It’s Open Enrollment Time: What to Look For
The leaves are starting to change, football season is back and open enrollment is about to begin for most employees. Most people simply choose the benefits they selected the previous year. It’s only human nature; go with what you’re used to. We beg to differ, however. Open enrollment is a great opportunity to review your options and ensure you’re taking advantage of the choices available. You can potentially save money and/or gain new benefits that provide more protection for your family.
The first thing to look for is whether your 401(k) plan now allows for a Roth 401(k). This first became available in 2006 and applies to both 401(k) and 403(b) plans. Employers have been slow to implement them, but we’re starting to see it more. Most people recognize the Roth IRA because it’s been around since 1998. The problem with it, however, is that there are contribution restrictions related to income.
Currently, a married couple must earn less than $160,000 of modified adjusted gross income ($110,000 for a single individual) to contribute to a Roth IRA. The contribution is post-tax, meaning the tax payer cannot deduct the contribution. Because it’s post tax, Roth IRAs allow for tax deferral and tax-free withdrawals after 59½ years of age. Additionally, Roth IRAs don’t have a required minimum distribution at any point during the account owner’s life, whereas the 401(k) and traditional IRA require these RMDs to begin at age 70½. In an interesting twist, Roth 401(k)s have RMDs, but Roth IRAs don’t. This means Roth 401(k) participants should perform a direct rollover of their Roth 401(k) to a Roth IRA upon termination of their employment.
Due to the income limitation, very few high-income earners accumulate significant Roth IRA balances. At Redwood, we’re big believers in “retirement income diversification.” We want our clients to have a nice balance of their retirement portfolio in Roth IRAs, traditional IRAs and 401(k)s as well as taxable brokerage accounts. The beauty of the Roth 401(k) is that there are no income limitations; anyone can make contributions.
An employee is allowed to contribute $17,000 to the Roth 401(k) and also take advantage of another $5,500 of “catch-up” contribution if they’re over 50 years of age. The employer match must be made into the traditional 401(k) account. The $17,000 limit applies to all 401(k)s, meaning you can’t contribute to both plans; the overall limit must be “shared” between the two. To avoid the Roth 401(k) RMD requirement, the employee can roll the Roth 401(k) into a Roth IRA via direct rollover upon termination of employment.
The ultimate planning for the Roth IRA is to then leave the account to an heir. In doing so, the account becomes an inherited Roth IRA, which requires distributions over the new accounts owner’s life. For example, if a husband dies and leaves his Roth IRA to his wife, she can leave the combined Roth IRA balances to their son/daughter. This allows the balance to continue being tax-deferred over the son’s/daughter’s life and provides tax-free distributions. The deferral period can be very long and the tax advantages carry on for the next generation.
High-deductible health plan
The second item to look for during open enrollment is whether your employer now offers a high-deductible health plan that you can couple with a health savings account (HSA). There are many things to consider when selecting an HSA.
I’m only going to focus on the ability to turn it into a “Roth IRA-like” account to be used within the context of long-term investing/retirement planning.
HSAs allow for the money within the account to be invested, so some clients use theirs as an investment account. They also allow for the “holy grail” of tax/investment planning:
• a tax deduction on contributions into the account
• tax deferral of the account growth
• tax-free distributions from the account when used for qualified medical expenses
I say the account is like a Roth IRA because of the tax-free distributions, but in actuality, it’s better than a Roth IRA because it allows for tax-deductible contributions as well.
HSAs work as follows:
Contributions are made to the account either through payroll deduction, which allows for pre-tax treatment, or through deposits that then must be claimed on the tax return.
The employee can withdraw amounts (tax free) during the year to pay for qualified medical expenses. Most employers issue employees debit cards to allow for easy withdrawal.
For our strategy, however, we don’t withdraw the amounts. We let them carry over to the following year. (HSAs differ from flexible spending accounts in that the balance can carry over from year to year and accumulate over time.)
In 2012, an individual covered under a high-deductible plan can contribute up to $3,100 to his/her HSA. A family plan allows for up to a $6,250 contribution. A catch-up contribution also is available in which participants who are 55 or older can contribute another $1,000 to the account. Similar to an IRA contribution, HSA contributions can be made until the tax return is filed (i.e., prior to April 15).
Now that the contribution is made, the amounts can be invested into whatever investments are available via the HSA trustee. One of the trustees we refer clients to allows for a broad array of Vanguard mutual funds. Over the years, as the contributions accumulate, your HSA balance can potentially become a great tax-free asset that you can use during retirement. Qualified medical expenses can include Medicare premiums, which start at age 65. There are plenty of opportunities to use the HSA balance for medical expenses as the account owner ages.
Many other factors should go into a high-deductible healthcare plan, including whether your family has the cash flow to fully fund the HSA account and not to draw from the account during the year as medical expenses are incurred. Also keep in mind that a high-deductible plan has a high deductible, meaning your out-of-pocket costs during the year could potentially be higher. An appropriate amount of money must be available for the out-of-pocket maximum that applies to the plan. Due to the high deductible, the plan’s premiums are lower, which saves some money over the course of the year. Plan participation also still allows for assessment of the insurance negotiated rates.
The third and final thing to look for during open enrollment is your long-term disability (LTD) options. Disability is the worst possible thing that can happen to an income earner:
• the individual can no longer work and make money
• the individual’s medical expenses now increase
• the individual’s life insurance does not pay off for the benefit of the family
Long-term disability is insurance designed to assist the disabled with continuing their income stream and paying for the ongoing medical and normal-life expenses.
Typically, group LTD is relatively inexpensive compared to an individual LTD policy. There often are a number of options for the LTD involving how much income the policy replaces and whether the employee or employer pays for coverage. Our recommendation is to maximize the amount of income replaced (typically up to 70% or so) and pay for the premiums with the employee’s own money (vs. the employer paying for it). The reason the employee should pay the premium is because the LTD benefit is now tax-free (vs. taxable if the employer pays the premium).
One final thought
I will end this article on one last note that involves a benefit that you shouldn’t select during open enrollment: accidental death and dismemberment (AD&D). Life insurance planning should not involve guessing how the insured is going to die. AD&D only pays off in the event of accidental death. You should decide the amount of insurance your family needs and pick that amount. Wagering on the probability of an accidental death to get that amount isn’t prudent and something you should avoid.