This time of the year is typically your opportunity to review and select your benefit plans for the upcoming year. Get more out of your paycheck by spending some time to review each of the programs. There are times when enrolling in a program can actually provide more money in your paycheck or significantly increase your longterm savings.
To make the point, this post illustrates how the goal of savings can be influenced by the type of benefit program you use. I’ll demonstrate how using the right combination of savings vehicles can either increase your take home pay or allow you to kick start savings and accumulate a whole lot more. Essentially, I’ll demonstrate how to get more out of your paycheck.
Access to the right plans
To get more out of your paycheck, you need to have access to the right plans – pre-tax plans. By using pre-tax plans, you pay for certain benefits before the government has a chance to tax you. Once money is deducted from your paycheck to pay for benefits, the government taxes you, but now on a lower taxable income. With reduced taxable income, the amount you pay in current federal and state income taxes is less.
Two approaches
Think about two ways to approach optimizing these types of programs. Either to put money in your pocket today or to put money into savings programs for your retirement. In either case, if you want an opinion on savings options, you can check out a pervious post titled How Would I Save.
Let’s go through a couple examples. In each case I make the following assumptions. Gross pay is $2k per year paid every 2 weeks ($52,000 annually). Federal withholding is 22%, State withholding is 5% and Social Security withholding is 7.65%.
Put more money in your pocket today
The first example illustrates the goal of saving $200 or 10% of pay. The goal is to save $5,200 each year. The person has their paycheck taxed and then invests or saves.
In Example 1, the person is paid $2,000 in wages and after federal, state, and social security withholdings has $1,305 deposited into their bank account. Our example then invests $200 into their investment account. They have accomplished their goal to save 10% of their pay. After a year, $5,200 will be contributed to the investment account. Additionally, the person has $28,730 (26 x $1,105) to spend throughout the year.
However, by using a pretax account, we can improve these figures by saving before being taxed. In the second example, instead of saving after being paid, the person elects to have 10% of pay withheld and contributed on a pre-tax basis to a 401(k) account on their behalf. The numbers look like this:
The savings are deducted from pay before taxes are calculated. Less federal and state taxes are withheld (note: social security remains the same at $153; there is no reduction for 401(k) savings). The results is $200 is saved through the 401(k) but the net pay to the bank account is $1,159 or $54 higher than the first example. The person still hits their goal of saving $5,200 during the year. However, now they have $30,139 (26 x $1,159) to spend throughout the year.
In both examples, the person attained their goal of saving $5,200. Yet by understanding the tax implications of saving pre-tax versus after tax more money can be put into your pocket. Simply by saving $200 inside the pre-tax 401(k) before being paid rather than investing $200 after taxes creates $1,409 each year to spend on other things.
Put more money into your retirement accounts
Let’s change the goal. Let’s look at an example of maximizing savings with a focus on the amount of net pay left over. How can we put more money into retirement accounts without having an impact on the final take home pay? In the example, the person was perfectly happy to have $1,105 left over each pay period. That’s what we want our end result to be and at the same time put more money into retirement accounts.
This is where it gets interesting! For Example 3 we try to solve for the amount to be withheld pretax to the 401(k) while maintaining a $1,105 deposit to the bank account.
The results are pretty amazing. In both examples the person has $1,105 at the end of each pay period to spend. There’s no difference in the standard of living. But using the right type of account can make a big difference. The amount that can be saved on a pretax basis in a 401(k) account increases by 37% compared to saving on an after tax basis. $274 versus $200. The annual savings increases to $7,124 or $1,924 more than an after tax investment of $5,200. That’s pretty significant.
Health Savings Accounts can be even more attractive
A Health Savings Account (HSA) can make this even more attractive. If you have access to an HSA then I strongly encourage you consider using it as a long term savings vehicle for retirement. To maximize the benefit of an HSA, the account must be used for medical expenses.
When retired you will undoubtably have medical expenses. Rather than tap your taxable 401(k) account use a tax free HSA. HSAs have three powerful tax benefits:
- Tax Exempt Savings
- Tax Deferred Growth
- Tax Free Withdrawals when use to pay for medical expenses.
For 2021, the annual contribution limits are $3,600 for singles and $7,200 for married filing jointly. While not as high as 401(k) limits ($19,000 annually or $25,000 for those age 50+), over time a significant amount can be accrued in an HSA to offset future medical costs. Not surprisingly, medical costs in retirement are projected to be a large expenditure. According to Fidelity Investments, a couple turning 65 in 2020 will need $295,000 to cover medical expenses in retirement.
The other benefit of saving in an HSA compared to a 401(k) is a reduction in social security taxes. Unlike a 401(k), contributions to an HSA are not subject to the combined 7.65% social security withholding. For every $1,000 contributed, $76.50 in social security withholding is avoided.
HSAs can maximize your savings
So, how does this help our goal of maximizing savings while retaining enough money to pay for other expenses during the month? Look at the fourth example for the answer. Here, the person maximizes the savings in the HSA first ($138 x 26 = $3,588…close enough to the $3,600 annual limit). Then saves as much as they can in the 401(k) but stops when the net pay equals $1,105.
While maintaining the $1,105 in net pay, the person can save $138 to the HSA and an additional $153 to the 401(k). By using both types of accounts and leveraging the additional social security tax savings, the combined contributions are increased to $291. An impressive extra $442 saved each year utilizing both accounts compared to just saving in the 401(k).
Using the HSA/401(k) combination compared to saving after tax nets a considerable amount without affecting the net pay. After tax savings yields $5,200 annually in contrast to $7,566 in HSA and 401(k) accounts. That’s a 45.5% increase in annual savings just by using the right accounts.
Maximize your savings opportunities
The fourth quarter is typically benefits open enrollment season. I encourage you to spend some time looking at your benefit options more closely to maximize your savings opportunities. Often you can snag an employer contribution to the HSA and most 401(k)s offer a match. These additional amounts are there for the taking. Don’t leave money on the table.
Stay safe and vote!
Once again, I sincerely hope you, your families, and your friends are staying safe and healthy during this pandemic. With the election right around the corner, I hope you can exercise your right to vote in whatever way you can, as safely as you can. Really, that’s it…stay safe and vote!
Are you in the middle of your open enrollment season? Have you made any changes for 2021 programs that will maximize your paycheck? Share your thoughts in the comments section below. I’d love to hear from you.
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Cover photo credit: Karolina Grabowska