rules.

The backdoor Roth IRA will close for contributions at 70½ because starting from that age no contributions are allowed to the Traditional IRA where the money has to go first. 

Will taxes in retirement be lower?

There are two views on how taxes will change in retirement. Some say they will go up or stay the same, the others say they will go down. Who is right? 

I wanted to know the answer when I got a recommendation from my 401k administrator to convert my 401k to a Roth 401k. 
He is convinced that it will be beneficial for me to convert and pay taxes now and get the distributions tax free later when I am retired. Yes I am in a high tax bracket now. But will it really stay the same in retirement? 


One possibility is that taxes in retirement will be the same or increase. This notion is mainly based on the fear and the experience that lately the taxes are more often increasing and rarely decreasing. 

The second view is that the taxes in retirement will be lower. This view is based on current tax code and the expectation that the tax laws will not change very much. 


When you work, you mostly just get a salary as a source of income - as one type of income.
When you retire, you will have different types of income. And the tax rules are different for different types of income. 

Here is the list of the most common types of income in retirement: 

1. Social Security benefits
This will only be taxed if you have additional income. No other income - no tax.
If you have additional income, up to 85% of Social Security benefits can be taxable.

  
2. 401k distributions
Traditional (non-Roth) 401k - the withdrawals will be taxed.
Roth 401 - withdrawals are not taxed.


3. IRA distributions 
Traditional IRA - withdrawals will be taxed. 
Roth IRA  - withdrawals are not taxed.


4. Investment gains (from taxable accounts)
Taxed will be dividends, capital gains (short or long term) and interest. 
If you are a HIP (=high income professional), you will "run out space" in your 401k and IRA due to the contribution limits and will have taxable savings and investment accounts with dividends, interest and capital gains.



5. Annuities
Some will have annuity distributions. Depending on the type of annuity different tax rules will apply.



I used various calculators, they are complicated. At the end I have an impression that my taxes in the retirement will either stay the same or will be lower. I asked my CPA and she hedged with "It is not possible to predict but generally the taxes are lower in retirement". 

I used various calculators, some were simple, some complicated. At the end I have an impression that my taxes in retirement will either stay the same or will be lower. 
That may influence some decisions like 401k to Roth 401k conversion. 
But overall it would be best just to have so much money that taxes will not matter.  

What is better - 401k or Roth 401k?

Will taxation in retirement matter for this choice?

My 401k plan adviser recommended to convert my 401k to a Roth 401k. That move will trigger substantial immediate taxes at the time of conversion. 
But it should make the later distributions tax free. 


Would this conversion make sense? 


Traditional 401k contributions are pre-tax. The money grows tax-deferred. When the money is withdrawn, every withdrawn dollar is taxed as ordinary income.

Roth 401k contributions are post-tax. Every contributed dollar is taxed. The money also grows tax-deferred. When the money is withdrawn, it is not taxed. 

With a Roth 401k I basically prepay my future taxes now.

When I pre-pay my taxes now, it will be at my current high tax bracket.
In retirement I will very likely have lower tax bracket.
It already doesn't make sense to pre-pay. 

In addition, I will probably not use up all my 401k money and part of the pre-paid taxes will go "unused".

My answer to my 401k adviser will be No. 

How much money do I need to stop worrying?

I remember days when my family didn't have enough money for buying bread. I was about 7 years old and I was scared. 

In school I had to smear the black shoe polish on my shoes every day, because they were so worn out, they were gray. The soles were glued back several times.

I was not allowed to touch eggs in the fridge if we had any. I liked to go to my friend for whom eating scrambled eggs every day was normal. She was nice to share with me sometimes. 

The winters were cold and I remember how I was dreading getting out from under the blanket in the morning because the house was so cold. 


Now I have my own house. It is never cold in my house. I eat eggs everyday, unless I am traveling. 

I promised myself that I will do everything I can to never be cold again. I keep my house at 72 F degrees in the winter even if my friends try to persuade me that I could save money by heating less and that it is healthier to sleep in a colder room. 


By now I have earned more money then both my parents in their entire lives combined. But I still feel unsafe. When will that feeling stop?

Financial uncertainty

Everyone is different. And the safety threshold to feel financially safe is different for everyone, dependent on their previous experiences.

When I researched about financial safety, I found a (quite esoteric) exercise which should produce your minimum number at which you will feel good/safe/comfortable. I tried it. 

Here how it goes:
You should say the dollar amount starting from small moving up and watch how you feel. At certain amount you will feel comfort. If you are under or over your comfort amount, that will make you feel uncomfortable, feeling "not enough" or "too much". 
My comfort amount was 2 million dollars. Per month! 


Obviously that exercise was useless, but it made me to find a more realistic method. I ended up with something what is generally recommended: calculating and estimating expenses versus savings.



What can I estimate? 


It is useful to make some estimates and projections. Nothing is certain so all the estimates and projections are very approximate.

As life goes on, there are 3 main development scenarios:

1. Something non-catastrophic happens, like loss of job.
2. Something catastrophic happens, like disability or death. 
3. Nothing will change. 


A windfall also can happen but it is not one of the main scenarios. It is rare, I don't expect it but I will handle it well. 


There are some things one can prepare in advance for the three main scenarios.  


1. A non-catastrophic event. 
It is good to be prepared for a non-catastrophic event like a job loss. 
The emergency fund is the best preparation here. The fund should cover expenses until you can find another job. 

The amount in the emergency fund will depend on the ease finding another job in your field and the estimated fixed expenses. 
For example, if you are a highly qualified specialist, such jobs are rare, and your fixed expenses are high, the emergency fund should be of appropriate size. 
Check. I've got that. 


2. A catastrophic event.
Life does not give any guarantees. For something catastrophic like disability, loss of partner or your own death some preparations could be done. 

Your own death will be the easiest. It will make all your worries (including financial) stop immediately. 

But if you want your family to betaken care of, a term life insurance would be a good choice. A term life insurance is cheaper because it will have no value at expiration. 
The point here is the replacement of lost income in case of death of income provider. 
Especially in families with young children it can be very important to have this kind of insurance.
Check. I've got that. 

A disability insurance should cover the case of disability. They are more expensive than term life insurances and are supposed to replace lost income. They don't cover disability related medical costs.
Check. I've got that. 

  
3. No events. 
Nothing will change. Expenses and savings will stay the same.
The usually recommended estimates of expenses versus savings will cover that.
No check. I have never estimated anything like that. I will work at that right now. 


To make those estimates for expenses versus savings I need 2 variables: years left to live and money amount to live on. 

Life uncertainty

Certainly there is an uncertainty about how long I will live but it doesn't bother me much if I die before my money runs out. If (when) I die, my financial worries will stop automatically. 
But to make the projections I need approximate expected length of life.

The Social Security Administration has actuarial life tables with estimates of the life expectancy.  They are for year 2014 and for that degree of uncertainty about life using them in 2017 will be fine. 

I am 43 now. Per table my life expectancy is 39 years. First thing I see is that I have less years left than I already lived. It is a little sad.

43+39=82. 


Maybe it is not so sad. I might have some genetic modifiers. My grandparents died at 85, 95, 56 (heavy smoker) and 68. 

Because of optimism (I would prefer to live longer) and because of pessimism (I would not like to run out of money) I will use the maximum: 95 (that means 52 years left for me). 

Actually even that might not be enough because I have a granduncle who is currently 102 years old (he was married several times, because his wifes kept dying before him). Maybe my extreme maximum should be 102 or even more.

Anyway, now with my life expectancy numbers I can start planning the financial part. 

Financial planning

Since the esoteric method gave me unrealistic results I will use information I found on most websites which calculate retirement planning related needs. 

According to most, the magic number is $3,000,000. That number makes you money never run out at 4% yearly withdrawal rate if you withdraw $100,000 per year. 

But will $100,000 be enough for me?


Calculating current fixed expenses 

I calculated fixed yearly expenses.

I didn't calculate the bare bone minimum. Bare bone minimum is too scary. I want to have enough room not to worry about my heating costs and other things that add to daily comfort. 
This is not a frugal estimate, this is a comfortable estimate. 

The expenses as of 2017 are about $55,000. 




 Estimating fixed expenses in retirement

After retirement some expense items will disappear, for example term life insurances and disability insurance. 

I estimated that the expenses are a little lower, about $42,500.
But they are not inflation adjusted yet.  

Now I will add 3% of inflation to every item, using inflation calculator (I used one on www.calculator.net).

At age 65 with yearly 3% inflation the $42,500  will become $81,270. 

Due to continuing inflation the number will continue to change. By my age of 85 (in 42 years) it will be $146,790. 
Of course those are only the estimates, inflation may be lower or higher... 

Calculating necessary amount of savings

As mentioned before, the magic number for the amount of necessary retirement savings should be $3,000,000. 

That number should make you money never run out at 4% yearly withdrawal rate if you withdraw $100,000 per year. 


But it looks like I might need $146,790 at age 85 (if I live that long). 


To better see what happens, I made two tables, using various calculators on www.bankrate.com.
The first table includes estimated Social Security benefits. 

The maximum Social Security benefit for 2017 is $2,687 ($32,244 yearly). 
Because Social Security is under stress and the benefits might not keep up with inflation, I will use only 1% inflation for the adjustments of Social Security benefits.

The second table doesn't have Social Security benefits.

For the savings growth rate I will use very low 1% growth rate. Markets will go up and down. Historical results don't predict the future. We all know that.

I am probably underestimating growth and overestimating spending, but I am not calculating the best case scenario. In general, I like to under-promise and over-deliver and it definitely shows here. 

In the table below the projected savings at age 65 (in 22 years for me) are $3,000,000. 
Is it a realistic number? That is a completely different question (for a different post). 

Back to the table. 
With the chosen settings of 1% returns and estimated expenses rising with 3% inflation it is clear that this $3,000,000 number will decrease with time. 

Difference to cover is the amount to be covered from savings after the Social Security benefits. 

The last line in the table is the age when the money will run out.

Looks like this estimate makes the money to run out at my age of 108. 

The second table is without Social Security benefits. 
Here the money runs out at my age of 95.  

Of course all numbers are very approximate. 

Taxes and not calculated. 

The taxes are estimated lower in retirement because they are mostly based on earned income. Other presumed factors also may be different.

But now I have something to work with and when I will approach my retirement age, it will be easy to recalculate and see where I stand. 
I probably will recalculate it more than once.

Summary

It looks like a $3,000,000 nest egg will be enough if getting Social Security benefits. 

I need at least $3,000,000  with or without Social Security.

Without Social Security benefits the money will run out at my age of 95. 

I really don't want to feel the pressure to die at age of 95.

What I need is to get busy with how to make sure the returns above 1% so I don't have the pressure to die at 95 or at 108. I want to beat my granduncle.  



10/12/2017:
I just posted an update with additional information and some recalculations.

What to do with health savings account (HSA)?

Health savings account is the new reality for almost everyone.
In the mind of most it is only connected to out-of-pocket medical expenses. But actually there is more...

In 2018 a single person can contribute a maximum of $3,450 per year into the health savings account. A family can contribute $6,9000 per year (actually it is only $6,850 - the amount was retroactively decreased by $50 in March 2018). All contributors have to have a high deductible health care plan as a requirement.
After age of 55 you can add an extra $1,000 per year. 

Starting at age 65 you will be on Medicare and you can't contribute to the HSA anymore, but you still can use this money for qualifying expenses.
   

Here is a summary of HSA features:

1.  Contributions are tax-deductible (you can set up deductions which will be taken from your pay check before tax or you can pay one time sum and deduct it from taxes at the time of tax return, see explanations below). 

2. The account grows tax-free (dividends, gains and accumulated interest are not taxed at the year end).

3. For approved medical expenses the withdrawals are tax-free (qualified expenses are copays, deductibles, coinsurance, dental and vision expenses and some other. Insurance premiums don't qualify. If you use the money from HSA for non-qualified expenses, you have to pay income tax on that amount (plus a 20% penalty if you’re under 65).

 4. HSA is not to confuse with FSA. The money in FSA (Flexible Spending Account) has to be used up by the end of the year or it will disappear.
The money in HSA will stay, it is yours. If you change your employer, it is still yours. 
Some employers contribute some amount to your plan and that money is yours too.

Here is some elements of an HSA that not everyone is aware of: 

1. After age of 65 HSA turns into a sort of traditional IRA account which favors medical expenses: you contribute money pre-tax, it grows tax-free and the withdrawal amounts are taxed at your ordinary income rate unless they are qualified medical expenses. 
There are no minimum required distributions at age of 70½ like in other retirement accounts (401k and IRAs). 

2. The money going into HSA via payroll deduction (via Cafeteria plan) is not subject to FICA (Federal Insurance Contributions Act, the amount goes toward Social Security and Medicare). 401k and IRAs contributions are subject to FICA and the difference here is 7.65% (Social Security 6.2 % and Medicare 1.45%).
If you use an HSA account not trough your employer and contribute money post-tax, there will not be savings of those 7.65%. There is also no mechanism to get it back or refunded. If you have more than one account, it would make sense to make all or at least majority of your contributions trough payroll deduction.

3. Not all HSA accounts are the same. They vary dependent on institution: a simple checking account or an investment account with mutual funds or even investment accounts with possibility to invest directly in stocks (for example Fidelity HSA). 

Most people just go with the HSA account offered trough employer.
If every year you use up all money you put that same year, a checking account will work just fine.
If you have none or very little expenses and money accumulates, it would be nice to invest at least part of it.
If you got stuck with a simple checking account but want to use investment opportunities for your money, what can you do?  

You can open your own HSA with the institution of your choice. Just go with a reputable company/bank and choose an account type dependent on your risk profile and needs.

How to avoid loosing the 7.65% (FICA) if you decide to open an account separate from your employers account?
It can be done. You will still use payroll deductions for your contribution and send the money to the employer related HSA. Then you will transfer the money to your own HSA.

This can be done specifically with HSA-to-HSA transfer. Par Fidelity customer support the transfers can be done any time and they are unlimited if the transfer is bank to bank. 
If it is a rollover, there is a 60 days limit to finish the transaction. 
This transfer is usually not associated with any costs and has to be initiated from the institution you want the money to go to.
You can request HSA-to-HSA transfer forms, fill them out and request the transfer. It usually takes 2 weeks. 
I transfer the entire cash amount every year, once a year, and that goes from a checking HSA to my HSA with investment capabilities. Investment accounts usually have maintenance/management fees (for example mine has $12 per quarter).  The account fees may vary from bank to bank. 

Some HSAs with investment capabilities have minimum required amount to start investing and that amount can be as high as $4,000. I picked one without any minimums.


How much is the 7,65% FICA difference in real numbers?

If you calculate the 7,65% on the yearly contribution amounts it is $260 for singles and $516 for family.
Some may say that this reduction of your contribution to the Social Security will reduce your future Social Security benefits. That is correct but I personally would prefer $561 per year in my own hands and not as nebulous promise in the future. 

If you are born in 1960 and later, your full retirement age defined by Social Security Administration is 67 years. Currently you can contribute to the HSA till age of 65, and in time from 55-65 you can put in an additions $1,000 (additional FICA savings of $76 per year).

If I decide to maximize my Social Security benefits and make all HSA contributions avoiding payroll deduction, this fill amount to $12,112 (7.65% FICA, calculating with contribution limits for 2017,  $516*22 (22 years till age of 65) + $76.5*10 (10 years of additional $1,000 contributions) = $12,112).

I don't know how big of a role will that amount play in increasing the social security benefits. The retirement age may be moved again and the benefits may be reduced. There are so many uncontrollable elements, that I just prefer to have that money, invest it myself and not hope to increase an uncertain benefit by an uncertain amount.


Some estimate that lifetime out-of-pocket health care costs for a 65 year old person retiring this year will be approximately $400,000. A rare HSA even successfully invested will come up to that amount.
If I take an example of someone of an 42 years old with contributions he doesn't use, invests all the money with an average of 5% yearly growth, in 23 years he will have approximately $250,000.