I had briefly covered special purpose investments as an objective earlier. I will detail out the products available and their relative benefits and disadvantages in this section. As the name suggest, these are investments used for a specific purpose. It can be either Education, Health or Retirement. The reason why these can be categorized as investments is that there is an option offered by them to invest the money into specified mutual funds and gain while the money awaits their special purpose to get triggered so it can be utilized. Obviously, it will not make good sense to have this money in a Savings account and accrue interest that is way below the inflation. What make these investments attractive and worth considering is that they are pre-tax and help you save tax in the year you have invested. The common disadvantage is that these must be used for a specific purpose or after a specific age (like in case of retirement plans).
Education
There are several companies that offer 529 plans where pre-tax money up to a certain amount per child during a tax year. This amount invested in this plan can be allocated to an equity or debt or similar mutual fund. This money and subsequent installments grow (or decline) based on the value of the underlying security selected. When the child is ready for college, they can use this money to pay for qualified education expenses.
On the face of it this plan looks very attractive, and it is if managed properly. There are a few key considerations that you must know to determine if it can be made applicable for you:
- If, for whatever reason, the child does not go to college, then this money can be withdrawn but with penalties and the withdrawal will be taxed as income in the year that it is withdrawn.
- If there is a downturn in the economy which leads to reduction in the value of the security that you have invested during the years when your child requires money for education, then you will fall short, and it will have to be financed through other means.
- If your child is eligible for scholarships or grants, then the college will deduct the amount in this account and release the remaining amount. This to me is the single most important reason where this plan fails. There are better investment avenues where this can be mitigated. See below:
Your child has access to education loan at 0% interest till such time your child drops off from their college. The loan remains non-interest bearing and requires no payment till 6 months after your child gets a job.
If you are planning to pay for your child’s education, you would be better off to fund your child’s education through a 0% education loan and keep your monies in an investment that would yield (say) 6% a year. That way, your money will grow substantially during the 4 to 6 years when your child’s loan is still non-interest bearing and then pay off the loan the moment it becomes interest bearing.
Health
Your organization would offer medical insurance each year. You usually have 3 or more options to choose from. The difference between these options is for plans that require lower payments to medical practitioner, higher amounts will be deducted from your paycheck (in a few cases employers match part of the premium for the plan). On the other end of the spectrum, you would have to pay a higher deductible for your medical visits and lesser amounts will be deducted from your paycheck (again, the employer may match partial amount based on your contribution).
If you are younger than 45 years, there is a higher likelihood that your medical expenses will be limited, and you do not need the best low deductible plan.
I would recommend that you estimate your numbers in a spreadsheet by inputting all the paycheck deductions and deductibles for medical visits and determine the best plan for you. The health insurance company also provides you simulators where you can input the expected number of visits and a few other parameters and it would recommend the best plan for you.
If the answer is a high deductible plan (which would be the case in most cases if yours and your family’s health is good) then ensure that you opt for an HSA Account and make a maximum allowable contribution from your pre-tax money for the year.
This will help you build investments for future medical payments when you will need it the most – after retirement or when you are diagnosed with a medical condition that would require higher medical payments. Most of these accounts allow you to invest the paycheck deposits into a mutual fund (again there are plethora of options from equity based to bond-based instruments to choose from) based on your risk appetite. This money will grow tax free during the period it remains in the account and you should have a substantial amount of money kept aside for medical emergencies.
The reason why I am recommending HSA accounts and not Education Accounts is that the chances of you and your family requiring medical treatments during your lifetime are certain whereas education may or may not happen and/ or you have other options like drawing 0% interest loans to fund your education.
Anytime in the future if you decide to move back to a low deductible plan then you can still utilize the HSA Account balance. Only restriction that would be imposed on you is that you will not be allowed to contribute to the account.
An additional option that your employer would provide is FSA account. This account can be availed irrespective of the medical insurance plan you select. The employer will deduct pre-tax the opted amount from your paycheck and credit this account (subject to maximum limits set by the federal government). You will have to use the entire amount during the same calendar year, or you will lose the money.
At an initial glance, this may sound scary and would keep you away from investing in the account. If you time your medical, dental, vision and mental health visits well, you would usually be able to utilize this amount during the calendar year. Also, if you also have HSA account you can keep that money growing and not touch is for the year. Obviously, the biggest risk is if you are not able to utilize the full amount then you will lose it (a few companies allow you to carryover about $500 to the next calendar year.
So, with just a bit of planning you can make the most from this option.
Retirement
You have a choice of several retirement schemes that are offered by your employer or those that you can invest for saving tax for a particular year. There are limits on how much you can invest in these schemes and these are usually revised upwards or kept the same each year.
Employer Provided Retirement Schemes
For the employer offered schemes (more popularly referred to as 401K), a few employers will match your contributions. The money invested in this account can be withdrawn only after your age of 59 ½ years. If you need this money earlier than this date, you will have to incur a 10% penalty. Your withdrawals will be clubbed to your existing income (irrespective of the age you withdraw) in that given year and taxed at the prevailing rates.
The employer will deduct your contributions each paycheck and invest in your retirement account. This account allows you to invest the paycheck deposits into a mutual fund (there are plethora of options from equity based to bond-based instruments to choose from) based on your risk appetite. The money will grow (or decline) based on the performance of your underlying mutual fund that you invest. This is a notional growth till you are 59 ½ years old. Penalty-free withdrawals are allowed only after this age and the entire amount (principal plus capital gains/ dividend reinvestment) is taxable.
Below are my recommendations for a 401K plan:
- If you are not a savvy investor and spend all your income, this is a good way for you to set aside so you are not financially insolvent the day you retire.
- The deposits will occur through your paycheck. This helps in systematic investing and de-risks the investments. However, these payments occur only on the days you receive your pay slips, and you do not have the flexibility to invest lump sum if the market dropped drastically on a particular day.
- The money that your employer will match your contribution is free money on the table for you and you should not miss it under any circumstances. It is a take it or leave it deal.
I recommend that you need to invest only up to the amount that your employer matches and not the complete limit.
- I also recommend that you do not invest more money in 401K as you will lose flexibility of withdrawing that amount if you need it before your age of 59 ½ years. There are other investments where you can divert this fund and they will provide you more liquidity and you can use some ideas to get better returns compared to 401K.
- Note that the entire amount principal plus capital gains being taxable in a 401K is a big disadvantage and, in a few cases, they wash away the tax savings that you realized when you were contributing. Your other investments will only be taxed for the capital gains, though they may be post-tax.
