Tax advantaged accounts contribution changes in 2019

Contribution limits for 401k, 403b and most 457 plans are increased to $19,000.
For people over 50 - catch-up contributions are additional $6,000.

Traditional IRA and Roth IRA: $6,000.
For people over 50 - catch-up contributions are additional $6,000.

HSA: $3,500 for single and $7,000 for family.
For people over 55 - catch-up contributions are additional $1,000.

 

What is FDIC and SIPC? How much money is safe to keep per account?

Every proper bank has a disclosure on their web site: FDIC insured up to $250,000. But what does it mean exactly?

What happens if you have more money than $250,000? Is your money at risk?

Probably only people who approach $250,000 in an account will ask those questions.

There are 2 types of insurance for different types of accounts.

The FDIC insurance is for deposit accounts: checking, savings, money market accounts, sweep accounts and certificate of deposit (CDs).

Surprisingly the retirement accounts such as IRA and 401k are included. The $250,000 insurance is per depositor per account category.


The SIPC insurance is for securities held in a brokerage account. The brokerage accounts are protected for up to $500,000 for securities and $250,000 limit for cash.

Why is there limit of only $250,000 for cash? Brokerage firms use sweep accounts for cash and cash is swept into deposit accounts through bank sweep programs. These sweep accounts are covered by FDIC insurance, which goes only up to $250,000 limit per person per each account type. 

All deposit accounts are FDIC insured per depositor, per each account category. 

That means that if you have one joined checking account with two co-owners, the entire account is insured for $500,000 ($250,000 per co-owner). If you have more accounts of the same type with the same bank, the limit will be shared among all accounts of the same type.

If you have a checking and a savings accounts with the same bank, the amounts will not be shared because those are different type accounts.

If you have two checking accounts and one savings account and all of them are joined, the insured amount will be $500,000 for both checking accounts and another $500,000 for the savings account. 

If you have an additional singe non-joined savings account with the same bank, this single account will share the limit with your portion of the insured amount in the joined savings account.  

If in addition you have more than one CDs, they all are counted as one account type.

The interesting thing is that IRA and 401k are insured by FDIC, only up to $250,000. Both IRAs and 401k accounts are considered to the same type of account. Health savings account is also in the same category. That means that the FDIC insurance limits will be shared among all three accounts if you have them at the same institution and entire sum of retirement money in IRA, HSA and 401k will be insured only up to $250,000. It might be the best to hold IRA, HSA and 401k with different institutions unless you are sure you will never reach the limits.

You can use the Electronic Deposit Insurance Estimator (EDIE) to play with the numbers and see what is insured and how. It works OK to get the feeling.

But who keeps so much money in a checking or savings account? You want your money to work and produce returns.

A more interesting question is how brokerage accounts are insured.

As I was approaching the $250,000 in my brokerage account I wanted to know if I should start opening  more brokerage accounts with other banks to have all money covered.

The securities in a brokerage account are insured by SIPC for up to $500,000. If there is cash in the account, the cash goes into the sweep account and which will be insured by FIDC for the time being.

I usually don't hold more tan $250,000 of cash in that account (yet). It is a joined account, So the sweeped cash is insured up to $500,000 because of 2 depositors and the securities are insured up to $1,000,000.

With all that information it looks like in my joined brokerage account I can hold up to $1,000,000 in securities including up to $500,000 in cash. This amount in cash is not in addition to securities but as parking cash position when some securities are sold and before the new once are bought. So total will still be $1,000,000.

Obviously there is still time left before I will get over those limits and will have to open another brokerage account.

And I probably worry too much. My research on the web showed that the SIPC insurance had to be used are exceedingly rare and that FDIC was used more frequently than SIPC.  

What happens when a FDIC insured bank fails?

The FDIC replaces cash up to insurance limits. It happens within few days of bank closing and it provides the insured with a new account at another bank and the insured will receive a check with the amount. If the money exceeds the limits, the bank assets will be first liquidated and the proceeds will be divided between debtors pro-rata.

Paying off student loan aggressively versus maxing out 401k?

 

My friend M. asked me following question: "Initially we were going to pay off the student loans aggressively and be done in 12-14 months. Now we are considering maxing out both 401ks to get the tax benefit. What makes more sense?"
 
 
The question is about prioritizing. Prioritizing maxing out 401k versus paying off loans.
But there are few more things which are in the priority list.
Usually after finishing residency most physicians have following major items where a lot of money has to go:

Loans
Student loan
House mortgage
Car payments
Insurances
Term life insurance
Disability insurance
Car/home/liability insurance
Savings
Health savings account
Savings for retirement
 
 
How to prioritize them?
 
One way is to prioritize by risk/consequences.
 
Prioritizing by risk means to prioritize by the most detrimental impact which have to be taken care off first. For example, if the breadwinner of the family dies, his/hers income should be replaced in some way.
 
The insurances can be grouped together and should be taken care of first:
 
1. Disability - will cover lost income.
2. Term life - will pay out a certain sum of money to cover lost provider, is necessary is the loss of provider will be financially very hard on spouse and/or child.
3. Car/home/liability insurances - helps with large assets in the worst case scenario if they need to be replaced, liability gives additional protection in case of unintentional harm to others.
 
After you are done with that, you can move to the group of Savings and Paying off loans:

1. Health savings account - for current or future disease related expenses.
2. Savings for retirement 401k, Roth IRA - if prioritizing by risk, tax-deferred accounts should be put before paying off mortgage because there is a better protection for retirement accounts in case of a bankruptcy - you get to keep your pension and retirement plan funds. In Tennessee tax-exempt retirement accounts, including 401(k) are protected. Roth IRA is protected up to $1,283,025 as of 2018. (This amount is adjusted every three years. For detailed information for your state go to NOLO.com.)
3. Car payment, house mortgage and student loan - I would group them together especially if they have similar low interest rates. They are not as well protected as retirement accounts.
 
 
But what if you say: Yes, prioritizing by risk is all good, but I personally think that the bankruptcy risk is very low for me. Maybe it will be better for me to pay off the student loans or mortgage first, before maxing out 401k and Roth IRA?
 
 
I already wrote about the difference of paying off the mortgage early versus investing the money that was used for the extra principal payments. Investing comes out ahead.

With current interest rates, it makes more sense financially to invest instead of paying off the mortgage early. If your interest on student loan is in the same ball park as the current mortgage rates, that would have the same effect. And by investing in a tax-deferred account like 401k, you will also receive tax savings. 


How much tax savings can you get?
 
If you contribute maximum ($18,500 for 2018) to the pre-tax 401k, you will save $5,920 in 32% tax bracket and $6,475 in 35% bracket. This is a significant amount which can be put into Roth IRA ($5,500 in 2018, see my post on how to use the back-door Roth IRA).

In 2018 most physicians will be in the 32% or 35% bracket.
If both spouses are maxing out their 401k, the tax savings are doubling and will be $11,840 in 32% bracket and $12,950 in 35% bracket, which is enough for maxing out both Roth IRAs.
You will not get those tax savings if you choose to contribute to Roth-401k (see here why I don't do Roth401k).
 


If you are 45 years old now and will make yearly contributions of $18,500 to your 401k, then at the age of 65 with 6% yearly growth and 3% inflation the balance will be $700,949. The number is of course approximate because returns will vary.
 
If you decide to pay off your student loans first, you will have less years left to contribute before tax. Dependent on how many years you will have left to contribute, you will forgo on:

19 years left:
401k balance at age 65: $643,297
Difference in total savings balance at age 65: $57,652
Lost tax savings, 1 year: $5,920
 
18 years left:
401k balance at age 65: $588,907
Difference in total savings balance at age 65: $112,042
Lost tax savings, 2 years: $11,840


But that is not all.

The employers contributions were not taken in account yet.

How much employers contribute is variable. The total maximum on total contributions (employee plus employer) is $55,000 in 2018 (or 100% of your salary, whichever is less).
This means that your employer could contribute up to $36,500 in 2018. 


In summary, if you compare paying off a low interest loan like a mortgage or a low interest student loan, versus investing in a taxed account, you will come out ahead with investing.

If you compare paying off a loan versus contributing to a tax-advantaged account like pre-tax 401k, you will not only come out ahead with investing but also have your savings grow fax free, you will save on taxes and you will get employer's contributions.




 

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.