January 2022 - Finance Memos

Financial Tip #12: Impact of mortgage debt on longevity risk

The existence of mortgage debt in retirement is shown to substantially increase the likelihood a person will totally deplete their retirement account and will have to rely exclusively on Social Security and Medicare for all expenses.

The Situation: Consider a person who took out a 30-year mortgage, 15 years prior to retirement. The initial balance on the mortgage was $600,000 and the interest rate on the mortgage was 3.6 percent.

The person retires with $1,000,000 in her 401(k) plan but the retiree also has an outstanding mortgage of $378,975 and an ongoing monthly mortgage payment of $2,728.

The retiree plans to spend $40,000 per year $3,333 per month to cover non-housing consumption in retirement.

The total annual disbursement from a 401(k) plan for a person with a mortgage is $72,735.

The total annual disbursement from a 401(k) plan for a person without a mortgage is $40,000.

Question One: What are the outstanding balances of the retirement plan after 15 years for a person with a mortgage and a person without a mortgage if the rate of return on investments in the retirement plan is 6.0 percent per year?

Answer:

The outstanding 401(k) balance after 15 years for the person with a mortgage is $691,380.

The outstanding 401(k) balance after 15 years for the person without a mortgage is $1,484,698.

Question Two: What are the 401(k) outstanding balances after 15 years if the person started retirement with $900,000 in 401(k) assets.

Answer:

The person with the mortgage has a 401(k) balance of $445,971 after 15 years.

The person without a mortgage has a 401(k) balance of $1,239,290 after 15 years.

Implications for longevity risk:

The existence of a mortgage payment substantially increases the depletion rate of the 401(k) plan. The mortgage payment cannot be avoided during market fluctuations. The existence of a mortgage during a market downturn at the beginning of retirement can have an especially adverse impact on retirement wealth.

The discussion presented here does not explicitly consider taxes.

All traditional 401(k) assets are fully taxed as ordinary income.

The person with higher spending due to a mortgage will have also have higher taxes.

This person may increase spending to have adequate non-housing consumption.

Financial Tip #11: Roth Conversions Early in Retirement

People entering retirement with liquid assets outside of their retirement account should delay claiming Social Security benefits, delay disbursement from traditional retirement plans and convert traditional retirement assets to Roth assets. This strategy requires substantial liquid assets outside of a retirement account

A previous post explored the potential gains from converting traditional retirement assets to Roth assets whenever taxable income was low. This post explores a specific situation, the conversion of traditional retirement assets to Roth assets early in retirement prior to a person claiming Social Security benefits.

Discussion:

Many financial advisors recognize the benefits from delaying claims in Social Security benefits.

Social Security benefits are reduced by 30 percent for workers born 1960 or later who claim retirement benefits at age 62 instead of 67. In addition, each month delay in claiming retirement benefits after reaching the full retirement up to age 70 age, increases benefits by 2/3 of 1 percent. Go here to the SSA site for a discussion of advantages of waiting until the full retirement age to claim Social Security benefits. Go here for a discussion of the advantage to claiming Social Security at age 70.

The potential gains from delaying 401(k) disbursements and delaying claiming Social Security benefits while converting traditional retirement assets to Roth assets have not been fully publicized.

The strategy of converting traditional retirement assets to Roth assets early in retirement can be profitably implemented if the household has substantial financial assets outside of a retirement account to fund current consumption. In some cases, these liquid assets can be obtained by a household downsizing to a smaller home and using the house equity to fund consumption.

The cost of converting traditional retirement assets is the additional tax paid on the increased income stemming from the conversion. A household in retirement not claiming Social Security benefits and not disbursing 401(k) funds will have a low marginal tax rate and low conversion costs.

The benefits of the conversion of the traditional assets to Roth assets are the reduction in tax during the year Roth assets are disbursed instead of traditional assets. The amount of Social Security benefits subject to federal and state income tax is linked to modified adjusted gross income. Since Roth disbursements are not taxed and not included in modified adjusted gross income the disbursement from a Roth instead of traditional retirement plan can have a substantial impact on taxes.

Go here for a discussion of the taxation of Social Security benefits.

Funds obtained from investment returns on the conversion of conventional assets to Roth assets cannot be disbursed without penalty or tax for five years starting January 1 of the year of the disbursement. The five-year rule pertains to investment returns on all conversions, even those that occur after age 59 ½.

An example of returns from converting traditional assets to Roth assets in retirement:

This example of the potential advantages of converting traditional retirement assets to Roth assets early in retirement was published in this Tax Notes article.

A married couple — filing a joint return with $10,000 in investment income — converting $34,550 in traditional assets to Roth assets would have taxable income of $19,750 and would pay $1,975 in tax. The cost of conversion in this instance is $1,975, the difference in tax paid with the conversion and the tax paid without a conversion.

The investment of $34,550 in a Roth account that earns a 6 percent annual return would be slightly more than $46,000 in five years. The one- year conversion would, in this instance, pay for the $39,000 distribution and would leave $7,000 for future distribution.

A household distributing $50,000 from a traditional retirement account would pay around $7,072 in tax. The household that distributes $39,000 from a Roth account and $11,000 from a traditional account would pay approximately $400 in tax.

The total tax savings from the conversion, assuming a 6 percent return on converted assets is around $7,700.

The rate of return on the conversion is estimated a 30.7 percent.

Concluding Remark: People entering retirement can extend the longevity of their retirement savings by initially using non-retirement assets to fund consumption, by delaying claiming Social Security benefits and 401(K) disbursements, and by converting traditional retirement assets to Roth assets.

Health Policy Memos: Fixing Disparities in Health Insurance Premiums and Outcomes

Several disparities in health insurance outcomes in the United States could be resolved by combining employer-based and state exchange insurance markets, by modification of the premium tax credit for state exchange insurance, and through the creation of new low-cost insurance options.

Introduction:

Nearly 12 years after enactment of the Affordable Care Act (ACA), substantial disparities in the cost of health insurance still exist. Some middle-income young workers without access to employer health insurance receive no premium subsidies and cannot afford state-exchange premium payments. Some low-income households with an offer of “affordable” employer-based health insurance are precluded from claiming the premium tax credit for state exchange insurance. This post discusses potential changes to ACA rules that would address these problems.

Background:

The Affordable Care Act (ACA) created state exchange health insurance markets for people without employer-based health insurance. The creation of a viable state-exchange market created an incentive for some firms to eliminate employer-based insurance.

The ACA maintained a dominant employer-based health insurance system through the inclusion of two rules.

The first rule described here disallows the premium tax credit for any person working at a firm that offers “affordable” employer-based health insurance. Affordable insurance was defined as self-only insurance costing less than 9.61% of household income.

The second rule, commonly called the employer mandate, described here, is a fine applied to large employers that do not provide affordable comprehensive insurance to 95 percent of full time employees.

These two rules have limited the size of state-exchange marketplaces. Currently, around 12 million people obtain their health insurance from state exchange compared to around 156 million people obtaining health insurance from their employer.

The American Rescue Plan (ARP) enacted by Congress and the Biden Administration includes provisionsmaking health insurance on state exchanges more affordable. The ARP increased the generosity of the premium tax credit for lower-income households, capped benefits at 8.5 percent of household income, and eliminated the rule denying any benefits to households with income exceeding 400 percent of the federal poverty line FPL.

These provisions of the ARP expire after 2022 unless extended by Congress. The Biden Administration has not altered the affordability rule, or the employer mandate and employers are still the source of health insurance for most working-age people and their dependents.

Analysis of Disparities in Health Insurance Premiums:

The existence of a large employer-based insurance market coupled with a fringe market for households without offers of employer-based insurance has caused disparities in health insurance premiums and outcomes.

State-exchange subsidies fail to assist young middle-income people seeking self-only coverage:

The premium tax credit provides a generous benefit to older households seeking expensive family-plan policies. However, the premium tax benefit often provides very little or even no assistance to young adults seeking self-only coverage.

The premium tax credit is not available to employees at firms offering employer-based insurance. Management of firms that decide to end offers of employer-based insurance to assist older workers seeking family coverage often substantially increase health insurance costs for young workers seeking self-only coverage.

The impact of the decision to offer employer-based coverage on two workers is illustrated with data from the Kaiser Family Foundation state exchange market-place calculator and data on the cost of employer-based coverage from the Kaiser Family Foundation annual survey.

The KFF state exchange premium tax calculator reveals a 30-year-old individual making $80,000 per year seeking self-only coverage would pay $4,664 for health insurance on a state exchange. This worker would not receive any premium tax credit. The average annual premium paid by a worker with employer-based insurance with self-only coverage is $1,299.

The KFF state-exchange premium tax calculator was used to find the premium and support provided to a family making $80,000 a year with two adults aged 50 and two children one age 12 and one age 15. The estimated financial help from the government in the form of a premium tax credit was $16,406 per year. The average cost to the family was $4,840 per year. The average cost to the worker for the family plan policy is $5,969 per year.

Many firms that offer employer-based health insurance subsidize all or part of the premium. The average subsidy in 2021 was $6,440 for single coverage and $16,253 for family coverage.

Small firms not subject to the employer mandate can avoid these costs by eliminating employer-based insurance. The decision to eliminate employer-based coverage helps older workers with families and creates additional costs for young adults seeking self-only coverage.

Health insurance issues for people who cannot afford their share of premiums of employer-based insurance:

Many people with an offer of employer-based insurance are ineligible for the premium tax subsidy for state exchange insurance even if the state exchange marketplace offers more affordable and more comprehensive health insurance options.

People with an offer of affordable health insurance from their employer are precluded from claiming the premium tax credit because of the affordability rule. The definition of affordable health insurance is based on the affordability of self-only health insurance leaves employer-based family coverage unaffordable for over 5 million families. These five million families are ineligible for premium tax credits but cannot afford a health insurance plan covering their entire family offered through their employer.

Many people believed the IRS incorrectly interpreted the affordability definition in the ACA because the original law contained an individual mandate. The repeal of the individual mandate may make this argument harder to make since people are no longer fined for lack of coverage.

The Biden Administration has not altered the employer mandate or the affordability rule. The definition of “affordable” in the affordability rule continues to be based on the cost of self-only insurance leaving around 5 million households unable to afford a family option.

The alteration of the affordability rule could cause some small firms to eliminate offers of employer-based insurance, could cause some large employers to pay fines under the employer mandate and could increase insurance costs for some firms.

The decision by the Biden Administration to leave the “affordability” rule and the employer mandate in place limited the impact of the more generous premium tax credit on the size of state exchange markets.

Reforms to health insurance markets designed to reduce the disparities in health insurance premiums:

Many disparities in health insurance premiums can be addressed by combining the employer and state exchange markets, by modifying the premium tax credit and through the creation of new low-cost but comprehensive health insurance options.

The proposed health insurance marketplace has the following rules.

All employers would be allowed to purchase health insurance for their employees on state exchanges rather than sponsor an employer-based policy exclusively for their own employees.

The employer subsidy for state exchange insurance would be a deductible business expense and would not be subject to personal income tax, as with the current treatment of employer expenditures on employee health insurance.

Employees would be allowed to use the employer subsidy for the purchase of any health insurance plan on a state exchange.

The state exchange would offer a public option or a new low-cost copper option.

Large employers choosing the new premium subsidy would be required to provide a subsidy equal to 60 percent of the cost of the state-exchange policy for every full-time employee.

Employers providing a subsidy on state exchanges would be required to provide the subsidy to all full-time workers.

Firms could make tax free subsidies up to 100 percent of the cost of a gold plan on state exchanges.

Self-employed people and people without an employer-based subsidy would receive a premium tax credit.

The new premium subsidy would have a floor of 40 percent of the cost of a silver plan and a ceiling like the existing premium tax credit based on household income.

The state exchange will offer a public option already offered in some states or a low-cost private option, patterned after the copper plans considered by Alexander and Murray.

Comments on the proposal:

Comment One: Businesses and workers could continue with employer-specific plans if insurance companies continue to provide the product. It is likely that workers and firms would prefer state-exchange subsidies because workers could choose any plan on the state exchange best meeting their needs.

Comment Two: Unions would negotiate the size of the health insurance premium and workers at firms with generous premium subsidy offers could purchase the most expensive state-exchange health plan.

Comment Three: The smallest permissible subsidy from employers and from the revised premium tax credit should be enough to cover the cost of the copper plan or the public option.

Comment Four: The floor of 40 percent of the cost of health insurance of a silver plan on the premium tax credit is less generous than the floor on employer-based insurance but it assures that a young adult seeking self-only coverage would obtain some support and does not dissuade companies from offering a more generous subsidy to attract talent in a competitive job market.

Comment Five: The public option proposed here is not free. The person could choose to spend its subsidy for a low-cost private or public option or could choose to purchase a more expensive private plan. The new system puts private insurance on a relatively even footing with the government option.

Comment Six: The new low-cost private and public options would be superior to short-term health plans that leave people with substantial financial exposure and do not protect people with pre-existing conditions.

Comment Seven: The existence of private high deductible health plans with tax-preferred health savings accounts could induce many households to select a private plan over the public option to take advantage of the tax savings from contributing to private health savings accounts. This tax savings would not be available for public insurance plans or for private comprehensive insurance plans.

Comment Eight: Some aspect of this proposal could be enacted through the tax reconciliation process by majority vote as described here.

Concluding Remarks:

Many disparities in health insurance outcomes could be resolved by having firms subsidize the purchase of state exchange health plans, through the modification of the existing premium tax credit and the creation of low-cost but comprehensive health public and private health insurance options.

Financial Tip #10: Convert traditional 401(k) funds to a Roth when income is low

The cost of converting a traditional IRA to a Roth IRA, the additional tax paid on the amount of the conversion, is generally low in years where a person leaves the workforce. The potential tax savings in retirement is considerable.

Introduction:

Often people leaving the workforce raid their retirement plans to fund current consumption. A departure from the workforce creates an opportunity for people to convert traditional retirement assets to Roth assets at low cost. The low-cost conversion to Roth assets can substantially improve financial outcomes in retirement. Households are only able to make this low-cost conversion if they have a decent ratio of liquid assets to debts.

Analysis:

A previous post, financial tip #6, found that people leaving a firm with a high-cost 401(k) plan should roll over funds from the high-cost 401(K) to a low-cost IRA to increase wealth at retirement. The rollover is often a prerequisite to converting traditional 401(k) assets to a Roth.

The tax code allows for the conversion of traditional IRAs to Roth IRAs. Distributions from a Roth account in retirement are not taxed and do not count towards the amount of Social Security subject to tax. The person converting previously untaxed funds in an IRA pays income tax on the converted funds in the year of a conversion. The cost of converting traditional assets to Roth assets, the additional tax paid stemming from the conversion, is low when households have marginal tax rates.

Marginal tax rates are lowest when a worker or a spouse leaves the workforce. This can happen when a person returns to school, decides to care for a family member, becomes unemployed or retires.
- Conversion costs are $0 if AGI including the amount converted is less than the standard deduction ($12,950 for a single filer).
- Conversion costs for single people filing an individual return are 10 percent of taxable income AGI minus the standard deduction for taxable income between $0s and $14,200. Increases in taxable income up to $54,200 increase conversion costs by 12 percent, the marginal tax rate.

The potential gains from converting traditional retirement assets to Roth assets early in a career perhaps when returning to school are tremendous.

A person leaving the workforce for school for a couple of years at around age 28 might convert $20,000 from a traditional IRA to a Roth at a cost of around $2,000.

The balance of the Roth account from this conversion after 30 years assuming a 6.0 percent return is $114,870.

The direct tax savings from the conversion assuming a tax rate of 10 percent would be $11,487. An indirect tax savings from the omission of tax on Social Security, assuming around $50,000 in Social Security payments spread over a couple of years, would be around another $5,000. The conversion can be thought of as an investment of $2,000 leading to a return of around $16,000 in around 30 years. The rate of return for an investment of $2,000 and a return of $16,000 in around 30 years is around 7.2%.

A person in a low tax bracket because she is young and single and returning to school and only working for the part of the year could be in a much higher tax bracket in retirement, especially if married and both spouses worked and claimed Social Security. In many cases, the returns from converting a traditional IRA to a Roth will be much higher than the one reported by the simple example in the above bullet. A person living 100 percent on Roth distributions and Social Security could easily pay $0 in annual tax after accounting for the standard deduction.

A person returning to school full time with no reported earnings could convert an amount equal to the standard deduction to a Roth and pay no additional tax. It would be irrational for a person with a 0 percent marginal tax rate to fail to make a conversion.

Workers leaving the workforce are often more concerned about meeting immediate needs than for planning for retirement. However, conversion costs are small during a year a person leaves the workforce.

Workers leaving the workforce with debt or with 401(k) loans often distribute funds from their 401(k) plan, pay a penalty and tax, and are unable to rollover or convert funds to a Roth.

The five-year rule imposes tax and penalty on funds disbursed from a Roth IRA funded through a conversion from a traditional IRA within five years from January 1 of the year of the conversion. A separate five-year waiting period is applied to each conversion. The five-year rule applies for conversions after age 59 ½ even though all funds in Roth accounts funded by contributions can be withdrawn without penalty and tax at that age. The purpose of the five-year rule for conversions and its implementation even after age 59 ½ is to prevent immediate access to funds in a traditional retirement account. The five-year rule for conversions appears to apply to disbursements from both contributions and earnings for both pre-tax and after-tax IRAs.

Concluding Remarks: The cost of converting a traditional IRA to a Roth IRA, the additional tax paid on the amount of the conversion, is generally low in years where a person leaves the workforce. The potential tax savings in retirement is considerable.

Several additional posts on IRA conversions are planned. One post considers issues related to conversions of non-deductible IRAs in a procedure called a backdoor IRA. A second post considers the advantages of converting pre-tax IRAs during retirement.

Student Debt Policy Proposal #1: Eliminate or substantially reduce first-year student debt

The elimination of student loans during the first year of college would lower total student debt incurred by most borrowers and provide the largest benefits to people most likely to default.

Potential Policy Changes: The proposals outlined here involve restrictions on student debt for first-year students, increased financial assistance for first-year students, and new programs to expand access to higher education prior to college.

Specific Proposed Policy Changes:

Design and provide funding and incentives for creation of financial assistance packages leading to a debt-free or tuition-free first year at both community colleges and four-year institutions.

Eliminate federal student loans until students have 9 credit hours of college credit from AP courses, community colleges or accredited on-line programs.

Provide federal, state, and private funds for programs that increase college-level work prior to college.

Increased incentives for quick transfers from community colleges to four-year institutions.

Comments:

Students who take out loans and do not complete college are around 3 times more likely to default on their loan than student borrowers who get a degree. The reduction of first-year debt will reduce the debt burdens of people who leave school early and are most likely to experience payment problems.

A proposal eliminating student debt for first-year students would reduce debt burdens by $5,500, the maximum allowable student loan for dependent first-year undergraduate students, if all other borrowing was held constant.

The stipulation that people complete some college level courses prior to full-time college will reduce initial access to higher education by low-income and minority students. However, these groups with higher student debt burdens would gain the most reduction of first-year debt.

The stipulation for some college level experience prior to full-time college would better prepare people for college and would reduce dropout rates.

The elimination or reduction in debt among people who leave college after a year or two could facilitate reentry to college after people get some job experience.

Low-income and minority students also stand to benefit the most from new programs that increase access to and use of higher education courses prior to full-time college. For some students, access to a community college or high-quality on-line course would be preferable to access to an AP course with a high fail rate.

Universities would be encouraged to increase off-semester admissions to facilitate the admission of more students after a single semester at a community college.

The proposed increase in financial assistance at both four-year and two-year institutions will allow more qualified students to choose a four-year alternative. By contrast, the Biden Administration free-community college proposal would encourage some qualified applicants to delay or forego four-year options.

Private schools and historically black colleges could also benefit from changes in financial assistance packages depending in part on the incentives tied to use of federal funds.

The changes in financial assistance programs could differ across institutions depending on the level of tuition and the level of state or private support.

Concluding Remarks: Many people are unprepared for full time college and the burdens of student debt immediately after graduating college. The proposals outlined here would help many young adults become better prepared for higher education before taking on any debt.

Financial Tip #9: Payoff the entire mortgage prior to retirement

Avoid taking mortgage debt into retirement to substantially reduce the likelihood of outliving your retirement savings.

Tip #9: People with mortgage debt in retirement must often take large taxable distributions from their 401(k) plan regardless of the level of the stock market. The elimination of all debt prior to retirement substantially reduces the likelihood a person will outlive their retirement savings.

General Discussion: Many financial advisors believe it is appropriate for their clients to keep some debt in retirement. They will advise their clients to take out a 30-year loan instead of a 15-year loan to increase contributions to a 401(k) plan and to take full advantage of the deductibility of mortgage interest. They also argue that people nearing retirement should make additional catch-up contributions to their 401(k) plan instead of increasing payments on their mortgage.

The decision to keep debt in retirement is a recipe for financial disaster, especially if the household is reliant on fully taxed distributions from a 401(k) plan and partially taxed Social Security benefits.

Issue One: The person with debt will more rapidly deplete their 401(k) plan and will pay higher taxes in retirement.

Discussion: A person taking out a 30-year $500,000 mortgage, 15 years prior to retirement has annual mortgage expenses of $26,609. The person that used a 15-year mortgage enters retirement debt free. See the example presented in Financial Tip #4 Guidelines for the choice between a 15-year and 30-year mortgage.

The person with the mortgage debt must either reduce non-mortgage expenditures or distribute additional funds from their retirement account to maintain the same consumption as the person that paid off her entire mortgage prior to retirement.

Large tax-deductible mortgages reduce payment of federal and state income taxes in working years but increase payment of federal state and income taxes in retirement.

Retirees without business expenses generally have lower itemized deductions than people in their prime earnings years, hence, the advantages from itemizing in retirement are often small.

An increase in the distribution of 401(k) funds to cover the mortgage is fully taxed as ordinary income.

An increase in 401(k) distributions increases the amount of Social Security subject to income tax as discussed on this page offered by the Social Security Administration.

Issue Two: The person without debt is better able to maintain current consumption levels and preserve wealth during market downturns.

Discussion: Typically, a person attempts to maintain a certain level of consumption perhaps 60 percent of pre-retirement income throughout retirement. A person with a mortgage or a monthly rental payment is less able to reduce expenditures when the value of stocks in their 401(k) falls because the mortgage payment or the rent are not optional.

Any reduction in disbursements from 401(K) plans, which are reduced in value due to a collapse in stock prices, would have to occur from a reduction in non-housing consumption.

The largest financial exposures occur when the market falls by a substantial amount in the early years of retirement when the entire savings from working years is exposed to the market. The market downturn in stocks in 2008 was somewhat offset by an increase in bond values. This time around both stocks and traditional bonds appear to be in a bubble. People may want to consider Series I or inflation bonds as discussed in financial tip #7.

Still, the best way to prepare for a market downturn is to eliminate all debt prior to retirement.

Concluding Remarks: During working years, many households take on a large amount of mortgage debt to reduce current year tax obligations. Failure to eliminate all mortgage debt prior to retirement often leads to rapid depletion of 401(k) assets, higher income tax burdens in retirement and increased exposure to financial volatility.

Financial Tip #8: Make contributions to a health savings account a high priority

Households with high-deductible health plans (HDHPs) need to contribute to their health savings account (HSA) even if lack of funds and limited income causes them to decrease savings for other goals.

Tip #8: The growth of high-deductible health plans (HDHPs) has increased financial risk and created an incentive for many people to reduce expenditures on essential health services. People with high-deductible health plans need to contribute to a health savings account (HSA) to offset these risks. When funds and income are limited, the increase saving for health care will reduce savings in retirement accounts and general liquidity.

Background on Health Savings Accounts:

An HSA is a tax-preferred saving vehicle for people who enroll in an HDHP. The primary advantage of an HDHP is reduced premiums for the employer and the insured person. The primary disadvantage is the insured must pay a large share of health expenses.

The minimum deductible on a HDHP in 2022 is $1,400 for individual coverage and $2,800 for family coverage. The maximum allowable out-of-pocket limits in 2022 are $7,050 and $14,100. It is permissible for the HDHP deductible to be as high as the out-of-pocket limit. A typical HDHP policy requires the insured person pay a share of all health care expenses after the deductible is met and until the out-of-pocket limit is reached.

HSAs, created as part of the Medicare, Prescription Drug Improvement Act of 2003 are now a major insurance option. An HDHP is the only plan offered by around 40 percent of employers and is sometimes the most affordable option through employers or on state exchanges.

People with high-deductible health insurance coverage are often exposed to large medical bills, take on high levels of medical debt, and often choose to forego necessary medical treatments. The health consequences can be especially severe for people who forego prescription drugs for chronic conditions.

People can reduce the adverse health and financial impacts associate with HDHPs by contributing to an HSA. However, this study by JAMA reveals that one in three people with an HDHP do not have an HSA and that 55 percent of people with HSAs failed to contribute to their account. An article by SHRM cites work by EBRI which found more than half of people initiating contributions to HSAs do so by reducing contributions to 401(k) plans.

The IRS caps the amount of funds a person can contribute to a health savings account. In 2022 the caps on health savings account contributions are $3,650 for self-only plans and $7,300 for family plans.

Contributions to HSAs result in significant tax advantages. The contribution to the account is not taxed during the year the contribution is made. The funds are never taxed if they are used for a qualified medical expense. Funds used for non-medical purposes prior to age 65 are subject to a 10 percent penalty. There is no tax penalty after age 65.

After age 65, funds disbursed from a HSA are fully taxed but are not subject to penalty. Funds placed in a traditional 401(k) plan are always fully taxed but are not subject to a penalty after age 59 ½. Fund placed in a Roth account and investment returns from funds in a Roth are completely untaxed after age 59 ½. In addition, withdrawals of contribution to a Roth are completely untaxed at any time.

Allocation of Resources between HSAs and other saving vehicles:

People with limited income and high debt have a difficult choice between saving for health-related expenses through a health savings account or saving for other priorities. There is no one-size fit all approach to the appropriate savings strategy.

Finance Tip #2, concluded that it was okay for a person entering the workforce with high student debt to forego contributions to a 401(K) plan to prepare for emergencies, maintain a solid credit rating and rapidly reduce their student debt. An HSA reduces taxes and allows for the use of funds for medical expenses. Young adults who have high debt and are dependent on a HDHP should likely contribute to an HSA instead of a 401(k) fund.

People with access to a 401(k) plan that does not match employee contributions are likely better off with a combination of a Roth IRA (see finance tip #3) and an HSA. The HSA gives some tax relief in the year of the contribution while the Roth IRA provides substantial tax savings during retirement.

Workers at a firm that matches employee contributions to a 401(k) plan should maximize receipt of the employer match, as discussed in finance tip #5 and then contribute additional funds to a mix of a Roth IRA and an HSA.

The choice between contributing the last dollar to a Roth or the last dollar to an HSA is affected by several factors.

The HSA is the only preferential savings plan that I am aware of that allows for a tax-free contribution and distribution. HSA distributions for qualified medical expenses are never taxed. The Roth contribution is fully taxed but all distributions after age 59 ½ are tax free and the distribution from the Roth does not increase tax incurred on Social Security benefits. Workers nearing age 59 ½ will often prioritize Roth contributions because the tax-free distributions could be used for any purpose.

HSA funds can be used to fund retirement after age 65, however, funds not used for medical expenses are fully taxed. It makes sense to spend HSA funds for health care and retirement funds for general consumption.

Concluding Remarks: The process of saving for retirement is complicated. Simply plowing everything into a 401(k) is not an optimal strategy. As noted in Financial Tip 2 people drowning in debt should even forego matching contributions into a 401(k) plan until they can bring their debt down to a manageable level.

The growth of HDHPs complicates the savings process. The increased likelihood of incurring high health care expenses increases the need for an emergency fund. A health savings account, like a 401(k) contribution, provides both immediate tax savings and funds for medical emergency. The analysis presented here and in previous supports the need for investors to use diverse savings vehicles.

Financial Tip #7: Invest in Series I Savings Bonds whenever possible

Middle income households should purchase some Series I Bonds from the Treasury annually.

Tip #7: Series I Savings Bonds should be included in every investor’s portfolio. This asset purchased directly from the U.S. Treasury without fees is an effective hedge against inflation and higher interest rates.

Characteristics and rules governing Series I bonds: The Series I bond, an accrual bond issued by the U.S. Treasury tied to inflation, is described here.

Key Features of Series I Bonds:

Backed by the full faith of the U.S. Treasury

Cannot be redeemed until one year after issue.

Redemptions prior to five years from issue date forfeiture of one quarter of interest.

The composite interest rate changes every six months,

The interest rate is based on two components – a fixed rate and the inflation rate.

The composite rate is guaranteed to not fall below zero.

The interest is taxed when the bond is redeemed.

Bond matures and stops paying interest after 30 years.

The Treasury limits annual purchases of the bonds to $15,000 per person with a limit of $10,000 on electronic purchases and $5,000 on paper purchases. The paper Series I bonds can only be purchased through refunds from the IRS.

Reasons for Purchasing Series I Bonds:

Series I Bonds, unlike traditional bonds and bond ETFs, do not fall in value.

In the current low-interest rate high valuation environment, traditional bonds and stock prices are almost certain to decline in value.

A retired person with I-Bonds outside of a 401(k) plan can respond to a market downturn by using proceeds from the redemption of I-bonds to fund current consumption rather than disburse funds from a 401(k) plan, which could be temporarily down in value.

The Series I Bond is a riskless asset. Investors with this asset can reduce holdings of traditional bonds and cash and increase investments in equities.

Difference Between Series I Bonds and TIPS:

Treasury Inflation Protection Securities (TIPS also allow investors to protect returns when inflation and interest rates rise.

Key differences between TIPS and a Series I bond as explained here:

The TIPS value can fall in an era of deflation. The Series I bond never falls in value.

The tax on interest from TIPS is paid annually and not deferred to redemption

TIPS bonds can be sold without forfeiture of any interest at any time. The redemption of a Series I bond is not allowed until after a year from the purchase date and sales prior to five years from the purchase date involve a forfeiture of a 3 months of interest.

All TIPS can be counted as a liquid asset. Only Series I older than 5 years from issue should be considered liquid.

Up to $5.0 million in TIPS can be purchased in a single auction. The annual limit on the purchase of Series I Bonds is $15,000.

Thoughts on Series I interest rates:

The current fixed interest rate on a Series I Bond is 0 percent. The current composite fixed + inflation component on bonds purchased prior to May 2022 is 7.12%. A delay in the purchase of a Series I bond until the second half of the year could result in a permanently higher fixed rate. However, investors would lose an annualized return of 7.12% accruing in May.

Bonds purchased years ago in a high interest rate environment have a higher current composite rate because the fixed component is higher. People are currently aware of I-Bonds because of the elevated inflation rate. The purchase of I-bonds also makes sense when inflation is low and interest rates are high because the investor will obtain both a higher fixed rate and increases in interest when inflation returns.

Concluding Thoughts: Investors should purchase a Series I bond every year. Investors who maximize receipt of the employer matching contributions to a 401(k) plan can then divert additional investments to a Roth IRA or a Series I Bond. People without a 401(k) plan that allows matching contributions should contribute to a Roth, invest Roth contributions in equities, and divert some funds to the purchase of Series I bonds.

Excel Hint #4: Calculating the future value of a mortgage

A key advantage of choosing a 15-year mortgage over a 30-year mortgage is the more rapid decrease in the mortgage balance and increase in house equity. This post discusses the use of Excel to calculate the future value of different mortgages.

Situation: A person is considering two options for a $500,000 loan. The first option is a 30-year term at an interest rate of 3.4%. The second option is a 15-year term at an interest rate at 2.9%.

How can Excel be used to calculate the mortgage balance at 7 years for the two options?

What are the mortgage balances for the two options after seven years?

The Calculation: The future value of the mortgages above are calculated in Excel with a two-step procedure.

Step One:

Calculate monthly payment from the PMT function.

The arguments of the PMT function are – the monthly interest rate, the maturity of the loan in months, and the initial loan balance.

The 30-year monthly payment is PMT(0.034/12,360,500,000) or $2,217.41.

The 15-year monthly payment is PMT(0.029/12,180,500,000) or $3,428.91.

These monthly payment values are input for the second step.

Step Two:

Calculate the outstanding loan balance from the FV function.

The arguments of the FV function are — the monthly interest rate, the number of months the mortgage is held, the monthly mortgage payment, and the initial value of the mortgage.

The outstanding mortgage balance at 7 years for the 30-year loan is FV(0.034/12,84,2217.41,500,000) or $424,180.

The outstanding mortgage balance at 7 years for the 15-year mortgage is FV(0.029/12,84,3428.91,500000) or $293,466.

Concluding thoughts: The more rapid build-up of equity from the use of a 15-year mortgage can allow a person to sell a home and pay off the mortgage even if housing prices fall. The calculations presented here were used in finance tip #4, a discussion of the advantages and disadvantages of 15-year and 30-year FRM.

Financial Tip #4: Guidelines for the choice between a 15-year and 30-year mortgage

People with substantial liquidity and secure income should choose a 15-year mortgage over a 30-year mortgage.

Tip #4: The selection of a 15-year mortgage reduces lifetime interest payments, leads to a rapid increase in house equity, and reduces the likelihood a person retires with debt. However, many homebuyers cannot qualify for or afford a 15-year loan.

A Numerical Example:

We compare outcomes from a $180,000 15-year and 30-year fixed rate mortgage. The analysis assumes interest rates of 2.9% for the 15-year loan and 3.4% for the 30-year loan, a typical spread for the two maturities.

The monthly interest payments are $1,234 for the 15-year loan and $798 for the 30-year loan.

The total interest payments over the life of the loan are $42,193 for the 15-year loan and $107,376 for the 30-year loan.

The total lifetime loan payments are $222,120 for the 15-year loan and $287,280 for the 30-year loan.

The remaining mortgage balances after 15 years are $0 for the 15-year loan and $112,435 for the 30-year loan.

Problems with the use of a 15-year mortgage:

Many potential home buyers cannot qualify for a 15-year mortgage. Whether an applicant can qualify for a 15-year mortgage depends on—household income, the size of the mortgage and magnitude of other debts. Lenders restrict monthly mortgage payments to around 30 percent of income and total monthly loan payments to around 40 percent of income. The applicant for a $180,000 mortgage considered above would require an annual salary of $49,360 for a 15-year loan and $31,920 for a 30-year loan, based solely on the limit on permissible mortgage debt.

A household with a secure job and large levels of liquid assets is better positioned to take out a 15-year mortgage than a household with a less secure position and a lower level of liquid assets. The choice of a 15-year mortgage necessitates more funds for an emergency; however, financial experts are largely silent about the amount of additional liquidity that is needed for recipients of a shorter-term loan. One potential rule of thumb is for borrowers to keep liquid funds equal to 12 monthly mortgage payments. Note as discussed in Finance Tip 3, contributions to Roth IRAs can be withdrawn at any time without penalty or tax, hence, owners of Roth IRAs may require less cash savings for emergencies than owners of traditional retirement plans.

The higher monthly payment associated with the use of a 15-year mortgage may cause the household to reduce contributions to retirement plans to meet daily living expenses. However, retirement plan contributions could increase once the mortgage is paid off. A decrease in contributions to traditional retirement plans can increase federal and state income taxes.

The use of a 15-year mortgage could reduce the amount of interest that is deducted from income against both federal and state income tax. The potential impact of the choice of a mortgage on taxes is small in the early years of the mortgage when most of the monthly payment is interest and high in the final years when the mortgage payment goes mostly toward payment of principal.

Substantial home equity can be seized by creditors even in a bankruptcy situation in most states. People with aggressive creditors or people facing litigation may want to maintain a large mortgage to repel claims by creditors.

Advantages of 15-year mortgages

The use of a 15-year mortgage allows for a rapid accumulation of housing equity, which can be used as a down payment for a future house purchase. The higher accumulation of equity from the use of a 15-year mortgage increases the likelihood that a person will be able to pay off the old mortgage and put a large down payment on a new home even if house prices fall in value.

Consider the outstanding mortgage balance on a $500,000 mortgage at a 30-year term at 3.4% or a 15-year term at 2.9%. The outstanding mortgage balances after 7 years are $424,180 for the 30-year term and $293,466 for the 15-year term. The outstanding mortgage balances after 3 years are $469,697 for the 30-year loan and $415,548 for the 15-year loan. The use of a 15-year loan can lead to substantial build up in house equity even over short holding periods when housing prices don’t rise.

A decrease in resources spent over a lifetime on home purchases increases resources available for other goals. Monthly mortgage payments are higher during the first 15-years of a 15-year loan but are non-existent after 15 years. The ability to end mortgage payments after 15 years is extremely important for a person nearing retirement, especially if this person is reliant on a traditional retirement plan, with fully taxed disbursements. The elimination of all mortgage debt prior to retirement allows retired workers to reduce 401(k) distributions, avoid tax and avoid rapid depletion of their 401(k) plans in years where the market is down.

Concluding Remarks:

Many real estate brokers favor the use of 30-year mortgages because it allows the buyer to entertain the possibility of a more expensive home. Many financial advisors favor the use of a 30-year mortgage because it allows the household to make larger contributions to retirement plans and brokerage accounts. These advisors often overstate the potential tax savings from the use of 30-year mortgages and often fail to discuss the extreme importance of total elimination of the mortgage prior to retirement.

The use of a shorter term mortgage allows a home buyer to accumulate equity quickly. Potential homebuyers should be able to calculate the impact of their mortgage choice on their future mortgage balance and future equity. Go to Excel Hint 4 for a discussion on how to calculate the future outstanding mortgage balance.

The use of a 15-year mortgage requires the homeowner to have a larger liquidity cushion to avoid payment problems from unforeseen events. Many people with low levels of liquid assets at the time of the house purchase and mortgage origination should refinance to a 15-year mortgage after increasing their annual income and their liquid assets.