Little Things Add Up

One way that I like to help my clients is to point out “little things” in their financial situation that initially may seem insignificant, but over time can result in substantial savings. Here are a few ideas that I often see:

#1 – Missing spousal catch up on HSAs

Many people these days have high deductible health plans (HDHPs) with a health savings account (HSA) attached to it. For 2024, the contribution limits are $4,150 for an individual and $8,300 for families. If you’re age 55+, you can deposit $1,000 as a catch-up contribution. However, many married couples with both spouses age 55+ will only do a single catch-up contribution in addition to their family contribution (e.g. $8,300 + $1,000 = $9,300). These folks often assume that they can only have a single HSA, but that’s not the case. It’s perfectly fine for the 2nd 55+ spouse to open their own HSA and deposit $1,000 into it.

This “extra” HSA contribution may seem like small potatoes. After all, it’s only $1,000. But if you can make this 2nd catch-up contribution for the years between when you turn 55 and before starting Medicare at age 65, and then let the HSA assets grow over time, the benefits can add up.

For example, if you make ten $1,000 catch-up contributions into an HSA, then at the end of 20 years (assuming a 6% growth rate) you would have about $23,600. If you had instead saved the $1,000 in a taxable brokerage account with 0.50% of tax “drag” (or a 5.5% after-tax return), you would end up about $1,600 worse off.

But you also get a tax deduction when making an HSA contribution. If we assume a 27% ordinary tax rate (22% federal + 5% state), then you would receive a $270 reduction in your tax bill for each $1,000 catch-up contribution. If you invest these savings in a taxable brokerage account over 20 years at 5.5% (again, after the 0.5% of tax “drag”), you would have about $5,900 after-tax.

All in, you could end up with an additional $7,500 of after-tax assets in 20 years by making the ten “extra” HSA contributions vs just saving those funds in a taxable brokerage account.

#2 – Spending down HSA assets early

Many people save money in their HSA, but then spend the funds right away or fail to invest the funds inside the HSA for long-term growth. Losing out on these potential long-term, tax-free investment returns doesn’t make much sense to me.

Again we’ll assume a 20 year time horizon and a married couple making $8,300 contributions each year to their HSA. If the funds are held in the HSA and invested at 6%, they can expect a future value of $305,000. If they choose to spend down the funds inside the HSA and instead invest within a taxable brokerage account at 5.5% (after an estimated 0.50% of tax drag), then they might end up with closer to $290,000.

And again, a small difference can add up to $15,000 of savings over time.

#3 – Missing out on backdoor Roth IRA contributions

Many high earners make too much to contribute directly to a Roth IRA. As a result, they have to make what’s known as backdoor Roth contribution. The backdoor Roth contribution involves two steps:

1. Make a non-deductible IRA contribution to a pre-tax/Traditional IRA
2. Immediately convert the assets to a Roth IRA

If you do it right, then there should be no tax due on the backdoor Roth. However, many folks in this situation have pre-tax money in an IRA – perhaps due to a 401(k) rollover from an old job – which can bring something called the pro rata rule into play and muck up the works when it comes time to execute the Roth conversion portion of the strategy.

You can avoid this situation by moving all pre-tax IRA dollars into some sort of 401(k) plan (either a employer based plan or a solo 401(k)), but this generates extra complexity and tends to cause people to throw their hands up and give up on the opportunity.

But what’s the cost for missing out on the backdoor Roth contribution? I’ve seen estimates for married couples that put the marginal value of backdoor Roth contribution at $1,000 per year. So after 20 years, it’s conceivable that a married couple could save $20,000 over that time if they choose to stick with the strategy.

#4 – Proper investment location

I see many investor’s who simply have their assets located in the wrong accounts.

When it comes to asset location, the #1 thing you can do is hold as many fixed income assets that pay taxable interest or ordinary dividends within pre-tax or Traditional accounts as possible within the framework of your target asset allocation.^* In effect, you want to shelter the ordinary dividend and interest payments within a tax protected account. Here are a few reasons why this can make sense:

1. Interest and ordinary dividends in a taxable brokerage account are taxed at ordinary tax rates, which are higher than the capital gains tax rates that apply to qualified dividends and long-term capital gains from stocks.
2. Fixed income investments usually pay higher rates of income on a rigid schedule. All else equal, this reduces tax flexibility compared to long-term capital gains – which are only taxable when realized. If these fixed income payments are in an IRA, you can regain some of that lost tax flexibility.
3. Stock investments receive a step-up in basis at the death of the owner which wipes out any associated capital gains tax liability. Assets held in an IRA do not. The higher expected returns on stocks compared to bonds can allow investors to potentially maximize this benefit. By holding fixed income assets into an IRA, investors can create more room for stocks in taxable brokerage accounts.
4. Holding stocks in a taxable brokerage account can also increase opportunities to harvest tax losses. Taxpayers can also use $3,000 per year of capital losses to offset non-capital-gain income such as wages.

It’s important to note that proper asset location doesn’t really effect on your asset allocation or the expected riskiness of the investment portfolio. Instead, proper asset location can simply help reduce the burden of taxes on your portfolio over time.

I think a rough estimate of the potential benefit from proper asset location is in the neighborhood of 10-20 basis points (bps) or 0.10%-0.20% per year. Some folks may think the benefit is higher, but I’m skeptical. And on its face, 10 bps doesn’t sound like much. However, if you start with a $1,000,000 and earn 5.5% vs only 5.4%, then after 20 years, you could expect to see about $55,000 of additional wealth. And this amount would only increase with time.

#5 – Not taking full advantage of 529 deductions

If you are a Virginia taxpayer and you pay tuition for a family member at a private K-12 school, then you might consider parking $10,000 per year in a 529 account for a couple days. Not to invest, but simply to harvest the state tax deduction. This can save you $575 per year per student. Over 13 schooling years, those savings invested at 5.5% could yield over $10,000 of savings per student.

And if you exhaust your 529 assets, but you still have ongoing educational expenses for a family member, then you might again consider parking those funds in a 529 account for a few days to gain the state tax deduction.

If you don’t live in Virginia, be sure to check the tax benefits offered by your state and make sure that you make full use of them.

#6 – Sub-optimal charitable giving strategies

The Tax Cuts and Jobs Act of 2017 significantly increased the standard deduction amount, while at the same time curtailing the availability of itemized deductions. As a result, most people who give to charity only get a limited tax benefit. However, with a few adjustments, it’s often possible to harvest more of the available tax benefits. Some ideas to consider include:

1. Avoid giving cash. Instead consider giving appreciated securities.
2. Stack multiple years of charitable giving into a single tax year. For example, if you give $5,000 per year to charity, maybe try giving $25,000 to a donor-advised fund now, and then send $5,000 to charities over the next five years.
3. If you are over age 70.5, consider using qualified charitable distributions (QCDs).
4. Consider giving under state tax credit programs.

All of these giving strategies have the potential to increase tax savings, especially over long periods of time

Conclusion

It’s certainly important to get the “big things” right when it comes to personal finances. By “big things,” I mean items such as:

• Choosing an appropriate claiming strategy for Social Security
• Purchasing adequate insurance coverage
• Implementing a robust estate plan
• Saving and spending at appropriate levels
• Creating a low-cost, low-maintenance investment portfolio
• Nurturing a process of good behavior management and decision making

These “big things” will often make the difference between success and failure in your retirement plan. So be sure to take care of the “big things” first, but don’t ignore the “little things” either. If you can combine some of the items listed here, you could reasonably expect to see savings of $50,000 – $100,000 or more over time. And most of these strategies only require a few minutes each year to implement and maintain.

And as the saying goes… every little bit helps.

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^* Note the emphasis on taxable fixed income investments. If you own municipal bonds or other tax-exempt fixed income investments, you’re better off keeping those in a taxable brokerage account.