401(k)

For a tech company, the 401(k) is the most common retirement account. There are annual contribution limits, which adjust based on inflation. For 2022, the maximum is $20,500 and it is $27,000 for those aged 50 or older. Your employer will make the contributions by using automatic payroll deductions.

A 401(k) comes with lucrative tax benefits. First of all, your contributions are deductible from your income. For example, if you contribute $20,000 and your total tax rate is 30%, then you will save $6,000.

Next, the earnings in your 401(k) account – such as capital gains, dividends, and interest – are tax deferred. This means that you do not pay taxes until you withdraw your money. The idea is that – by the time you retire – you’ll be subject to a lower tax rate.

Your employer will have a set of investments options. They will often cover a variety of funds, such as for stocks, bonds, and foreign investments. It’s also common to have target-date funds (see more about these in Chapter 8). Keep in mind that the funds are usually actively managed and are not based on indexes.

There could be the option to invest your money in your employer’s stock. There may even be a deferred annuity, which is a vehicle that provides a fixed amount of income for the rest of your life.

You can also have penalty-free distributions if you use rule 72t (this refers to the IRS code). You do this by making Substantially Equal Periodic Payments (SEPPs). The IRS provides three options for this.

A 401(k) will also have a penalty for those who do not withdraw funds once a person reaches age 72 1/2. This is known as a required minimum distribution (RMD). This starts at about 4% of the total amount in your account and increases over time. Your bank, brokerage, or financial services company will disclose what you need to withdraw.

What if you do not comply with the RMD? The penalty is a stiff 50%.

Employer Matches

Some employers will match part or all of your contributions. This is free money! In other words, one of the smartest things you can do is to make sure you contribute enough money to get the match.

The employer will usually have a maximum limit, which is a percentage of your salary. This may be 4% or so.

Then what about the $20,500 or $27,000 contribution limits? These apply to you, not your employer. Your employer has other contribution limits.

An employer may also use vesting restrictions, which will encourage retention. This could be a four your schedule, in which you get ownership of 25% of the match after each year at the company. Then there is cliff vesting. In our example, this means that you get 100% of the match after four years. But keep in mind that vesting only applies to matches, not the contributions you make.

401(k) Loans

You are allowed to borrow from your 401(k). This avoids having to pay taxes or the 10% penalty.

Based on your employer’s policies, the amount you can borrow can be as much as 50% of the value of the account for a maximum of $50,000. This is for a 12-month period.

You will pay interest on this loan and need to repay the loan amount, usually by five years. Note that the interest goes back into your account, and you can invest the money.

However, if you leave your job or are terminated, you will likely have to repay your loan. If you cannot do so, the amount you withdraw will be subject to taxes and the 10% penalty. A silver lining is that a default does not appear on your credit rating.

Roth 401(k)

So far in this chapter, we have been focusing on the traditional 401(k). But your employer may offer another flavor – the Roth 401(k).

Yet it generally is not as popular. Some people may not even know that their employer offers it.

If you do not meet these requirements, your initial contributions into the account will be free from tax. Instead, you will pay the tax on the earnings generated in your account.

This is done by prorating the amounts. Here’s an example: Suppose the total value of your account is $20,000. This includes $16,000 from contributions (80% of the total) and $4,000 in earnings from your investments (20% of your total). If you withdraw $5,000, then 80% of this or $4,000 will be considered to be from your contributions and not taxable. The remaining amount, or $1,000, will be earnings and subject to taxes and perhaps a penalty.

One reason to use a Roth 401(k) is that if you expect your tax rate – when you retire – to be at least as high as it is now. Next, there are no income restrictions on the contribution limits. This is a major benefit for higher-income people.

Now the Roth 401(k) is subject to RMDs. However, you can avoid this by rolling over the account into a Roth IRA.

During the year, you can contribute to both a traditional and Roth 401(k). But they cannot be simultaneous. One approach is to make contributions to one during the first half of the year, and the second one for the rest. To do this, you will need to talk to your HR department or plan administrator.

No Retirement Plan

If you work for an early-stage startup, you may not have access to a traditional 401(k) or Roth 401(k). But there are other retirement options.

You can have an Individual Retirement Account (IRA), which you can set up with a bank, brokerage firm, or other financial services company. Like a 401(k), your contributions are deductible and the earnings in the account accumulate tax free. If you make withdrawals before age 59 ½, you will be subject to taxes and a 10% penalty. But after this, there will be no penalty. Moreover, the RMD rules apply.

For 2022, you can contribute up to $6,000 in an IRA. There is an additional $1,000 for those who are 50 and older.

Then there is the spousal IRA. This is where you can set up an IRA for a spouse who has little or no income. The contribution limits are the same as for a regular IRA. But you need to file a joint tax return.

However, if your spouse works and has an employer that offers a retirement plan, then your tax-free contributions may be reduced based on the family income level.

Next, there is the Roth IRA. Like a Roth 401(k), the contributions are not deductible, but the earnings are generally tax free (see earlier in the chapter for the rules). The contribution limits are the same as for the traditional IRA. But they are reduced based on your modified adjusted income (MAGI). You can contribute the maximum if you are single, and your MAGI is less than $129,000 or if you are married and filing jointly and your MAGI is less than $204,000. For income above these limits, the contribution amount is gradually phased out.

IRA Investments

But be careful. There are certain types of investments to avoid, like variable annuities. After all, they already benefit from tax deferral of the earnings.

While an IRA is a good way to save for your retirement, the contribution limits are a big drawback when compared to traditional and Roth 401(k)s. But a strategy is to ask your employer for you to become a contractor (although, you need to factor in the need for getting your own health insurance, which we will cover later in this chapter).

Finally, you can set up a Health Savings Account, which can actually be a useful vehicle for saving for retirement. We’ll cover this type of account later in the chapter.

401(k) Rollovers

If you lose or leave your job, then you need to make a decision about your 401(k). You can keep it with your employer if the account has at least $5,000 in investments. A common reason for this is if you are 55 or older. This means you can make penalty-free withdrawals from the 401(k).

Another advantage is if you have stock that has appreciated significantly. The amount you contributed is taxed as ordinary rates and the gains are taxed at capital gains rates, which will likely be lower. For example, suppose you bought your company stock for $10,000 and included it in your 401(k). After three years, you leave the firm, and the stock is now worth $50,000. Assume your ordinary tax rate is 35% and your capital gains rate is 20%. In this situation, the taxes on the $10,000 will be $3,500 and $8,000 for the gains – for a total of $11,500. However, if you transferred your account to an IRA, the taxes would have been $17,500.

There are some downsides to maintaining your account with your employer. There may be limits on when you can take money, and the staff may be less responsive because you are a former employee. You also cannot make any new contributions.

Regardless of the type of rollover, your employer will usually liquidate your account and issue a check. After this, you will set up your portfolio.

So, what account should you rollover into? There’s no clear-cut answer. In one sense, a 401(k) is better since you can borrow against it. But an IRA or Roth IRA certainly have their advantages as well. You will have many more investment options available. The fees may be lower too.

The Super IRA

Before becoming a Governor, Senator, and a Presidential candidate, Mitt Romney was a successful partner at Bain Capital, a private equity firm. From 1984 to 1999, he was able to accumulate anywhere from $21 million to $102 million in his IRA, according to campaign disclosures.⁴

But this was not a one off. Just look at Peter Thiel. He is one of Silicon Valley’s most successful founders and investors. He co-founded breakout companies like PayPal and Palantir. He was also the first outside investor in Facebook. Other notable investments included SpaceX, Asana, Lyft, and Airbnb.

As for his IRA, it has exceeded $5 billion.

OK then, how did Romney and Thiel amass huge sums in their IRAs? In the case of Romney, it’s not clear. Although, one theory is that he allocated limited partner interests of Bain Capital in his IRA when the valuations were extremely low.

As for Thiel, he used a Roth IRA to buy 1.7 million shares of PayPal in 1999 for $1,700.⁵ When the company sold to eBay in 2002 for $1.5 billion, he reinvested his gains in other startups – all tax free.

These examples show how retirement vehicles can be an extremely effective way of creating wealth. But there are risks too. Tax advantages can be easily changed.

For IRAs, Congress has been exploring ways to make it more difficult to accumulate large sums in the accounts. After all, these accounts were meant for middle class people to save for their retirements – not for billionaires.

Health Insurance

The US healthcare system is the largest in the world. According to CMS.gov, the amount spent on it came to $4.1 trillion, or $12,530 per person in 2020.⁶ It’s nearly 20% of the gross domestic product.

While the US healthcare system has many positives – especially the vibrant innovation of biotech and pharma companies as well as many highly skilled physicians and healthcare workers – there are many downsides. Besides the high costs, there are many complexities. The billing systems can be mind-numbingly difficult. Then there is the jargon.

There are a variety of ways you can receive your services. These involve the use of plan types and include a provider network. This is essentially a list of doctors, hospitals, facilities, and other healthcare professionals. If you use someone outside of the provider network, you may have to pay part or all of the bill.

Regardless of the plan, they all provide necessary services for emergencies that involve providers outside the network. Yet there are occasions when you may get hit with a huge bill. Unfortunately, this often means having to deal with a complex bureaucracy, and it can take time to resolve the matters.

For the most part, it’s recommended to use in-network providers. This should help keep your healthcare at lower levels. It’s always smart to ask for discounts as well.

You should read your policy and see what is covered. This can avoid having to pay potentially large bills. Keep in mind that health plans often change.

For example, if you go on vacation in another country, your plan may not provide coverage. You may want to get a travel policy.

In some cases, you may have a minor ailment. For this, the cheaper alternative may be to go to a local clinic at CVS, Walgreens, Walmart, or Target.

Your plan may even have some interesting perks. Examples include weight-loss programs, massage therapy, and gym memberships.

By law, a health insurance plan must provide preventive services for free. Some examples include cancer screenings, immunizations, and mammograms.

Since you have to pay for your healthcare costs before you hit the limit on your deductible, it is worth looking at ways to economize. There are a myriad of apps and services that can help out. One is GoodRx. This app allows you to get significant discounts on prescriptions and OTC (over the counter) medications (if purchased at a pharmacy), which can be over 80%.

Then there is ClearHealthCosts.com. This service provides the cost breakdowns for healthcare procedures in various cities. Interestingly enough, you might find that paying out-of-pocket may be cheaper than using insurance, since there will be a copayment or coinsurance.

Flexible Spending Accounts (FSAs)

An employer may offer a flexible spending account (FSA) as a supplement for the health plan. You will select it during the open enrollment season for the company.

For 2022, you can contribute a maximum of $2,850 and this is deductible. You can use this money for qualified medical expenses – tax free. Your employer will usually provide you with a debit card for the transactions.

As for what is not covered, these usually include procedures purely for cosmetic purposes. However, before you make a purchase with an FSA, check your plan to make sure that it is covered. You also need to maintain documentation of your expenses, such as with bills and invoices. In some cases, you may have to get a letter from your physician for certain treatments. This is called a letter of medical necessity. Keep in mind that – if you make an unqualified expenditure – it will be subject to taxes and a 20% penalty. The penalty applies until your reach 65, which is when you become eligible for Medicare.

FSAs are usually based on the principle of “use it or lose it.” That is, by the end of the year, any unspent funds will revert to the employer. Because of this, you should try to estimate your annual costs before contributing to your FSA.

Some employers may allow you to carry over unspent funds to the following year. The limit is $570 for 2022. Or an employer may give you a grace period of the first 2.5 months of the following year to spend the money in your FSA.

Next, there is the dependent care FSA. This is for expenditures for children under 14 years of age or for your spouse or relatives who cannot care for themselves. Some common qualified expenditures include babysitting, nanny, day care, nursery school, preschool, and eldercare. The maximum contribution is $5,000 for a married couple filing jointly and $2,500 for a single person.

Health Savings Accounts (HSAs)

An employer may offer a health savings account (HSAs). This is if you have a high-deductible health plan. This means that – if you are single – the deductible on the policy cannot be lower than $1,400. The amount is $2,800 for a family plan.

For 2022, a single person can contribute a maximum of $3,650 for an HSA account and $7,300 for a family. These amounts are tax deductible. If you are over age 55, there is an additional $1,000 for the annual contribution.

You can pay for qualified medical expenses with an HSA, and they are tax free (see the prior section for examples of these).

A nice feature of an HSA is that you can carryover all unspent contributions to the following year. In fact, you can invest the funds in mutual funds and interest-earning accounts. This means you can use an HSA as a way to help fund your retirement.

If you withdraw money, you will owe taxes on the amount and pay a 20% penalty. But like an FSA, the penalty goes away after you reach 65. Interestingly enough, the HSA does not have RMDs.

If you leave your job, you keep your HSA. You can rollover the account into another one, such as with a brokerage firm or bank.

COBRA (Consolidated Omnibus Budget Reconciliation Act)

If you leave your employer, you can continue your health insurance. This is according to COBRA (Consolidated Omnibus Budget Reconciliation Act). You can maintain your coverage from 18 to 36 months. But you will need to pay 100% of the premiums.

Yet COBRA is a good option. You do not want any gaps in your health insurance coverage. You can then spend time looking for another job – and get a new plan – or you can buy a healthcare plan from the Affordable Care Act exchange.

Affordable Care Act (ACA)

The Affordable Care Act (ACA) – or Obamacare – is an option if you work for a small company that does not offer health insurance or you are self-employed. This allows you and your family to get coverage even if there are preexisting conditions, like cancer, diabetes, or even a pregnancy.

The enrollment is usually from November 1 to the end of December. But some states may extend this to January 31. If you miss this, you may meet the requirements for Special Enrollment. This means you can enroll any time if you have a life event, such as the loss of a job, you move out of the coverage area, or you get married.

To sign up for ACA health insurance, you can enroll online at Healthcare.gov or your state’s marketplace. You can also call at 800-318-2596. For free, you can get the help of a navigator.

For an ACA policy, you will fill out a form that requests information about your family, income, address and so on. You will then shop around for a policy, which include Bronze, Silver, Gold, and Platinum. They have different premiums, copays, and maximum costs. There are also varying levels of services, drug coverage, and networks.

If you have significant medical needs, you may first want to look at the total costs of the coverage – which is the annual deductible plus the maximum out-of-pocket costs – as an initial filter. You can then research the providers and services. You can also see the types of drugs that are available, which is provided on the formulary on the profile page for the insurance company.

ACA policies have subsidies, which reduce the costs of the insurance. This applies to those households with income of 100% to 400% of the federal poverty level.

The ACA handles the tax subsidies through the use of tax credits. You have two options. First, you can estimate your income, and then the monthly premium will be reduced. Or, you can get the tax credit when you file your tax return.

If you take the first option, there is a potential problem – that is, if your income increases. This could mean that you will need to reduce your refund or even have to pay a higher tax. This is why you might want to be conservative with your estimate of your annual income.

Conclusion

Benefits are certainly complex and confusing. Even experts have problems understanding them. But it is a good idea to read through the materials. You can also get the help of an insurance agent or financial planner.

As we’ve seen in this chapter, there are some big gotchas with benefits. You definitely do not want to get hit with a huge bill.

You should also take advantage of the employer matches. This is an easy way to boost your investments for your retirement.

For the next chapter, we’ll take a look at employee stock options and other equity compensation.