Archives for February 2023

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HSA Contributions: Effect on FICA Tax and Social Security Benefits

A reader writes in, asking:

“On the subject of social security, extremely belatedly I realized my ‘catchup’ strategy of max deferral to traditional 401(k), HSA, and sometimes traditional IRA impacts my social security benefits.

Have you looked at this at all, is there a strategy for deferrals that would take impact on social security into account? By this point the ship has sailed for us (I think), but maybe it’d be beneficial to others to keep this in mind or understand the trade offs.”

To back up a step, the effect this reader is asking about (i.e., contributions reducing your FICA tax and therefore potentially reducing your ultimate Social Security benefit) is specific to HSAs — and it only applies when contributing as a payroll deduction.

That is, contributions to a tax-deferred 401(k), contributions to a traditional IRA, and contributions made from a checking account to an HSA will all reduce your adjusted gross income (and therefore taxable income), but they do not reduce the amount that shows up in Box 3 of Form W-2 (“Social Security wages”). And they will not, therefore, reduce your ultimate Social Security benefit.

For contributions that you make to an HSA on a pre-FICA-tax basis (i.e., contributions made as payroll deductions, rather than money going from your checking account into an HSA), yes, they do reduce your Social Security wages for the year. And they will therefore reduce your ultimate Social Security benefit, unless a) the reduced amount of Social Security wages for the year is still above the limit ($160,200 for 2023) or b) you still have 35 other years of maximum taxable earnings.

Many people though (in particular, people with higher earnings histories) will actually find the net result to be positive. That is, the taxes saved are likely to be more valuable than the reduction in ultimate benefit. Specifically, that’s most likely to be true for anybody whose 35 highest years of (wage-inflation-adjusted) earnings will ultimately put them above the second “bend point” in the PIA formula. (In today’s dollars, that would require about $2.8 million in wage-inflation-adjusted earnings during those 35 years — an average of about $81,000 of earnings per year over 35 years, in today’s dollars.)

There is a bit more to it than that just earnings history though. For example, the greater the number of people who will receive a benefit on your work record, the more detrimental a smaller benefit would be. So, for example, somebody whose spouse did not work for pay and who has one or more adult disabled children would be more likely to find it advantageous to pay the additional Social Security tax, relative to another person with the same earnings history.

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Investing Blog Roundup: Treasury Interest from Mutual Funds and ETFs (Avoiding Unnecessary State Income Tax)

Interest from Treasury bonds is exempt from state income tax, and that’s just as true for interest from Treasury bonds held by mutual funds that you own. But as Harry Sit points out this week, the 1099-DIV the brokerage firm sends you doesn’t tell you how much of the dividend distribution from a fund is from Treasury bond interest. If you don’t go look it up yourself, you can end up paying unnecessary state income tax.

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Social Security and Safe Spending Rates

A reader writes in, asking

“I’m a big fan of Morningstar and the stuff they’ve released recently on ‘safe withdrawal rates.’ My question is how I should be thinking about future Social Security payments, when I calculate my ‘safe withdrawal rate.’

To me, it makes sense to add the NPV (calculated conservatively) of the future Social Security payments that I expect my wife and I to receive to our current portfolio, before I do the math on what our starting annual withdrawal number looks like.

Have you published anything on how to think about that question?”

That’s a great question, and it gets directly to the limitations of safe spending rate research. That is, such research is very helpful for determining approximately how much a person should have saved before retiring, but when trying to use it as an actual spending plan, it comes up somewhat short.

The biggest issue isn’t that the strategy of spending a fixed (inflation-adjusted) amount from the portfolio every year is necessarily a bad strategy (though it does have some drawbacks). Rather, the issue is that such an idea is simply not applicable for most real-life households.

That is, in most households, it’s rare that (inflation-adjusted) spending from the portfolio will be kept constant from one year to the next, because the amount of non-portfolio income changes meaningfully over time — for example as the person semi-retires, then fully retires, then Social Security begins. And for a couple, there are even more distinct phases, because there are twice as many retirement dates and twice as many Social Security start dates.

As far as considering the expected present value of your lifetime Social Security benefit to be a part of the portfolio, and then calculating an initial spending amount accordingly, the issue I see with that is that it depends significantly on what real interest rates are at the time of the calculation. And the higher that real interest rates are (i.e., the higher the discount rate used in the PV calculation), the lower the PV will be, which would indicate spending a lower dollar amount. And that’s rather backwards (i.e., higher real interest rates should indicate that you can spend at a higher rate).

My preferred way to incorporate Social Security into the analysis is to consider it a reduction in spending, for the years in question.

You can do this manually. Calculate what your non-portfolio income will be, year-by-year (including Social Security, earned income, and anything else). Then you can carve out a piece of the portfolio to “replace” that income in the years in which it won’t exist. And then you can spend at a fixed (inflation-adjusted) rate from the rest of the portfolio. (In the context of Social Security, this is often referred to as creating a “Social Security bridge.”)

Very basic example: Bob is single. He’s 65, just retired. He plans to file for Social Security at age 70, at which point he’ll get $36,000 per year. He could allocate 5 x $36,000 = $180,000 to something safe (e.g., a short-term bond fund or a 5-year CD ladder). And he could spend from that chunk of money at a rate of $36,000 per year. And he would spend from the rest of his portfolio at a fixed (inflation-adjusted) rate, which would lead to a fixed (inflation-adjusted) total spending rate also.

As mentioned above though, a real implementation of this idea is likely to be more complicated than this simple example, because there may be a phased retirement — or perhaps a pension or annuity that starts on some particular future date. And there may be two people involved, which would mean even more dates at which the level of non-portfolio income will shift.

Also, ideally, the above calculation would be done on an after-tax basis.

And, admittedly, all of that can get rather cumbersome when taking a DIY approach.

If you want, you can use financial planning software for this, because it can do all of this math (including the taxes) very quickly. The software I use for retirement spending analysis is RightCapital. It’s great, but it’s priced for advisors. The only reason I mention it is that, because I’m happy with the software that I’m using, I’m not also spending time test-driving a whole bunch of other software packages. So I can’t confidently recommend one software package or another for individual users. I have heard good things about the following, but I have not tested them myself.

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Investing Blog Roundup: I Bond Interest Confusion

A reader wrote in, wanting to share this experience in case it’s helpful to anybody else who has recently purchased I Bonds for the first time.

“I purchased $10K worth of I-Bonds for the first time in 2022, specifically on July 1st, when the annualized interest rate was 9.62%. Funds left my bank account on that same day, July 1st. Fast forward to mid-January; using straight-line logic, I’m expecting to see $481 posted into the account, perhaps a few bucks less, but only associated with timing issues. I didn’t expect to see only $236 posted (???) Could not work the math, any which way.

Called the Treasury Department, waited almost two hours on hold before talking to a human being. The Rep was fabulous to deal with – polite, professional, and knowledgeable – but the two hours on hold was brutal. He assured me that I HAD earned the full interest, but shared with me that Treasury does not actually post the interest accrued into the account, even if only for viewing purposes, due to the ‘3 month penalty’ rule for holding the security for less than 5 years. According to the Rep, this is on a rolling calendar basis and the most current 3 months of interest will NEVER show in the account, until the ‘held for 5 years’ criteria is met. The owner will never see the full interest accrual until year 5.”

Other Recommended Reading

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