Investing and tax question

[vanroth]

This is really two/three questions although related.

I currently max out my 401k (traditional) and contribute about $2500/year to an HSA. AGI wise we are at the point where our IRA contribution deduction is phased out completely. We have decent 401k balances, a small IRA, and two small Roth IRAs.

I have about $15K in cash sitting in my savings account collecting near zero interest (note: this is in excess of our “emergency fund”). Where would the board recommend putting this? HSA, Roth IRA, taxable investment, pay down mortgage? Understanding the yearly contribution limits.

For deduction maximization, I believe the HSA is my only option left -- though I already have a healthy HSA mutual fund balance and lifestyle (I’m 36). I realize that a HSA is one of the best tax deals going, but I worry about having too much locked into it. In my 20 years of adulthood, I’ve probably spent no more than $1k total in healthcare costs (outside of premiums). And I foresee both and my wife remaining healthy.

This leads to the question of putting some of this into a Roth to grow tax free. However, I also have about $80K of short-term capital gains loss carry-forward (thanks to the 2008 down turn). Is it more prudent to invest this money in a taxable account and use up the loss carry-forward? The theory being that the funds would not be immediately locked in a Roth IRA and could be reallocated later?

What investment vehicle is recommended? With the debt ceiling and budget issues looming, I’m leaning heavily towards very conservative options.

thanks,
vanroth

[MakeAStash]

Roth IRA sounds reasonable. In general, assets with the least-favored tax treatment (bonds are one) should go in IRAs. One problem with bonds is they have been in a 30-year bull market many feel will end this decade.

Investing to "use up" a capital loss carryover assumes capital gains, which are never a sure thing. You'll have some gains eventually, so IMO don't twist your asset allocation to simply use up a loss. Also remember that interest and dividends cannot be erased by a capital loss carryover.

[MonkeyMama]

I'd max out the HSA and put it into ROTHs.

HSAs can be used for retirement funds eventually, so would still be locked up for a while, but would eventually be accessible for more than just health costs.

ROTHs are the most flexible retirement vehicle - you can pull out contributions any time without penalty - so there is not "tied up until retirement age" like all the other retirement savings vehicles. I would not invest any money in taxable accounts until ROTHs were maxed out, accordingly.

I wouldn't personally plan around the losses. You will eventually have gains to offset, but is not a logical reason to pay a lot more taxes in the now. Like MakeaStash pointed out - you'd still be taxed on interest and capital gains.

[violet80907]

I think the right answer depends on your other investments and debt, and your Roth eligibility.

Since you are covered by a 401K plan, and you mention that your IRA deductions are phased out, I'm guessing you are not eligible for a Roth contribution. (I really mean I'm guessing; tax law is not my specialty. So verify if a Roth is even an option for you.)

If the Roth is an option for you, then you can choose to invest in the Roth or a non tax-defferred account, as with $15K and an $80K backlog of carry forward loss, you will likely be investing for many years to bring down the loss. Except that to have accumulated the loss, I'm (again) guessing you have other taxable investments you may not have mentioned.

Summary of that - IF you could keep this money in a taxable account, and trade for many years to come without any capital gains (as a result of your carry forward loss), that seems like a reasonable approach that affords long term flexibility. If you have other account that may quickly use up the carry forward loss, AND you are eligible for the Roth, that seems like a good approach.

However, if none of that is true (you are not eligible for the Roth, and you have taxable accounts that are likely to use up the carry forward loss in the near future), then I'd be looking at paying off debt. You mention you have a mortgage. I look at paying off a mortgage as similar to investing in a low yield long term bond. (Yes, there are differences like tax deductions for the mortgage interest; but in the big picture the net effect is similar when I have analyzed the two cases.) Pay off any higher interest rate debt first.

So also consider this an opportunity to diversify your portfolio by "investing" in debt. (If your entire portfolio is in equities, owning real estate is a diversification approach; even if it is your home.)

[vanroth]

Thank you all for the advice. For now my plan is to the advice max out the HSA (I probably only have $1.5-2K left before the limit).

In regards to the Roth IRAs, I really need to wait until tax time as I have not kept track of my AGI enough to see if I'm phased out there as well -- it is close. But if I can, I will max it out as well. MonkeyMama, thanks for reminding about the contribution withdraws. I had totally forgotten!

Violet, good point on the mortgage. It is my only debt, but I'm at slightly higher than market rate (5.35%) and cannot refinance in the immediate future. Paying this down some would give me a small "return" and enable me to refinance sooner. And to your question, I have no taxable investments right now (cashed out to settle my second mortgage (gone!!) and do some needed home repairs).

My wife and I are able to save about $20-25K cash a year, so I will have the same decision to make next year!

Thanks,
vanroth

[jpg7n16]

In my 20 years of adulthood, I’ve probably spent no more than $1k total in healthcare costs (outside of premiums). And I foresee both and my wife remaining healthy.

I personally think it's a very bad assumption to base future health care costs (at older ages) on your health of your prime adult years.

Fidelity Estimates Couples Retiring In 2012 Will Need $240,000

As others have said above, the combo is the best. HSA for tax deduction today AND tax free medical withdrawals later in life, and Roth for tax free withdrawals on anything you need in retirement.

In regards to the Roth IRAs, I really need to wait until tax time as I have not kept track of my AGI enough to see if I'm phased out there as well -- it is close. But if I can, I will max it out as well.

If it's phased out, and you don't have other IRAs, you can also "backdoor" your Roth contribution.

Make a non-deductible standard IRA contribution (no income limit on non-deductible contributions), and then convert the full balance to a Roth. As you'll have a basis of the full contribution, no additional tax due, and you'll have a Roth. Nice.

[thesimplemoneyblog]

As others have said above, the combo is the best. HSA for tax deduction today AND tax free medical withdrawals later in life, and Roth for tax free withdrawals on anything you need in retirement.


If it's phased out, and you don't have other IRAs, you can also "backdoor" your Roth contribution.

Make a non-deductible standard IRA contribution (no income limit on non-deductible contributions), and then convert the full balance to a Roth. As you'll have a basis of the full contribution, no additional tax due, and you'll have a Roth. Nice.

Vanroth, it sounds as if you have a good plan now. Finish contributing the max to your HSA, then consider contributing to a Roth if you find that you aren't phased out. Then, with any excess, you can contribute to a regular investment/brokerage account although as you have indicated it might make sense to split out some of the contributions to pay more on your mortgage.

As JPG stated, you can still contribute to a Roth in a roundabout way. However, if you have other Traditional IRA monies, when you do a Roth conversion, the IRS will treat it is if it was a pro-rata conversion. I.e. if you had $10,000 in a Traditional IRA, and $5,000 in an non-deductible IRA (regardless of whether the accounts are together, same custodian, different custodian, etc.), then the conversion of $5,000 would be assumed to come from 2/3 Traditional IRA (and thus would owe income taxes) and 1/3 non-deductible funds even if it was the monies in the non-deductible IRA portion that you converted.