Guest Post: Intro to Income Taxes and Your Paycheck

Editors’ note: I’m excited to introduce Krista D’Innocenzo as a guest poster. Krista is a mechanical engineer graduated from the Colorado School of Mines. To kick off 2017, Krista gives an introduction to Federal Income Taxes and addresses the persistent myth that you should take a lower salary to avoid taxes.

When I saw that Will was working on a personal finance blog, I figured I’d follow along, since personal finance is a passion of mine. As someone who has been all over the financial “spectrum,” I reached out to Will because I want to share my experiences and findings (and especially mistakes) so that others can learn. I am by no means an expert and obviously I don’t know all the answers. I’m merely someone who gets depressed seeing all the articles claiming “1% of millennials have more than $10 in their bank accounts!!” and wants to do something about it.

Why do I care?
When I first started looking at information about personal finance, I was bombarded with books and articles where the first paragraph had acronyms like 401k, Roth IRA, VSTMX, and ETF and my eyes would just glaze over. I had no idea what any of those words were and all the information I found seemed to assume I already had a working knowledge of personal finance. My goal as a guest contributor is to explain what I know about personal finance in basic terms that anyone can understand.

Learning to control your finances is powerful because it will take you to a place where you are truly in charge of your life, rather than a credit card company or the bank that owns your student loans. The reality is that most of our generation was never taught personal finance and has graduated with student loan debt; it can feel pretty depressing to be in a hole that you see no way to climb out of. Some have graduated with little debt and a high paying job, but have no idea what to do with the money. Some may be saving up to buy a house or have a child but feel that dream is unreachable. My goal is to be able to share the information I’ve learned from being in these situations so that others don’t have to go through the struggle that I did to find it.

My Financial Goals
I approach my personal finances with the goal of financial independence, living a lifestyle independent of income. My goal is to eventually retire early and live off of passive investments within the next 16 years. While this lifestyle isn’t for everyone, it’s more easily attainable than you might think. While I do my best to live somewhat frugally, I am by no means a spendthrift and still enjoy traveling, eating out, and buying tech gadgets. I hope to be able to offer information to others who want to retire early as well as those who don’t.

Introduction to Income Taxes
When I first looked at my first paycheck as a teenager, it shocked me to see the government take so much of my money, the horror! With time, I’ve grown to enjoy seeing my sweet, sweet tax refund check arriving each year in April. Who knew I’d be so excited about providing an interest free loan to the federal government?! Let’s start with all the different types of taxes you’d typically see on your paycheck:

Federal Income Taxes
When most people curse the IRS, it’s in reference to their federal income taxes, taxes paid to the federal government deducted from your earned income (salary, Social Security benefits, investment income, etc. ). The U.S. follows a progressive tax system, meaning that as income increases so does the rate of taxation. This leads to different tax rates ranging from 10% of the first $9,275 earned to 39.6% of income earned over $415,050 per year. Bands of income receiving the same tax rate are known as “brackets,” and 2016 tax brackets are as follows:

Rate Single Filers Married Joint Filers Head of Household Filers
10% $0 to $9,275 $0 to $18,550 $0 to $13,250
15% $9,275 to $37,650 $18,550 to $75,300 $13,250 to $50,400
25% $37,650 to $91,150 $75,300 to $151,900 $50,400 to $130,150
28% $91,150 to $190,150 $151,900 to $231,450 $130,150 to $210,800
33% $190,150 to $413,350 $231,450 to $413,350 $210,800 to $413,350
35% $413,350 to $415,050 $413,350 to $466,950 $413,350 to $441,000
39.6% $415,050+ $466,950+ $441,000+

The Tax Bracket Myth
Have you ever heard someone complain about a promotion or raise because making more money would put them in a higher tax bracket, causing them to take home less money than they did before? This is a myth caused by people mistakenly assuming that their highest income tax rate will apply to all of their income. This is false and easy to debunk if you look at how these tax rates work. Let’s say you are a single person who made $35,000 this year. Your federal income tax you would be 10% on the first $9,275 earned plus 15% of the amount earned between $9,275 and $37,650. The math looks like this:

So at the end of the year, you have paid $4,786.25 in tax, which leaves $30,213.75 leftover. Now let’s assume you get a raise and now make $38,000, putting you just over the threshold into the 25% bracket. Now you pay:

So you pay $5,271.25 in taxes, leaving you with $32,728.75. You do pay more in taxes, as one would assume with a higher income, but at the end of the day you still take home more income. Remember, bumping up into the 25% tax bracket does not mean that your entire income is taxed at 25%, just the portion of your income above the lower tax brackets is taxed at that amount. More money gross always leads to more money net!

Your Status Is Not Complicated
What’s the difference between single, married filing jointly, and head of household? Single filers are people not married on December 31 of the tax year with no dependents. Married filers are people who are legally married on December 31 of the tax year. Notice that the IRS does not care if you were married until December 30th and divorced on December 31st, you will still have to file as single for the year.

Your Roommate is Not a Qualifying Dependent
Head of household filers are people who have dependents that live with them who they are not married to. The word “dependent” is the IRS definition of a dependent, which can be found here. In short, a dependent is a child or relative for who relies on you as their primary source of financial support. For example, divorced parents cannot both claim the same child as a dependent. Full criteria for filing head of household can be found here.

Income thresholds are higher for the married and head of household filers, because they are assumed to support more than one person. For married couples where one spouse makes much more than the other, this often manifests as paying less in taxes than if each person were to file as single. For married couples where both spouses have high incomes or both make very little, this often manifests as paying more in taxes than if each person were to file as single. To see if you and your spouse are getting a “marriage bonus” or a “marriage penalty,” check out the interactive chart here (using 2015 tax numbers).

State Income Taxes
Different states have different income tax percentages, and some do not take income tax at all. If you live in one state and work in another, or have income from another state, you will need to file tax returns in every state you have earned income (and possibly more). For more information, review this article from Intuit.

Social Security and Medicare tax
Social Security and Medicare taxes are withheld from your paycheck at 6.2% and 1.45% respectively, and only the first $118,500 (Social Security) and $200,000 (Medicare) earned each year are subject to these taxes for the 2016 tax year. It is important to note that the income limit for Social Security tax is being increased in 2017 to $127,200.

Tax Withholding
What does it mean to have tax withheld and how do you know if you will get a refund or have to pay taxes in April? The federal government knows that it can’t just take money for taxes as a lump sum once per year, because a vast majority of people would not have funds available. Therefore, taxes are withheld by your employer on each paycheck at a rate that is dependent on your income, your pay schedule, and how many deductions you’ve claimed with your payroll department. Think of withholdings as an estimation of roughly how much tax you should pay. At tax time, the amount that was withheld (what you DID pay in taxes) is compared to the actual amount required and you will either have to pay more or you get some money back.

A refund means that you provided a short-term interest free loan to the federal government, but this may be the easiest way to handle your taxes if you do not want to take the time to figure out all of your deductions beforehand or don’t want to take the risk of estimating incorrectly. Deductions can be fairly complicated and are another blog post to themselves, and obviously I am not a tax professional and your personal situation may vary. Consult with a CPA for specific advice on your own taxes.

Why money matters

I still find it difficult to articulate why I care so much about money. I have no debt, a good job, a good work-life balance, and by most standards, a pretty easy life.

However, I also remember who I am when money is tight. At 25, I had high blood pressure because I worked in a job I loathed. I worked 10-12 hour days because I thought it was the only way I could succeed. I pushed people to buy things they didn’t need, understand, or would benefit from. I barely slept 4-6 hours per night. I ate cheap, terrible food because there was no time to cook or simply forgot to eat at all. I canceled time with my girlfriend and friends to work more. I felt exhausted all the time and slept all day on weekends.

In 2015, I finally hit my breaking point and quit my job. It wasn’t smooth sailing from there because:
  • I had moved into a one bedroom apartment with a high rent ($2,100 per month plus utilities) I could barely afford.
  • My old employer tried to get me fired from my new job.
  • My longest close friendship ended primarily due to financial disagreements.
  • My long-term girlfriend and I broke up. Finances and work-life balance were major factors.
  • My new employer was acquired by another company, so I was laid off and started a new job working as a federal consultant.
By December 2015  I was back to being lonely, exhausted, on my 3rd job of that year, and treading water financially. Reviewing 2015 I took away these lessons:
  • I want to work because I choose to, not because I have to.
  • Poor finances can ruin rich relationships.
  • Making good money with bad people is soul-crushing.
  • Making bad money with good people is untenable.
  • Nice things don’t fix loneliness.
So In January 2016, I reviewed my relationships, career, and finances, resulting in these four goals:
  1. Study and build a plan to no longer need to work as soon as possible (financial independence) by the end of February 2016.
  2. Spend less time at work (average 8.5 hours per day).
  3. Move out of my apartment and get rid of clutter when my lease expires in July.
  4. Try new experiences, meet new friends, and put people first by committing to a new weekly hobby.
 So in 2016, I:
  • Adopted a new financial plan to not need to work by 2026.
  • Began a new relationship with my lovely girlfriend!
  • Spent less time at work and now average 8.5 hours per day.
  • Learned Dungeons and Dragons and continue to play every Monday with an awesome group of guys and gals.
  • Move to a smaller, lower-cost studio apartment in July.
  • Cooked the majority of my meals.
  • Saved around 50% of take home income.
  • Switched my employer to a low-cost 401k plan and cover all plan administration costs.
Money isn’t everything, but it reduces stress and frees time to let me focus on who and what is most important to me. I started this blog to share what I’ve learned and hold myself accountable to my financial plan. If there’s any of you feeling like I was in 2015, I wish you a better new year and hope this blog can help you find your solution.

How to game your credit score

A few readers have reached out asking how to raise their credit scores, specifically their FICO scores. Luckily, it’s easy to game your way to a better score without accumulating any debt.

Image from Dennis Eakin Kia

Credit scores vs. credit reports

Credit scores and reports are not the same. Credit reports are a history of your debt and include prior loans, missed payments, credit inquiries (when you ask for a loan), and other specific actions that may give a bank pause before extending you more credit. Credit reports are provided by three companies: Equifax, Experian, and TransUnion. You can obtain a free copy of your credit report once per year for free from each of these agencies.  Credit reports do not have a number or score.

A credit score, such as your FICO score, is a formula used to assign a numerical value to your creditworthiness (the likelihood you can pay back a loan) using the data in your credit report. You are not entitled to a free copy of your credit scores (though there are free ways to get them).

How are credit scores used?

Credit scores only matter if you’re seeking a loan. If you don’t need a loan, you don’t need a credit score. The purpose of credit scores is to asses your likelihood to pay back a loan and determine the terms of the loan (interest rate) available to you. However, credit scores and reports have crept into employment screenings, background checks, insurance applications, rental applications, and other evalations of financial fitness or character.

How are credit scores calculated?

Not all credit scores follow the same formula. The most popular score, FICO  (Fair, Isaac, and Company), ranges from 300 (awful credit) to 850 (perfect credit). According to myfico.com, FICO scores approximately follow this formula:

  • 35% – Payment history: The more late payments, the lower your score. Over time, a history of on-time payments can balance out a prior late payment.
  • 30% – Amount owed: The more you owe, the less likely you will be able to pay off new debt. Using more than 30% of your available credit (utilization ratio) on any individual credit card will also hurt you.
  • 15% – Length of credit history: The longer you’ve successfully managed a credit card or loan, the less risky you are for a new loan.
  • 10% – New credit: Applying for six credit cards at once will raise eyebrows. The more often you ask for new credit, the riskier you are for a new loan.
  • 10% – Credit mix: Lenders prefer to see debtors with a mix of installment (mortgages, auto-loans) and revolving (credit cards) credit lines.

What doesn’t affect your credit score?

  • Anything not related to debt – If you pay all your bills on time, have no credit cards, and are completely debt-free, you have no credit score.
  • Debit or prepaid card transactions – You do not receive a loan to make debit or prepaid card transactions, so they have no effect your credit score.
  • Paying non-loan bills on-time – Paying your electric bill on-time does not affect your credit score. However, non-loan payments do affect your credit score when they’re unpaid and become debts.
  • Paying or carrying interest – Making the full payment vs. the minimum payment on a loan or credit card will not affect your credit score except for the total amount owed. It is never beneficial to pay unnecessary interest on a loan.
  • Closing a bank account or opening most bank accounts – Closing a bank account will not affect your credit score. Some banks will check your credit when opening an account.

What’s a good credit score?

An average to above average credit score is good enough to obtain favorable interest rates. The average FICO score is 670 to 739.

Score Rating Delinquency Rate
800 – 850 Excellent 1%
740 – 799 Above Average 2%
670 – 739 Average 8%
580 – 669 Below Average 28%
< 580 Poor 61%

Source: Experian

Opt Out Option

Again, credit scores only matter if you want a loan. If you don’t have credit cards or loans and pay for everything in cash, you have no need for a credit score and can live blissfully without one.

How to game your way to a good credit score:

If you want a favorable loan or credit card, it’s easy to build an average to above average credit score in two years.  A simple path from no score to an averagee score (700’s) is to:

  1. Open one credit card with no annual fees every 3 months until you have 3-7 cards.
  2. Never allow expenses to go above 1/3 of the credit limit of each card (utilization ratio).
  3. Pay balances in full every month on each card.
  4. Raise credit limits as high as possible every 6 months to lower your credit utilization ratio.
  5. If you don’t want to deal with an old credit card, charge an automatic $1.00 expense per month and set up automatic payments for the full balance.

After two years, you won’t have a perfect credit score, but as long as you keep your credit cards open, you’ll have no debt, a perfect payment history, few new credit inquiries, and a moderate credit history. If you already have a low credit score, this method will also work for you, it will just take a longer.

Trust, but Verify Your Paychecks

My two favorite days of the month are paydays. Seeing a deposit post in my checking account still sets my heart aflutter. But with my joy always comes a tinge of skepticism, “Is my paycheck the right amount?”

An American worker and her paycheck united in sweet ecstasy.

I’ve worked for nine employers in my life. The number that have always paid me the right wages, on time, with accurate withholdings is one. At every other job, I’ve either had to prove to my employer that my paycheck has an error or accept a loss on earned income. I even quit my first salaried job specifically because of frequent payroll errors.

This post dives into common payroll errors (all of which have happened to me) that you should look out for and how to resolve them. At a minimum, everyone should review their wages before the end of each year, but I recommend completing this assessment before the final pay period of every quarter. That way, if there is an error, there’s time and funds available to fix it.

Below are seven basic compensation errors. Notice that errors almost always occur when something in your compensation formula changes, such as when you change your 401k contribution, move across state lines, or receive a promotion.

Error Typically occurs when:
Wrong Wages New job
Raise or promotion
Missing Bonus After bonus payout deadline (end of quarter)
Missing Expenses Expense request submitted
Incorrect Taxes/
Withholdings
New job
New job site
Change of address
Incorrect 401k Contributions 401k enrollment
401k contribution change
Missing Paycheck New job
End of job (fired, laid off, quit)
Paid Time Off (PTO)/
Vacation Error
New job
Promotion or increase in PTO

How to Resolve Pay Issues

The first time I noticed a pay error, I was livid. The tenth time? It becomes routine. Whenever I find a pay error, I try to remember this quote by Robert J. Hanlon, “never attribute to malice that which is adequately explained by incompetence.” No one is trying to swindle me, I just care infinitely more about my paycheck than anyone else.

If we assume incompetence, the burden falls on us to rectify the situation. Here’s a straightforward game plan:

  1. Always, always, always, keep separate copies of all records and communication regarding compensation including job offers, paychecks, expense reimbursements, bonuses, and anything else that may affect your compensation.Always keep copies on a separate location from your work computer. Keep a backup. If you lose your job, you don’t want to lose your compensation history too. If it’s not in writing or you can’t find it, it doesn’t exist.
  1. Review your next paycheck after any change to your compensation formula.If you submit an expense reimbursement request, make sure it is paid in full at the appropriate time. If you move to a new state, make sure you’re paying the taxes to the right state(s).
  1. If you suspect a problem, start by contacting your payroll department and only your payroll department. Your colleagues in payroll do not want to look incompetent. Ideally, you can make a quick email followed by a phone call to resolve the issue discreetly. My favorite strategy is to play dumb and ask for help understanding your paycheck, “Hey Bill, I noticed my last paycheck was for $X, but I expected it to be $Y because… Can you help me figure out why that’s case?” By asking for help, you’ll either receive a valid explanation for why the paycheck is right, or payroll will identify the error and resolve it.
  1. If the pay issue still isn’t resolved, escalate up the chain of command. If you can’t resolve the issue with payroll directly, raise the issue to your boss and ask for a timeline to resolution. Provide supporting documentation, be courteous, and have patience. The more people involved, the more likely your paycheck will transform from a clerical issue to a political one.
  1. If the pay issue still cannot be resolved, weigh legal options. Specific processes to recoup lost wages vary from state to state.  Unfortunately, unless you’re owed a substantial sum, the time and legal fees can easily cost more than the amount owed. It hurts to leave money on the table, but know when to give up.

Finally, keep in mind that errors go both ways! If an employer overpays you, flag it immediately and come up with a solution to pay it back. Not only is it the honest thing to do, you’re legally on the hook to pay back income you didn’t earn.

End of 2016 Checklist

As the end of 2016 approaches, I’m optimizing my spending and investment strategies to maximize tax credits and deductions for 2016. Below is a general checklist that I try to execute in the final quarter of every year.

General:

  • Have you audited your income and expenses at least once in 2016?
  • Are you on pace to meet your savings goals?

Investments:

  • Have you maxed out your annual 401k contribution limit ($18,000)? If not, can you increase your monthly contribution through the end of the year? Deadline is December 31, 2016 or your last paycheck in 2016.
  • Have you maxed out your annual $5,500 IRA or Roth IRA contribution? Deadline is April 15, 2017.
  • Have you maxed out your annual $3,350 HSA contribution (see below)? Deadlines is April 15, 2017.

Employment:

  • Have you reviewed your paychecks for 2016 and confirmed you have been paid the correct amount? Every company I’ve worked for has had payroll errors, it’s worth checking.
  • Are you on pace to use all of your paid-time-off (PTO) or vacation days by the end of 2016?
  • Have you updated your resume and LinkedIn profile in the past 6 months?
  • Have you paid your dues and met educational qualifications for any professional associations you belong to?
  • Are you current on employer reimbursements for qualified spending?
  • If your employer offers a training budget or other benefits, are you on pace to spend your entire budget for 2016?

Health:

  • Are you overdue for free preventative care during your current plan year? Always complete your annual physical, 6-month dental cleanings, and annual eye exam.
  • Do you have proper documentation and receipts for your healthcare expenses?
  • If you have an HDHP, have you made your maximum tax-free HSA contribution of $3,350? The deadline for 2016 HSA contributions is April 15, 2017.
  • If you have an HSA, have you submitted your claims for qualified medical expenses for 2016? Deadline is December 31, 2016.
  • Does your health insurer offer any special benefits or wellness programs? Can you complete requirements for these programs before December 31, 2016?

Credit and loans:

  • Have you pulled your three free annual credit reports from Experian, Equifax, and TransUnion? Note that your credit report is required to be free by law, never buy anything from these companies.
  • Have you checked your FICO score (credit score) in 2016? I like Discover’s free FICO score tool, but most credit cards will now provide your FICO score for free.
  • If you have a loan, have you reviewed rates for refinancing in the past 6 months?
  • If you have credit card debt, do you qualify for a low-interest balance transfer card?
  • If you do not have credit card debt, are you on pace to meet promotional spending bonuses for new credit cards? If not, can you pull highly certain expenses from 2017 forward to meet the requirements?
  • Do you have expiring credit card points? Can you spend them before they expire?

Education:

  • Have you calculated your 2016 qualified education expenses? Do you have proper documentation and receipts for these expenses?
  • Are you eligible for education credits and deductions? For example, income above $65,000 may disqualify you for the Lifelong Learning credit.
  • Does your state offer income tax deductions for 529 savings plans? Here is a list of states providing income tax deductions for 529 contributions. The first $4,000 contributed to the DC 529 plan are exempt from state income taxes.
  • Have you made your annual 529 savings plan contributions? Deadline is December 31, 2016. This is most appropriate for those in school, those with children, or those with highly certain education expenses in their future.

Donations:

  • Are you on pace to meet your charitable donation goals for 2016?
  • Do you plan to donate clothing, books, etc. in the near future? Can you pull these donations forward to 2016? Deadline is December 31, 2016.
  • Have you tracked and itemized donations to allow maximum deductions in 2016? If not, it’s time to start requesting receipts.

Automating Finances Part 1: Set Up a Tracking System

In January 2015 I wanted to automate my finances and take myself out of the equation as much as possible due to poor spending and investment decisions. To do so, I needed a way to track spending to know exactly where my money goes. Whatever tracking system I implemented needed to provide up-to-date answers to these questions:

  1. How much money do I have and where is it located?
  2. What is my average monthly income and total annual income?
  3. What are my average monthly and total annual expenses?
  4. Where, exactly, am I spending money, when, and how much?

These questions seem like no-brainers but were unclear because I used a mix of cash, debit, and credit cards that hid expenses because I could not see the whole picture of my finances. Further, because I took on odd jobs for extra income, looking at high-level net savings reports hid higher spending in months where I earned more.

Before making any changes to my finances, I attempted to complete my 2014 taxes, which would require all information needed to accurately calculate annual income for the prior year and show exactly where my funds are allocated. My search identified:

  • A Health Savings Account (HSA) from a prior employer I had forgotten about, and was bleeding money due to monthly fees.
  • Stocks I purchased through RobinHood that I don’t remember purchasing.
  • A savings account from a local bank in Colorado that I … misplaced.

I now had an accurate list of all accounts that held investments, savings, or debt (credit cards) and could begin building a tracking system.

Automate Finances Step 1: Setup a Tracking System

An effective automated tracking system should fulfill four basic tasks in an easily repeatable manner:

  • Consolidate income and spending information from all sources
  • Capture data for individual purchases including date of purchase, vendor, and enough information.
  • Export data to a .csv file for analysis in Excel or a similar program.
  • Automatically pull and display information to provide an accurate financial snapshot with little effort.

Luckily, I had already set up the infrastructure for a tracking system by signing up for Mint.com. Mint is a free service that automatically pulls account information from most savings, checking, brokerage, and other investment accounts (401k, HSA, etc.) and itemizes income and expenses in one spreadsheet. Further, Mint allowed me to set budgets for specific expenses and receive notifications when approaching or exceeding those budgets. Once I added my missing accounts to Mint, my tracking system was in place, and I could begin auditing my expenses (Step 2). If you are comfortable with an online tracking system, Mint is an excellent and free place to start.

 

If you don’t have a way to track spending at all (no debit or credit card, no receipt system for cash), then start by either signing up for a checking account with a debit card or instituting a record-keeping system for your cash purchases. Evernote (paid) and OneNote (free) allow you to scan receipts with your phone and convert them to searchable text if you want to track receipts but don’t have space for paper.

Automation vs. Security – There is no truly secure way of managing finances. If I keep everything in cash, my cash could be physically stolen. If I manage all of my accounts online, my passwords could be hacked and my funds electronically stolen. Since I’m at risk either way, I’d rather accept the risk that simplifies my process and manage funds electronically. However, hacking is a real and serious threat and you should consider all available options and risks before signing up for an automated tracking service.

Homework:

If you already have an effective tracking system, great! If not:

  1. Identify all of your income and investment sources: checking accounts, brokerage accounts, 401ks, IRAs, etc. Reviewing sources of wage, interest, and capital gains income from your prior year’s tax return is a good start.
  2. Identify all of your spending sources: credit cards, debit cards, checking accounts, Paypal, etc.
  3. Choose an automated or paper tracking system.
  4. Accurately track income vs. expenses for one month. Do you know exactly what you’ve earned and spent? Can you easily follow your system for another month?

 

Why I’m not allowed to manage money

I moved back into Washington, DC in July. Since I downsized from a 1 bedroom to a studio, I’ve been selling, donating, and depositing items in the Bermuda Triangle outside my building to get more space. The more I go through my stuff, the more I realize that (a) most of it is crap, and (b) I wish I never bought it in the first place. Highlights from junk pile are:

  • Rice cooker (paid $120 retail), I rarely cook rice
  • Fishing reel (paid $120 retail), I lost the rod that goes with it
  • Hand exerciser ($15 retail), why?

I don’t remember most of these purchases or why they made them. I definitely haven’t improved my decision making over time. Looking around my apartment, here’s a list of of junk I’m keeping:

  • A keyboard I never use ($500 retail), I promise I’m going to start practicing tomorrow
  • Fly-fishing equipment ($300), it was too hot this summer and now it’s too cold
  • A top of the line ironing board I rarely use ($100), I hate ironing

At the time of purchase, all of these expenses seemed like a good deal, an investment in myself, or a way to save money over time. However, if any of those things were true, I probably wouldn’t have an apartment full of junk.

So, if I know I’m a terrible decision maker, how should I manage my time and finances? For me, the best money management system is one where me and other people are least involved as possible because:

  1. I choose to make terrible purchases and investments for irrational reasons and justify them after the fact
  2. Other people also choose to make terrible purchases and investments for irrational reasons and justify them after the fact
  3. The probability of success is multiplied every time a human decision is removed from my money management system
  4. The system must support a minimal amount of waste (stupid purchases) to placate me to the point that I won’t try to screw it up

Therefore my optimal financial system is:

  1. Simple,
  2. Automated, and
  3. Has enough margin of error for inevitable mistakes

The next series of posts will provide a guide for creating a simple system that tracks and automates finances to achieve specific goals for reducing debt, investing, or making large purchases.

Choosing a healthcare plan pt. 2: What if I go to the doctor a lot?

I met up with a friend this morning who read the prior post on choosing a healthcare plan. He goes to a physical therapist and has to pay a specialist co-pay every visit. He raised the question, “If I know I have to pay a lot of co-pays for physical therapy, shouldn’t I take the higher-cost plan with lower co-pays?” It sounds reasonable, but when paying more looks like the right choice, it’s time to bust out the calculator.

First, co-pays do not always count towards your deductible. That means if my friend meets his deductible and goes to a specialist with a $30 co-pay, he may still pay the $30 co-pay. However, this is not true with all plans, so he needs to check if his plan counts co-pays towards its deductibles.

So how do co-pays affect plan cost? Here’s the cost of 10 specialist visits for each plan from the first “How to Choose a Healthcare Plan” article:

  Platinum Plan Gold HMO Silver HDHP with no HSA*
Deductible $500 $500 $2,000
Specialist Co-Pay $30 $30 $50, post deductible
Cost for first 10 visits $300 $300 $1,000
Remaining deductible $500 $500 $1,000
Total annual cost $2,352 $1,332 $1,000
*Assuming $100 cost per visit without co-pay  

The key difference between the plans is that the high-deductible plan offers no co-pays for specialist visits until he hits his deductible. This means that he is on the hook for the full cost of each visit, but that the cost of each visit counts towards the deductible. In the absence of the actual cost of physical therapy, we assume $100 per specialist visit paid out of pocket.

So which plan should my friend choose? It’s uncertain, but still leaning towards the low-cost HDHP. To make a firm decision he needs to calculate his actual costs, frequency of visits, and contribution to his health savings account. For example, if he pays $150 per specialist visit instead of $100, he’s almost reached the deductible for his HDHP. If he maxes out his HSA contribution and is in the 25% tax bracket, he can save to $837.50 in taxes to offset the additional costs.

There are two key takeaways from this analysis:

  1. The insurance company is going to make money, no matter which plan you choose. So if you’re paying lower co-pays, they’re probably not counting towards your deductible. If you have a high deductible, your going to have high co-pays and minimal support until you hit that deductible.
  2. My friend and I both initially thought he would be better off with a higher cost plan because a $30 co-pay is cheaper than the full cost of each visit. We both severely underestimated the monthly cost of having more coverage and how quickly he could hit the deductible in an HDHP by paying the full cost of each visit.

Human beings are terrible at estimating risk and marketers know this. It’s more painful to pay $100 for a doctor’s appointment in cash than $100 a month from your paycheck for a healthcare plan with lower co-pays. If one plan seems like a great deal, do the math and you’ll probably find your costs will be at least similar, if not more expensive than the lower-cost plans.

How to choose a healthcare plan

This week is my company’s open enrollment period for new healthcare plans. I usually go with the cheapest plan that requires no employee contribution. This year, however, the cheapest plan, and its $2,000 deductible, was conjuring images of medical and financial ruin. If I ended up in the hospital would I go broke?

My mind immediately wanted to select the “safe” middle-priced plan, but I remembered that’s exactly what the insurance company wants me to do. So instead, I opened a spreadsheet and calculated my prior year’s healthcare costs in all three plans.

It turns out I’ll still save more with the cheapest plan with the highest deductible, even if I had a major medical emergency. Further, if my medical expenses hold the same as last year, I will profit around $400 from tax incentives that favor high-deductible plans (HDHPs) with health savings accounts (HSAs).

Analysis: My company provides three healthcare options:

Cost 1. Platinum Plan 2. Gold HMO 3. Silver HDHP
Deductible $500 $500 $2,000
Max out of pocket $1,500 $4,000 $6,000
Employee Share 60% 75% 100%
Monthly Employee Cost $171 $86 $0
Annual Employee Cost $2,052 $1,032 $0
Non-Network support? Yes No No
Health Savings Account (HSA)? No No Yes

A quick comparison is to add the deductible and annual cost to see the true cost of reaching the deductible:

  • Platinum plan – $2,552
  • Gold HMO – $1,532
  • Silver HDHP – $2,000

The Gold HMO is looking pretty good, but we still have to compare the actual costs and features of the plans. To do this, I created a comparison table of co-pays and costs for each plan. Unfortunately, the table looked like gibberish until translated to real-world examples, so I used a best and worst-case scenario for each plan to compare the costs.

  • Best-case scenario: Annual physical, two illnesses with urgent care and preferred prescriptions (my 2016 medical history). These costs were calculated using the benefits tables provided for each plan.
  • Worst-case scenario: Diagnosis with type-2 diabetes (stand-in for a chronic medical condition), I use the estimated costs provided for the insurer for this scenario.

Here’s how the plans compare now:

Cost 1. Platinum Plan 2. Gold HMO 3. Silver HDHP
Annual Cost $2,052 $1,032 $0
Best-Case Costs $300 $300 $400
Total Best-Case Cost $2,352 $1,332 $400
Worst-Case Costs $680 $1,268 $2,610
Total Worst-Case Cost $2,732 $2,300 $2,610

Now I’m much more confident choosing the High-Deductible Health Plan (HDHP). I would need a major medical emergency or a chronic condition to justify the costs of the next step up. But wait! There is another benefit unique to HDHPs that makes the lowest-cost plan even more appealing.

The magic of Health Savings Accounts (HSAs): HDHPs are low-cost but expose plan holders to the risk of unpredictable and potentially high medical expenses. To compensate for this risk, individual HDHP plan holders can make tax-free contributions up to $3,350 per year to Health Savings Accounts (HSAs). You can then make tax-free withdrawals for qualified medical expenses (just about anything you can think of). Further, HSA tax deductions are not limited by income, meaning that the higher your tax bracket, the more you save by contributing to an HSA.

Since I’m in the 25% marginal tax bracket, moving $3,350 to an HSA nets me $837.50 in tax savings. Here’s how the Gold, Silver, and Silver with HSA contribution plans compare when I max out my annual HSA contribution:

Cost Gold HMO Silver HDHP Silver HDHP with max HSA contribution
Annual Cost $1,032 $0 $0
Best-Case Costs $300 $400 $400
Total Best-Case Cost $1,332 $400 -$437.50
Worst-Case Costs $1,268 $2,610 $2,610
Total Worst-Case Cost $2,300 $2,610 $1,782.50

In my best-case scenario, I’m actually getting paid $437.50 through tax deductions to choose the cheapest healthcare option so long as I max out my HSA contribution. In the worst-case scenario, the tax savings of the HSA make the HDHP the best plan per dollar.

You can invest your HSA! Yet another benefit of HDHPs paired with HSAs is that you can invest your HSA contributions to save for future medical expenses or retirement. Capital gains from HSA investments are also tax-free. HSAs are like IRAs but better, because you can make withdrawals with no penalty at any time for qualified medical expenses. Since my worst-case financial scenarios revolve around medical emergencies, HSAs are the first investment vehicle I contribute to after my 401k. 

But what if I end up in a coma? Medical emergencies are expensive, but they’re also rare. Further, if I have a major medical issue that prevents me from working, I can use my employer’s default short-term disability insurance. There’s no need to invest more in health insurance for events covered under other insurance.

What if I have kids or a chronic medical condition? Get the plan that covers your projected costs in the cheapest manner. Luckily, I’m a young invincible with no children, so I’ll enjoy low-cost healthcare for at least a few more years.

Should I try the healthcare exchange instead? I briefly considered forgoing healthcare from my employer and buying my own healthcare from an exchange instead. I did not for these reasons:

  • After a brief look on DC’s exchange, I did not see any plans that were cheaper or substantially different from what my employer offered.
  • With employer-provided healthcare, I do not pay taxes on my employer’s contribution to my healthcare. This means that it’s cheaper to have the same healthcare plan through an employer than through an exchange.
  • I would need to negotiate the cost of my healthcare as an increase in salary to cover the cost of purchasing my own healthcare. Further, I’d have to get a raise larger than the cost of my healthcare to cover additional taxes as well.

Homework: When your open enrollment period comes around, calculate the actual costs of your healthcare choice using this exercise as a template. You may be surprised how much you can save with the cheapest option.

What would you like to see?

These are potential topics I could cover in the upcoming weeks. Please comment on what you want to see or write a topic you want me to research and report on. I will do my best to cover the topics with the most likes.

  • Key resources (next post)
  • How I would start over again (will happen)
  • Financial planning tools (will happen)
  • Cash management
    • Basic cash management strategy
    • Best checking accounts
  •  Debt
    • When debt is a good idea
    • Credit cards, points, and miles
    • Credit scores
  •  Taxes
    • Tax credits
    • Tax deductions
    • Doing your own taxes vs. a tax professional
  • Investing
    • Investment vehicles (taxable, non-taxable)
    • Investment choices (stocks, bonds, mutual funds, index funds, ETFs)
    • Why I don’t invest in bonds
    • Robo advisors
    • How to choose a financial advisor
    • Recommended investments
    • Asset allocation
    • Risk tolerance and risk management
    • Inflation protection
  • Increasing income
    • How to find good jobs
    • How to write a good resume
    • How to get a job and stand out as a candidate
    • How to negotiate a raise
    • How to prioritize time at work to get as much money as fast as possible
  • Businesses/side hustles
    • How to start a business
    • How to identify opportunities for side hustles
    • Side hustle experiments
  • Major expenses and cost management
    • Renting vs. buying a home
    • Negotiating/getting the same stuff for less
    • Lowering cable/utility bills
    • Getting the same stuff for less
  • Insurance
    • Health Savings Accounts and Flexible Spending Accounts
    • Choosing a health insurance plan
    • Most efficient way to pay for medical expenses
  • Philosophy
    • Calculating the value of your time
    • How to prepare for the next recession
    • Strategic ignorance and low-information diet
    • How to buy things
    • Money vs. passion
    • How to take risks/when to take risks