CFP® Book No. 2

College of Financial Planning

📚 GENRE: Business & Finance

📃 PAGES: 354

✅ COMPLETED: July 12, 2024

🧐 RATING: ⭐⭐⭐

Buy Book

Short Summary

The second of seven books in the CFP lineup, Risk Management, Insurance, and Employee Benefits Planning provides a solid education on different insurance and risk management products. It also outlines offerings commonly available to employees in company benefit packages. 

Key Takeaways

1️⃣ Insurance: Transferring Risk — All of us face risks every day. Put simply, the purpose of insurance is to give you the option to transfer risk over to a third party. The insurance company charges a fee (a “premium”) for absorbing the risk. Prior to the birth of insurance, people suffered losses individually — some people were lucky and didn’t have any issues while others were not as fortunate. Insurance allows the loss to be spread across society; the money we all collectively spend on premiums allows us to have coverage when something bad happens. 

2️⃣ HSA: Another Retirement Account? — The HSA is a terrific medical benefit for employees who choose a high-deductible company health plan. But, if used strategically, the HSA can also serve as another retirement plan because you are able to make contributions, and those contributions can be invested and grown within the account. Once you reach age 65, you can then withdraw HSA funds for any purpose. You will just have to pay regular (ordinary) income tax on the money.

3️⃣ Homeowners Insurance — You should buy enough homeowners insurance to cover the cost to replace your house, known as the replacement cost. Ideally, you should insure your home for 100% of its replacement cost. 

Favorite Quote

“Perhaps the simplest method for arriving at a life insurance coverage amount is to multiply the wage earner's salary times a number that works for the client. The ‘six, eight, or ten times salary’ rules have been used for quite some time in an effort to make the needs determination process less complex. The concept behind this rule of thumb is that by replacing the salary of the deceased for a period of years, the family will be able to continue as they were.”

Book Notes 📑

Ch. 1: Principles of Insurance

  • Risk Management — People face risks every single day. These risks can affect a person’s health, property, automobiles, life, and more. One of the jobs of a financial planner is to make clients aware of the unique risks they face, based on their life and lifestyle, and help them manage the risks. A good financial planner will sit down with the client and help them pinpoint their risks, develop a plan to address those risks, and implement the plan. 
  • Insurance Types — Insurance products are designed to help people transfer risk and protect their assets. Insurance essentially protects an individual from potential events that may or may not happen. Prior to insurance, people just suffered losses individually — some people were lucky and didn’t have any issues while others would not be so fortunate. Insurance allows the loss to be spread across society — the money we all collectively spend on premiums allows us to have coverage when something bad happens. Common types of insurance products include:
    • Home Insurance
    • Liability Insurance 
    • Life Insurance 
    • Health Insurance
    • Disability Insurance
    • Auto Insurance
    • Jewelry Insurance
    • Long-Term Care Insurance 
    • Annuities (Longevity Insurance)
  • The Risk Management Process — Financial planners should sit down with each client and help them assess their risks based on their lifestyle. There are four primary issues that should be addressed during these meetings:
    • Step 1: Identify — The first step is to help the client identify and establish risk management goals. This will look different for every client. Keys to this part include:
      • Risk Toleration — How much of the client’s lifestyle does he want to protect? Is the client willing to stop doing certain things in order to reduce his risk and avoid paying for insurance? For example, would the client be willing to give up his boat so he doesn’t have to pay for coverage on it? The planner needs to explore the boundaries the client wants to set. 
      • Pinpoint Unique Risks — Every client is different and carries out their own unique lifestyle. Think through each of the client’s activities and identify the financial risk that could result from the activity.
      • Educate — Insurance premiums are charged based on the probability of events occurring and anticipated costs of claims, plus underwriter costs and profits. Insurance companies are underwriting the probability of risk. Premiums are adjusted to account for the frequency and severity of a client’s activities. Auto insurance, for example, is costlier for somebody who has been in accidents before and has a collection of speeding tickets. It’s all based on probabilities. Help clients understand this.
    • Step 2: Gather Data — Gather data to determine risk exposure. This involves gathering as much information as possible on the client’s current insurance policies and their overall financial situation. 
    • Step 3: Analyze & Evaluate — Look at the information and assess the big picture from a risk perspective based on the client’s assets and activities. You will need to identify the risks and evaluate whether each risk is one that the client can afford to retain and cover on their (i.e. own out of pocket) or whether other risk mitigation techniques (e.g. insurance) are needed. 
    • Step 4: Develop a Plan — For each risk the client faces, select the appropriate action to cover it. This will likely include selecting certain insurance products. 
    • Step 5: Communicate, Implement, and Monitor — Communicate the plan to the client. Help the client implement the plan. Monitor the plan over time. 
  • Risk Avoidance & Reduction — For certain risks where the potential loss is small, the client or business is often better off covering it out of pocket without insurance. An example of this could include deciding not to cover certain pieces of jewelry. Another example would be me not insuring my $500 e-bike. In these cases, the client or business retains the risk. If losses are incurred, they pay the costs. This might be a good option as well if the cost of insurance is outrageously high and there are no better alternatives. If a client retains the risk, they should reduce the activity in question as much as possible to limit their chances of a problem. Not having to pay insurance premiums is one of the advantages of retaining risk and reducing the activity in question.
    • Quote (P. 11): “Reasonable risk retention could include not insuring antiques, gun collections, jewelry, and damage to an older vehicle. Self-employed individuals may choose to retain risks related to some of their business equipment, office overhead, or other risks. How much risk clients decide to retain could influence the size of their emergency fund, cash flow planning, life and disability coverage, and investment model.”
  • Risk Transfer: Insurance — The alternative to risk retention is risk transfer. This involves transferring your risk over to a third party who is willing to accept the risk in exchange for a payment (this is called a “premium”). Insurance is purchased by people to protect themselves against potential financial loss in the future. Actuaries are in charge of determining the price of premiums, and they use several factors to make their decision. One of the most important pricing factors are anticipated losses. Insurance companies like to make money, so actuaries are trained to predict possible losses for certain common scenarios. By doing this the insurance company knows roughly how much money certain scenarios will cost them. Therefore, if a customer is looking for coverage for some weird possible scenario, the insurance company likely won’t cover it. 
  • Deductible — A deductible is the portion of insured losses that the insurance customer is expected to pay before the insurance company pays anything. Anytime you have an insurance policy, there is a deductible. As the customer, you are responsible for paying any amount up to the deductible, but that’s typically the most you will have to pay. After the deductible is met, the insurance company pays anything over that amount. Typically, customers who choose insurance plans with higher premiums have a lower deductible and therefore pay less when a loss actually happens. These plans are usually chosen by people who feel that they are more likely to incur a loss. For example, somebody who is battling health issues might choose a health insurance plan with a lower deductible. Alternatively, somebody who is young and in great health might choose a higher deductible plan, which allows them to have a lower premium.
  • Categories of Insurance — There are three main categories of insurance. These are: social insurance, public insurance, and private insurance. Social insurance and public insurance are mandatory and are withdrawn from your paycheck by the government. Below is a little bit about all three:
    • Social Insurance — Social insurance is mandatory insurance administered by the government. The purpose of it is to protect people from large fundamental risks of life. Examples include Social Security, Medicare, and Medicaid. Social Security provides monthly income for people in retirement. You can receive Social Security payments as early as age 62. 
    • Public Insurance — Public insurance is also mandatory and administered by the government. This type of insurance is designed to enhance public trust in financial institutions. Examples include the Federal Deposit Insurance Corporation (FDIC) and Securities Investor Protection Corporation (SIPC). The FDIC insures deposits in banks and savings associations up to $250,000 per depositor. The SIPC’s coverage is up to $500,000 in total value per customer, including up to $250,000 for cash. These types of public insurance are in place to protect people from bank/financial institution collapses. 
    • Private Insurance — This is insurance offered by companies that create policies for home, auto, health, jewelry, life, and more. This is your typical State Farm policy. Or Geico. Or Progressive. 
  • Insurance: Regulation — Insurance is a regulated industry. The three main reasons for regulation of the insurance industry are (i) prevent the abuse of consumers, (ii) prevent the failure of an insurance company (think bank failure), and (iii) to maintain competition. Too much competition is actually a bad thing in the insurance industry because it will entice companies to underestimate future losses and lower their premiums in order to survive. This could easily spiral into a situation where insurance companies can’t cover losses and end up failing. This is why regulators prevent too many companies from entering the industry. Regulation of insurance companies is left to the states, but the federal government does have an indirect impact through its various legislation and policies. 
  • Collateral Source Rule — This rule states that if others cause you to suffer a loss, they are obligated to pay you for your loss and they do not have their liability reduced just because you had insurance to cover the loss. The insurance company that paid the claim has the right to seek repayment from the person causing the loss. In my garage leak situation, although my insurance paid me to cover the damages caused by the unit above me, they technically could sue the unit above me to reclaim those funds based on this rule (I think). 
  • Interesting Fact — Pools at apartment and condo complexes are gated mostly to protect the property owner from possible liability in the event of a drowning or serious injury. Pools are what is called an “attractive nuisance” which refers to something about a property that is likely to attract and possibly injure children. Property owners have to take steps to prevent harm, like putting up gates and installing locks. 
  • Insurance: Voiding — Interestingly, most insurance contracts operate with a “good faith” approach in which the insurance company trusts that everything the customer provided in his application is accurate and that nothing is being withheld. For example, the application for auto insurance often asks about previous tickets. If the customer later files a claim and it is discovered that he lied or withheld information in his application, the insurance company could void the contract. 
  • Underwriting & Adjusters — Underwriters have the job of determining whether a risk is reasonable and the degree to which the insurance company is willing to accept it. They then deliver a price for the premium/coverage. A lot of factors go into the underwriting process, including past history of the customer, current health, hobbies, and a lot more. The underwriter is essentially trying to decide how risky it is for the company to take on the customer’s potential risk of loss and what price justifies the risk they are taking on. People who have issues now, or in the past, are typically given a higher premium because there is more risk involved. Adjusters are responsible for investigating claims and determining the amount that should be paid out.
    • Quote (P. 191): “Underwriting is the process of evaluation that takes place when someone applies for insurance. The individual who reviews an insurance application and evaluates the financial, vocational, avocational, and health issues is called the underwriter. It is the underwriter’s responsibility to determine whether the proposed insured falls within a normal range of acceptable risks. If the proposed insured does, the policy is issued as requested. If the proposed insured falls outside of this range because of health reasons, job risks, avocation risks, or financial circumstances, the underwriter may decline the application, may charge an additional premium, or may exclude coverage for certain types of risk exposures for a specified period, or permanently.”
  • Adverse Selection — Ideally, insurance companies are looking for healthy people who don’t have a past history of issues. These are the people they want to insure. Adverse selection occurs when the insurance company is mostly insuring people who are high-risk candidates. These high-risk people know they are high-risk, which is why they are seeking insurance. Low-risk people often don’t seek out insurance. The result is adverse selection.
    • Ex. Auto Insurance — Auto insurance companies want to minimize the number of high-risk candidates; their goal is to have a pool of insureds that represents the average of the population, not one that is skewed toward the high-risk population. People who drive a great deal more than average and/or have a less-than-stellar driving record are more likely to seek insurance to help pay for their greater likelihood of having a claim.
  • Chapter Takeaway — We face a lot of risks every day. As a result, there are a lot of different forms of insurance an individual can choose from. Ultimately, all forms of insurance are designed for individuals who would like to transfer risk over to an insurance company. In some cases, it makes sense to assume the risk yourself, but insurance companies are always there as a form of protection. 

Ch. 2: Property and Casualty Insurance

  • Homeowners Insurance — There are three main types of homeowners insurance: Basic Coverage, Broad Coverage, and Open-Peril Coverage, which each successive type covering more and more stuff. Each successive type also therefore costs more. Open perils coverage is designed to protect against all perils except those that are specifically named and excluded. There are then six main homeowners insurance forms (policies) customers can choose from. The HO-3 form is the most popular and widely purchased of the six policies, accounting for the majority of homeowners policies purchased today. Under the HO-3, the customer is covered on an open-perils basis, which is the type of coverage that provides the most protection. 
    • HO-2 — Broad Form (named perils)
    • HO-3 — Special Form (open perils)
    • HO-4 — Contents Broad Form (for tenants or renters)
    • HO-5 — Comprehensive Form (open perils)
    • HO-6 — Unit Owners Form (for condominium owners)
    • HO-8 — Modified Form for Special Risks (older or historic homes)
  • Insurance: Law of Large Numbers — The “law of large numbers” is one of the core principles of insurance. Insurance companies basically want to spread their risk exposure over a very large number of customers. The more customers, the less overall risk they have because their risk is spread out. This is partly why owners of very expensive homes sometimes have a hard time getting coverage. There are significantly fewer multimillion-dollar homes relative to the number of homes priced below $500,000. Fewer homes at that price means more risk for the insurance company.
  • Home Insurance: How Much Coverage? — You should buy enough coverage to cover the cost to replace your house, known as the replacement cost. Ideally, you should insure your home for 100% of its replacement cost. However, some people underinsure their homes, sometimes insuring them for only 50% of the replacement cost. This underinsurance can result in insufficient premiums being collected by insurance companies, which in turn affects their ability to cover losses adequately. To address this issue, the coinsurance provision was introduced. This provision typically requires homeowners to insure at least 80% of the replacement cost of their home. This ensures that the insurance company collects enough premium to cover claims. If a homeowner does not meet this 80% requirement, they may face penalties or reduced claim payouts in the event of a loss.
  • Home Insurance: What Drives Pricing? — There are a few different factors that go into the price a customer will receive for coverage of their home. These include the following:
    • Construction — The price of labor and materials at the time of an application matter
    • Location — The safer the neighborhood, the lower your premium 
    • Policy Type — The type of policy you select affects your rate
    • Deductible — The deductible you select will affect your premium; the lower the deductible, the higher your premium. And vice versa. 
    • Insurer — The company you select will have an impact on your rate  
  • Personal Liability Insurance — Personal liability coverage is typically included in most homeowners insurance policies, although you can also purchase stand-alone personal liability coverage. The latter is known as a comprehensive personal liability (CPL) policy. Personal liability insurance provides financial protection in the event you are held legally responsible for injuries to another person or damage to their property. This is crucial for people who rent their home to a tenant. 
  • Auto Insurance — States require drivers to have auto insurance, though not everyone actually has it. Typical auto insurance coverage is shown in the 25/50/10 format, where liability for bodily injury is covered for up to $25,000 per person, $50,000 of coverage is assigned per accident, and $10,000 is covered for property damage. Each state has its own required coverage levels, but most follow this 25/50/10 format. A person’s auto insurance does not apply if they are using their vehicle for business, like Uber or Lyft. For that, you have to buy a business auto insurance policy. Auto insurance covers three general types of loss: legal liability, injury to the insured and family, and damage to the vehicle. Each auto policy has the following six parts that explain a person’s coverage:
    • Liability Coverage
    • Medical Payments Coverage
    • Uninsured Motorist Coverage 
    • Coverage for Damage to the Vehicle
    • Duties After an Accident or Loss
    • General Provisions   
  • Umbrella Liability Policy — An umbrella policy is like an extra safety net that can be used in addition to the personal liability coverage that comes with homeowners insurance and auto insurance. Umbrella coverage gives you some extra protection. Most umbrella policies require that you have a certain amount of liability coverage on your home and auto insurance. It then sort of acts like a backup policy if you get into a situation where you use up all of your personal liability coverage in your home and auto insurance policies. Because the umbrella policy works closely with the other policies, it is recommended that you get an umbrella policy with the same company that you bought your home or auto insurance with. 
    • Quote (P. 60): “Umbrella insurance provides additional liability coverage beyond the limits of your standard policies, such as home, auto, or boat insurance. It helps protect your assets from major claims and lawsuits, offering coverage for incidents that may not be covered by other policies. This type of insurance is particularly useful for those with significant assets or higher risk exposures.”

Ch. 3: Life Insurance and Annuities

  • Life Insurance — The purpose of life insurance is to provide funds to others in the event of the policy holder’s death. There are several types of life insurance, but all of them are designed to provide funds to the family of the policy holder after his death. These funds can help the family cover any outstanding debts (e.g. pay off a mortgage), pay for general expenses, and help them transition to a new life without their loved one. A customer’s health often has a big influence on the price of life insurance — the younger and better one’s health, the lower the premium on coverage. As an individual gets older, the price of life insurance increases. Another draw of life insurance is that the death benefit is received income-tax-free by beneficiaries and any earnings in the account grow tax-deferred.
    • Quote (P. 123): “Replacing the earning power of a family income earner and assuring liquidity for an estate to meet the surviving family’s cash needs when the estate is settled are the primary functions of life insurance for most families.”
  • Life Insurance: Family Situation — A client’s family situation will determine if he needs life insurance. A single person without any dependents likely doesn’t need life insurance. On the other hand, a husband and father of four children likely needs to have life insurance. Having coverage in place will help the family prevent financial hardship in the event of the policy holder’s death. 
  • Types of Life Insurance: Term — There are several different types of life insurance you can choose from. One is called term insurance, and it is used to cover yourself over certain amounts of time (hence the word ‘term’). With term life insurance, you get a guaranteed death benefit but no “cash value.” With whole insurance (next bullet), you get a cash value that builds over time. You don’t get that with term insurance. Within term insurance, you have a few options you can choose from. These include:
    • Annually Renewable Term — An annually renewable term policy provides death protection for one year at a time. The policy renews each year, and the policy holder pays the premium for another year of coverage. 
    • Level Term — With level term, you have the ability to choose coverage for certain intervals of time, such as 5 years, 10 years — all the up to 30 years. The premium you pay is typically guaranteed (or “locked in”) for the duration of the interval you choose. Therefore, the longer the interval you choose, the higher the premium. 
  • Types of Life Insurance: Whole — Whole life insurance is sometimes called permanent insurance because these policies are designed to last for the rest of your life rather than for a certain period of time, as is the case with term insurance. With all forms of whole life insurance, you get a “cash value” that can build over time. Within whole insurance, you can typically choose from the following options:
    • Whole Life — Whole life insurance is the most commonly chosen form of life insurance. The premium you pay is the same for the duration of the policy. The cash value you get with this policy is placed into the insurance company’s general account and grows very slowly but safely. You’re not going to grow your cash value with this type of whole life insurance, but you get a guaranteed death benefit and predictable premiums that are due at various intervals throughout the length of the policy. This type of policy is more conservative. 
    • Variable Life — Variable life insurance is similar to whole life insurance with one big difference: the cash value is placed into the insurance company’s separate account, which acts more like a mutual fund. In this way, your cash value is not guaranteed; it theoretically could go to zero because your money is invested in mutual fund-type investments. As with whole life insurance, your death benefit is guaranteed and you pay regular premiums over the length of the policy. To provide an example of how this works, let’s say the annual premium is $1,000 — $400 of that amount is applied to the death benefit and $600 is allocated to the sub account (cash value). This type of policy is riskier. 
    • Limited-Pay Life — Limited-pay policies are whole life policies with a shorter premium-paying period. Unlike whole and variable life, the premium payments eventually stop at a certain point (e.g. 20 years). However, the death benefit is still guaranteed until the time of death. Because the premium payments eventually cease, the premium payments are usually higher than the other policies. There is also something called a single premium life policy where you pay one lump sum payment and there are no other premiums to be paid. This is usually used when somebody inherits a large sum and wants to get some life insurance on the books with no additional premiums due. 
  • Types of Life Insurance: Universal — Flexibility is the big advantage with universal life (UL) insurance. Universal life gives policy owners the ability to adjust the premium, death benefit, and cash value to meet their financial goals. Unlike whole life insurance, universal life does not have a structured premium requirement; instead, it’s very flexible. Universal life comes with monthly deductions for mortality and administrative expenses; as long as the cash that the policy holder puts into the account (premium) is enough to cover those expenses, the policy remains in good order. If the cash surrender value is insufficient to support the deductions, the policyowner is required to deposit additional premium to avoid a policy lapse. Because of its flexibility, universal life insurance might be the only life insurance you’ll ever need. You can adjust so many features of it. A few of the big benefits with universal life include:
    • Flexible Premium Payments — Flexible premium payments allow the policy holder to determine when and how much they want to contribute to their plan. Premiums can be made at different intervals or can be stopped temporarily and resumed later. As long as the cash value in the account is enough to cover the amount withdrawn each month for mortality and administrative expenses, the plan is good to go. 
    • Adjustable Death Benefits — Policy holders can increase or decrease the death benefit to be paid out. For example, a father will need more life insurance coverage when his children are young. The death benefit should be higher to help the family in the event of his death. But when the kids grow up and become independent, the father can reduce the death benefit. The universal life plan allows for that flexibility. 
  • Types of Life Insurance: Variable Universal Life — This policy is a blend of universal life and variable life. It acts more like an investment account, and there is no guaranteed death benefit. The policy holder takes on a lot of risk. As an example, if the annual premium is $1,000, the entire amount is placed into the insurance company’s sub-accounts, where it is invested and could grow or decline. If the sub-accounts decline in value to a point that it cannot cover the monthly charges of the policy, the policy is dead. This is different than a variable life policy, where the sub-account could drop to zero and there is still a guaranteed death benefit. There is no guaranteed death benefit with variable universal life. 
  • Types of Life Insurance: Equity-Indexed Universal Life — These policies act like universal life insurance but are tied to an investment index, such as the S&P 500. They are not risky like variable policies. These are generally safe policies that offer the upside of potential gains in cash value via a market index. 
  • Life Insurance Riders — Most life insurance policies come with very basic coverage out of the box. There are a wide variety of “riders” that you can attachment onto your policy to customize the coverage to your needs. These riders include things like how the death benefit is paid out after the policy holder passes away, provisions for potential future disabilities or health concerns, and more. 
  • Life Insurance: Determining Coverage — Once a client is set on the idea of purchasing life insurance, the next big issue to tackle is deciding how much coverage to buy. There are several ways to do this, and some of them involve fancy calculations that can be done with software and calculators. One simple way to do it is called the “Multiple of Salary Method.” This involves multiplying the client’s salary times a number that they are comfortable with. The 6, 8, and 10 multipliers are commonly used, but you can use any number you want. Many people use this method because of its simplicity. The idea is to determine the salary of the individual over a period of time and purchase that amount of coverage. By doing this, the client’s family will receive the death benefit and hopefully be able to continue living the same lifestyle.
    • Quote (P. 124): “Perhaps the simplest method for arriving at a life insurance coverage amount is to multiply the wage earner’s salary times a number that works for the client. The ‘six, eight, or ten times salary’ rules have been used for quite some time in an effort to make the needs determination process less complex. The concept behind this rule of thumb is that by replacing the salary of the deceased for a period of years, the family will be able to continue as they were.”
    • Quote (P. 129): “Remember, the most important question in the life insurance selection process is not what type of coverage the client needs, but how much coverage the client needs. If the client needs a large amount of insurance and has limited resources, term insurance with a lower premium may be the only possible solution. The major concern is to cover the client’s risk exposures, which may require some compromise as to the type of insurance.”
  • Annuities — Annuities were created to address concerns about people outliving their money. Standard annuities typically involve a person making payments into the annuity for a period of time, and those payments are then given back later in life in the form of a monthly payment. Some annuities will allow the funds to grow while it is waiting to be dispersed later in life. These products are designed to provide financial comfort and relief in a person’s later years. Annuities are considered nonqualified when payments into the annuity are used with after-tax dollars. This means there is no tax to be paid when the individual later receives the money from the annuity. There are also qualified annuities, which involve payments using pre-tax dollars. These dispersions will be taxed later on when the annuity begins to pay out. Below are some of the features and choices involved with annuities:
    • Premium Payment Options 
      • Single Premium — One big up front, lump sum payment only
      • Fixed Premium — A predetermined premium which is paid in regular intervals on a scheduled due date (e.g. monthly)
      • Flexible Premium — The premium deposit can be changed by the annuity owner at any time 
    • Benefit Commencement Options 
      • Immediate Annuity — Income payments to the named beneficiary of the annuity start within a year after the contract is started 
      • Deferred Annuity — The annuity begins to pay out at some date in the future
      • Longevity Annuity — Similar to a deferred annuity; this one is specially designed to for a person’s later years. The annuity begins to pay out when the person is in their 60s, 70s, and 80s to provide some financial comfort and relief. 
    • Accumulation Options
      • Fixed Interest Annuity — There is a fixed interest rate that is paid on any money you place into the annuity
      • Variable Annuity — Money invested into the annuity is placed into separate accounts, which act like mutual funds and allow the money to grow (or decline) while the person is in the accumulation stage of the annuity. These are typically riskier because the money could tank if the market performed poorly. 
      • Equity-Indexed Annuity — This combines the previous two: there is a fixed interest rate on any money placed into the annuity (usually this rate is tiny) AND there is a second interest rate that is tied to an index, typically the S&P 500.
  • Types of Annuities: Single Premium vs. Deferred — Most annuities fall into one of two big buckets: Single Premium or Deferred. The single premium annuity involves one (usually giant) payment at the start of the contract, with dispersions then beginning the next month and continuing every month for the rest of the person’s life. Deferred annuities involve an accumulation stage where the person is making regular payments into the annuity, and a dispersion stage where the person (in the future) begins receiving monthly dispersions from the annuity for the rest of their life starting at a specific age. Between the time the person begins making payments into the annuity and the time that the annuity begins to make dispersions, it is possible to grow the money in the account depending on the type of deferred annuity that is chosen. There are three main types of deferred annuities: Fixed, Variable, and Equity-Indexed. Fixed is more conservative, while variable is riskier. 
  • Annuities: Payout Options — You also have quite a few different options when it comes to how you would like your annuity to pay out once the accumulation phase ends. A few of these options include:
    • Withdrawal — You can manually withdraw your money. Most contracts allow you to withdraw up to 10% of the accumulated value annually without a penalty. 
    • Fixed Payment — When the contract becomes annuitized (i.e. shifted from accumulation phase to distribution phase), the monthly payment is determined based on life expectancy and stays at that level for the rest of the payout period chosen (e.g. 20 years). You receive the same payment every month for that entire period.
    • Variable Payment — At annuitization, the contract is converted to a specified number of units based on amount in the contract minus contract fees and state premium taxes along with age, gender, and assumed investment rate (AIR). Annuity payments then increase or decrease in proportion to the extent that the net investment performance exceeds or lags the AIR. Market risk and returns are built into the payout structure that is based on the original amount invested. The principal is not depleted by the payments, and payments continue for the balance of the payout period chosen.
    • Straight Life Income — A straight life income option provides for the proceeds to be paid out in equal payments over the lifetime of the recipient and provides the maximum income that would be guaranteed not to run out as long as the annuitant lives. This is similar to the ‘fixed payment’ method except it is guaranteed to pay out for the rest of the person’s life rather than just over a certain period of time (e.g. 20 years). 
    • Life Income With Period Certain — This option allows beneficiaries to receive a person’s monthly annuity distributions for a certain period of time (e.g. 20 years) if the person passes away before the end of the period. If the person happens to outlive the period certain timeframe, they continue to receive payments for the rest of their life. This one essentially allows beneficiaries of an annuity to receive the annuity distributions if their loved one passes away. 
    • Life Income With Refund — This is similar to the one above. The difference is that the time period, rather than being something like 20 years, is the person’s entire lifespan. With this option, the beneficiary receives the person’s monthly annuity payments until the annuity is completely empty. Once again, this option helps ensure that beneficiaries get the person’s annuity payments if they pass away. 
    • Joint and Survivor Life — When a person wants the income from their annuity to last as long as either one of two people are alive, a joint and survivor option should be selected. A straight joint and survivor option will pay one amount as long as either person is alive. 
  • Taxation of Annuities — One of the reasons annuities became so popular is the opportunity for tax deferral. Most annuities are nonqualified, meaning the person is paying into the annuity with after-tax dollars during the accumulation phase. During the many years of the accumulation phase, the money is usually growing a bit. When the annuity is later annuitized, any distributions above the amount that was paid in by the person are taxed as ordinary income. But that’s OK, because a person’s ordinary income tax rate when they are old is likely much lower than when they were young (when they were making contributions). Any money that was contributed with after-tax dollars during the accumulation phase (i.e. the principle) is not taxed at all because taxes have already been paid on that money. A typical monthly annuity distribution will contain a mix of principle (not taxed) and earnings (taxed). Eventually, the full principle amount will be distributed. At that point, everything that follows will be taxed because it’s all earnings.
    • Quote (P. 144): “For most annuities, all money withdrawn on or after the annuity starting date will normally be taxable as ordinary income until all the earnings have been withdrawn (LIFO rules — last in, first out). After the earnings have been withdrawn, additional withdrawals will be considered a nontaxable return of principal/ original investment. For example, an annuity with $100,000 deposited is now worth $150,000. Withdrawals of any amount up to $50,000 will be considered earnings, fully taxable as ordinary income. Any withdrawals exceeding $50,000 will be considered a return of principal, which is not taxable.”
    • Quote (P. 144): “Once a contract is annuitized, each periodic payment from a nonqualified annuity is considered one part return of principal (tax-excluded) and one part return of interest (taxable).” 
  • Chapter Takeaway — Life insurance is purchased by people who want to ensure that their loved ones are covered financially in the event of their death. Annuities are purchased by people who are concerned about outliving their money. Annuities allow an individual to make deposits (the accumulation stage) which are then dispersed at a later stage in life (distribution stage). 

Ch. 4: Health, Disability, and Long-Term Care Insurance

  • Health Insurance Laws — There are three health-related financial exposures many people face at some point in their lives: medical costs, the loss of income due to disability, and the huge amount of costs for long-term care (LTC). The financial repercussions of these three things can cause a lot of stress. When it comes to health insurance, there are three main laws to know about: the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA), the Health Insurance Portability and Accountability Act of 1996 (HIPAA), and the Patient Protection and Affordable Care Act of 2010 (PPACA). More on these three below:
    • HIPAA — This law was passed in 1996 and ensures that people who are changing jobs, and dealing with any kind of pre-existing medical condition, are covered during the transition. It was also put in place to provide data privacy and security provisions for safeguarding medical information. 
    • COBRA — This law helps people who are leaving work (willingly or unwillingly) stay covered under their former employer’s health insurance plan for an extended (but limited) period while they transition. COBRA only applies to the core health insurance coverage, not added ancillary benefits such as dental or eye insurance. With COBRA, employees can maintain their former employer’s group health insurance for up to 18 months after leaving work — but the employee is responsible for paying the premium. Overall, COBRA ensures that individuals can maintain their health benefits, at their own expense, during transitions between jobs or other life changes.
    • PPACA — This law, known as the Affordable Care Act, aims to make healthcare affordable for everyone, including individuals who are not employed. This act was pushed forward mostly due to the fact that people who were not employed with a company (and therefore under the company’s health plan) had a hard time getting good healthcare. Among many things, this act makes it possible to buy healthcare in the open market. Plans are ranked using Bronze, Silver, and Gold labels. This act allowed me to get healthcare when I first moved to Arizona and didn’t have a job. I bought healthcare coverage in the open market. 
  • Health Insurance: Triggering Events — For most plans available through an employer, you can only make changes to your health insurance elections during the open enrollment period (usually in November). However, there are a few exceptions, known as triggering events, that will allow you to make changes to your health insurance anytime (usually anytime within 60 days). Below are the triggering events:
    • Marriage
    • Divorce 
    • Death 
    • Disability 
    • Losing or Changing Jobs
    • Reducing Number of Hours Worked
    • Moving (In or Out of State)
    • Turning Age 26
    • Turning Age 65
  • Healthcare Insurance: Medicaid — Medicaid is a government insurance program for people of all ages who do not have enough money and resources to pay for healthcare. You have to qualify for Medicaid. When you apply, officials look at your assets and determine if you are eligible. They also look at your residency and immigration status. Medicaid is a federal government program, but it is primarily carried out by the states. Therefore, every state handles Medicaid a little differently. Medicaid covers most health care costs, including hospital and doctor bills, as well as nursery home care. Your Medicaid coverage stops as soon as you no longer meet the qualifications.
  • Healthcare Insurance: Common Features — Most healthcare plans have similar features, including things like deductibles, copayments, coinsurance, maximum out-of-pocket limits, and more. Below is some information about a few features you’re likely to see with any plan:
    • Deductible — A deductible is the amount of money the individual will need to pay before the insurance company steps in. Once the deductible is met, the insurance company will step in and pay all expenses above that amount in accordance to the plan’s coinsurance stipulations (see next few bullets). Premiums are paid based on the deductible. For somebody covered under an employer’s healthcare plan, the premium is usually taken out of each paycheck. The higher the deductible, the lower the premium. The lower the deductible, the higher the premium. Many people who are healthy select the high deductible plan in order to pay less premium. 
    • Copayments (“Copay”) — Many plans have copayments, which are fixed fees for each visit to a doctor or physician. The fee, for example, can range from $5-$25 (or more) and is paid regardless of the service received. Let’s say your copay is $20; every time you go see your doctor for any reason, you will be responsible for a $20 copay in addition to any other money you end up owing for the visit. Copays contribute toward your deductible and annual out-of-pocket maximum. Many plans have separate copays for hospital stays and emergency room visits. 
    • Coinsurance — Once you meet your deductible, the insurance company steps in to help pay for things. Most plans have an 80/20 coinsurance stipulation, which means they will pay 80% of all costs above the deductible, as long as the services are covered under the plan. You are therefore responsible for paying the other 20%. The insurance company will continue to pay 80% of all costs until your out-of-pocket maximum is reached, at which point they will pay for 100% of covered costs. 
    • Out-of-Pocket Maximum — Every plan has an annual out-of-pocket maximum, which is the most you will have to pay for medical expenses that year. Once the out-of-pocket maximum is reached, the insurance company pays 100% of all medical expenses that are covered under the healthcare plan. With most plans, any money that goes toward your deductible, copays, and coinsurance payments contribute toward your out-of-pocket max. The out-of-pocket max is a huge relief in situations where a serious health crisis comes up. This is one of the best reasons to always have a healthcare plan, because medical expenses are extremely expensive. 
    • Supplemental Coverage — Supplemental coverage includes add-ons to the plan like dental, vision, and accident insurance. 
  • Healthcare Insurance: Preferred Provider Organizations (PPOs) — PPOs are one of a few Managed Care Plans. I’m including information on it here because my healthcare plan (through my employer) is a PPO. A PPO is a group of providers (e.g. doctors, specialists, hospitals, and clinics) that have agreed to be included in a particular healthcare plan. The plan pre-negotiates with these providers all the charges and fees for the various kinds of services a patient might need. The fees that come out of these negotiations are typically slightly below what a patient without a plan would have to pay for the services. The reason the providers are fine with giving discounts to the healthcare plan is that they are expecting more volume to their offices as a result of agreeing to be part of the healthcare plan. An example is when you call around to see if a certain doctor “takes” your insurance. Doctors that are “in network” with popular healthcare plans will likely receive more patients than ones who are not. PPOs typically have coinsurance stipulations that encourage patients to remain in network (e.g. 80/20 for in-network providers vs. 50/50 for out-of-network providers). 
  • Healthcare Insurance: Health Maintenance Organizations (HMO) — HMOs are the other major type of healthcare insurance organization. Similar to PPOs, HMOs provide healthcare services through a network of doctors, hospitals, and other healthcare providers. Unlike PPOs, HMOs emphasize preventive care and wellness programs to keep members healthy and reduce healthcare costs. HMOs require members to choose a primary care physician (PCP) and obtain referrals for specialist care, and they do not cover out-of-network services at all. PPOs, on the other hand, provide more flexibility, allowing members to see any healthcare provider without referrals and covering a good chunk of the costs for out-of-network services, but they generally come with higher premiums and out-of-pocket costs compared to HMOs.
  • Healthcare Plan In Action: An Example — Assume Frank has a major medical health insurance policy with a $1,000 deductible, a 20% coinsurance provision (80/20), and a $5,000 out-of-pocket maximum. Due to a hospital stay, Frank has $25,000 of eligible medical expenses. He first must pay the $1,000 deductible. Then, the coinsurance provision of the policy takes effect, under which he will pay 20% of covered medical expenses above the deductible until the out-of-pocket max is reached. After the $1,000 deductible is applied, $24,000 of eligible medical expenses remain; Frank’s 20% of this amount is $4,800. This amount plus the $1,000 equals $5,800. However, Frank is only responsible for an out-of-pocket max of $5,000. The insurance company will cover the additional $800 not paid by Frank plus 100% of the remaining covered expenses, which totals $20,000.
  • Medicare — Medicare is a federal health program mostly designed to assist people age 65 and up in their retirement years. Everyone contributes to funding Medicare — a portion of a person’s paycheck usually goes toward Medicare through payroll taxes. Employees and employers each contribute 1.45% of the employee’s wages to Medicare. In fact, one of the qualifications for Medicare is that you have contributed to the Medicare system via these paycheck taxes from your company for at least 10 years. There are benefit amounts, premiums, and copays involved with Medicare, and the details for all of these change every year and are announced in an annual booklet and online. Medicare has four basic parts:
    • Part A — This part covers four main basic areas: inpatient hospital care (i.e. in the hospital care), posthospital extended care in a nursing facility, posthospital home health services, and hospice care. Most people do not have a premium to pay with Part A, but there are copays and coinsurance for services received. 
    • Part B — This part pays doctors and physicians for other outpatient care (i.e. out of the hospital care/doctor’s visits), certain preventative services, screening tests, and other services. There is typically a premium that must be paid monthly to get Part B. 
    • Part C — This is called “Medicare Advantage,” and it provides four program alternatives: Medicare HMO, PPO, private fee-for-service, and Medicare special needs plans. These are offered by private insurance companies and work similarly to the group plans offered by employers. Part C essentially covers healthcare delivered by these managed care plans. 
    • Part D — This part provides prescription drug coverage. It’s intended to provide protection for seniors who have significant drug costs. People enrolled in Part D have a prescription drug deductible to meet, then their specific healthcare plan and Medicare will step in to help with prescription drug costs after that. 
  • Disability Income Insurance — Disability income insurance is designed to protect you in the event of an injury or illness that puts you out of work entirely, limits the hours you work, or prevents you from earning the same amount that you were before. A fixed, stated amount of money is paid to you every month while you’re disabled and is designed to replace your income. The definition of disability varies a lot. Generally, the broader the definition, the higher the premium. The person’s occupation is the most significant factor in the underwriting process; blue collar jobs, or jobs like police work or firefighting, are much riskier to insure, therefore coverage is more expensive than it is for people in white collar jobs. As with all other forms of insurance, there are “riders” that can be attached to a policy that make the policy customizable. The “cost-of-living” riders, for example, are essential — they monitor the inflation rate and increase your monthly payout accordingly. 
  • Long-Term Care (LTC) — Estimates show that 70% or more of those age 65 will need some form of LTC during their lifetimes. But what is long-term care in the first place? There are three general levels that define LTC. They are:
    • Skilled Nursing Care — This is the highest level of care, and generally refers to 24-hour availability of a registered nurse under a doctor’s supervision 
    • Intermediate Care — This refers to less intensive nursing or rehabilitative care that does not require 24-hour monitoring 
    • Custodial Care — This refers to care that is not medical in nature, but is nonetheless necessary for the health of the individual. This includes things like assistance with daily living (e.g. bathing, toileting, moving around, etc.) Most LTC falls in the custodial category and is often provided while the recipient is at home. 
  • Long-Term Care (LTC) Insurance — The problem with LTC is that it is really expensive! That’s why you can buy LTC insurance, which provides coverage (medical and nonmedical) for individuals with chronic illnesses, cognitive impairment, or difficulty performing daily living actions. LTC policies today tend to offer a pool of money that can be used for home care, adult day care, assisted living facilities (e.g. Papa Bud), nursing home care, hospice care, and more. Once you begin paying for LTC insurance, there are two ways that benefits become activated and begin to pay out. These typically occur when you are old:
    • Inability to Perform — You can no longer perform without serious help two or more activities of daily living, which include bathing, continence, dressing, eating, toileting, or transferring/moving from place to place
    • Impaired Cognitive Ability — You suffer from dementia, Alzheimer’s, or some other form of cognitive decline
  • LTC Insurance: Benefit Amount & Benefit Period — With LTC insurance, the benefit amount refers to the amount of money per day, week, or month that the policy will pay. A monthly benefit payment is usually best because it provides a lot of flexibility: the monthly payment can be put toward a variety of therapy appointments, nurse visits, and anything else that might be needed during the month. The benefit period refers to the number of years benefits will last before the policy ends. Choices often range from 1-10 years. There typically is not an option to have the benefit period last for the remainder of an individual’s life. 
  • Chapter Takeaway — You can use health, disability, and long-term insurance to protect yourself from the enormous costs of healthcare in the United States. Without these policies, medical costs can completely bury you. 

Ch. 5: Deferred Compensation and Stock Plans

  • Qualified vs. Nonqualified Plans — There are two types of plans that companies can offer to employees: qualified and nonqualified. Qualified plans include things like 401(k) plans, pensions, and profit-sharing plans. These are offered to all employees. There are also nonqualified plans like stock options and deferred compensation plans. These can be offered to chosen employees, usually high-ranking executives. The biggest differences between qualified and nonqualified plans involve the way they are taxed and the discrimination that is allowed, or not allowed. A closer look at both of these:
    • Taxation — Qualified plans like pension plans and company 401(k) plans qualify for favorable tax treatment, hence the name. This means an employee is not taxed on employer contributions or accumulated earnings (think 401k) until the funds are received from the plan at a much later date, when the employee is old and in a better tax bracket. With qualified plans, the employer gets to deduct contributions from its taxes at the time of its contribution to employees. Nonqualified plans do not qualify for favorable tax treatment, hence the name. These plans do not allow the employer to take a deduction for plan contributions until the employee actually receives the money, which is usually many years later. 
    • Discrimination — Companies use deferred compensation and stock plans in order to retain valuable, high-level leaders. Normally, you can’t give these types of rewards to employees due to discrimination rules. Various discrimination rules are in place for qualified plans, which include things offered to employees like 401(k) plans, pensions, and profit-sharing plans. But nonqualified plans do permit discrimination and are designed specifically to attract and retain executives and high-level leaders. Nonqualified plans include things like deferred compensation and stock options.
      • Quote (P. 215): “Employers are generally concerned with employee retention and performance motivation as important factors in achieving the company’s goals. These factors are especially critical at the executive level, where turnover could be very disruptive to the continuity of operations. In an effort to retain key employees, an employer can provide performance incentives and retirement benefits to employees through qualified plans. Qualified plans, however, cannot be offered to select employees since they must comply with nondiscrimination rules to maintain their tax-favored status. Nonqualified plans, because they do not receive the favorable tax treatment of qualified plans, are not subject to the nondiscrimination requirements of the Internal Revenue Code (IRC) and therefore can be offered to employees on a discriminatory basis.”
      • Quote (P. 219): “The greatest advantage of a nonqualified plan is that it is not subject to the nondiscrimination rules imposed by the IRC and ERISA. Therefore, the plan can discriminate in favor of selected, highly valued executives.”
  • Nonqualified Plans: Benefits — Nonqualified plans come with some unique benefits for both employers and employees. Again, these are plans that allow companies to recruit, retain, or reward select executives and other valuable employees. These plans allow companies to reward these leaders beyond the standard qualified plan limits (e.g. the 4% annual contribution into every employee’s 401k). A summary of these benefits:
    • Benefits for Employers — As mentioned above, the use of nonqualified plans is generally appealing to companies that want to provide compensation to executives in excess of qualified plan limitations (e.g. the annual company contribution into all employees’ 401k). In addition to providing retirement benefits, a nonqualified plan can be used to provide valuable employees with insurance coverage, incentive pay, and severance benefits. Again, nonqualified plans do not allow companies to take a tax deduction (unlike qualified plans); therefore, deferred compensation via nonqualified plans is especially attractive for employers that are in a low income tax bracket and do not need the immediate tax deduction associated with qualified plan. 
    • Benefits for Employees — One of the big benefits of nonqualified plans for executives and other valuable leaders is that they are rewarded with compensation beyond what is allowed for all other employees of the firm who are enrolled in qualified plans. Qualified plans limit the amount a company can contribute (e.g. the company will only allow an annual contribution of 4% in everyone’s 401k). This additional compensation usually goes a good job of keeping these selected employees at the firm, which prevents turnover at the executive level, leading to greater stability. With nonqualified deferred compensation plans, the employee also gets to defer their benefits/money until well into the future, which allows them to pay less taxes on the money than they would currently. 
  • Nonqualified Plans: Funding Methods — While qualified plans such as 401(k) arrangements have to always be funded, nonqualified deferred compensation plans can fall into one of three categories: unfunded, informally funded, and funded. More on these:
    • Unfunded — In an unfunded plan, the nonqualified plan benefits are supported by the general assets of the company. Therefore, the employee has no assurance that they will ever receive their promised funds. If the company goes bankrupt, the employee may never see their money. For this tradeoff, employees in nonqualified plans do not get taxed on the money until it is paid, which is usually far into the future when they are old and in a much lower tax bracket than they are currently. 
    • Informally Funded — Informally funded nonqualified plans are preferred by enrolled executives because they involve the company setting aside a separate reserve of money that is used to pay the future benefits. This is unlike unfunded plans, which draw on the company’s cash flow. With informally funded plans, the company is making an attempt to set money aside to pay executives enrolled in nonqualified plans. 
    • Funded — Funded plans are ones in which the benefits promised by the company are secured. For an employee, funded plans provide relief because the money is all but guaranteed to be paid, even if bankruptcy occurs. The downside is that the income is considered to be received in the current year and is therefore taxed at the executive’s current tax rate. The other plans don’t tax the executive until they receive the money, which is usually well into the future when they are in a much lower tax bracket. 
  • Nonqualified Plans: Types — Again, the intent of all nonqualified deferred compensation plans is the same: to provide benefits to executives at some future date in excess of those provided to normal employees. Nonqualified plans typically fall into two broad categories: elective and non-elective. More on these below:
    • Elective — In an elective nonqualified deferred compensation plan, employees/executives choose to receive less current salary and bonus compensation than they would otherwise receive, postponing the receipt of that compensation until a future tax year when they are in a lower tax bracket. Salary reduction plans are the most common form of elective nonqualified plans. In this plan, the employee elects to give up a specified portion of current compensation (salary, raise, or bonus). In turn, the employer promises to pay a benefit in a future tax year that is equal to the deferred amounts plus a predetermined rate of interest.
    • Non-elective — Non-elective plans are plans in which the employer funds the benefit and does not reduce the employee’s current compensation to fund future payments. Excess benefit plans and SERPs are the most common non-elective plans, and both of these essentially allow selected employees to receive more than the average employee in their qualified plan (e.g. 401k) each year. 
  • Chapter Takeaway — Qualified plans (e.g. 401k) are typically offered to all employees of an organization, while nonqualified plans (e.g. deferred compensation and stock options) are used by companies to attract and retain really valuable employees, like high-level executives. Employers can discriminate with nonqualified plans; meaning they can select who participates in them. This is not allowed in qualified plans; these must be made available to all employees of the organization. 

Ch. 6: Employee Group Benefits

  • Group Life Insurance — Group life insurance works by providing life insurance coverage to a group of people under a single policy, usually offered by an employer. Overall, group life insurance via your employer offers a convenient way for employees to acquire life insurance coverage; it’s easier than getting an individual policy on your own. I have a group life insurance policy with my employer. Below is how it works:
    • Eligibility and Enrollment — All employees are eligible to enroll in the group life insurance plan, usually during open enrollment periods or after being hired.
    • Premium Payment — The employer typically negotiates the policy terms with an insurance company and pays the premiums. The cost of the premiums is usually fully covered by the employer, but it could also be covered by employees via paycheck deductions.
    • Coverage Amount — The coverage amount is usually a multiple of the employee’s salary (e.g., one or two times the annual salary) or a fixed amount.
    • Beneficiaries — Employees designate beneficiaries who will receive the death benefit if the insured employee dies while covered by the policy.
    • Portability & Conversion — When an employee leaves the company, they may have the option to convert their group life insurance coverage to an individual policy, usually at a higher premium, or to take the coverage with them through a portability option. 
    • Claims Process — In the event of the employee’s death, the beneficiary files a claim with the insurance company. The insurance company processes the claim and, if approved, pays the death benefit to the beneficiary.
  • Flexible Spending Arrangements (FSA) — FSAs are usually made available in all company group health insurance plans. This feature allows an employee to set aside money from every paycheck and put it into an FSA. The money can then be used on a wide variety of covered services, from medical procedures and eye appointments to chiropractic care and more. To qualify as an FSA, there can be no employer contributions to this account, so it is entirely funded by the employee. A couple key features of the FSA:
    • Avoiding Income Tax — Money contributed into the FSA is taken from each paycheck, which, from a tax standpoint, lowers the employee’s salary. This means they will basically avoid paying income tax on that portion of their paycheck that goes to their FSA. 
    • Use It or Lose It — The money in the FSA must be used during the calendar year at some point, or else it is lost forever. The employee has a grace period of 2.5 months, so they technically have until March 15 of the following year to use their funds.  
    • Bonus Advantage — In addition to not having to pay income taxes on the money contributed to the FSA from each paycheck, the money also avoids payroll taxes (Social Security). A portion of every employee’s check is taken and contributed to Social Security (usually 5.65% of the check). But money contributed to the FSA avoids that.
      • Quote (P. 290): One great advantage with FSAs is that employee deferrals into an FSA are not only free of any income taxes (pretax dollars), but are also free of any payroll (Social Security) taxes. This is an immediate savings of 5.65% — the employee’s portion of FICA (Social Security) taxes. Add to this whatever marginal tax bracket an individual falls in, and the FSA can be quite a deal. Even for someone in a low federal tax bracket, such as 12%, they are saving 17.65% when taking into account the 5.65% that they would have lost to payroll taxes.”
  • Health Savings Accounts (HSA) — HSAs are available in most company group health plans to employees who select the high-deductible health plan option. Employees can set aside a portion of their paycheck to contribute to their HSA. Unlike the FSA, employers are allowed to contribute to this account, and any contributions from the employer are tax-free to the employee (e.g. my employer contributes $500 annually). A few other features of the HSA:
    • Triple Tax Advantage — The best part about an HSA is that, if used correctly, it could be used to help with your taxes in three ways. Number one — Money contributed into the HSA is taken from each paycheck, which, from a tax standpoint, lowers your salary, which means you’re paying less taxes on your salary. Just like the FSA, this means you will basically avoid paying income tax on that portion of their paycheck that goes to their HSA. Number two —the money in an HSA will earn interest and can also be invested in the market while it’s sitting in there. Any earnings you gain on the principle grow tax-free. Number three — the money in an HSA can be withdrawn completely tax-free if it is used for qualified medical expenses. 
    • Contribution Limits — The maximum an employee can contribute to the HSA in a single year is $3,650. For families (i.e. both parents have an HSA), the limit is $7,300. 
    • Penalties — There is a 20% “additional tax” levied for withdrawing HSA money and using it for reasons not covered by the plan. 
    • Age 65 — Once you reach age 65, you can withdraw HSA funds for any purpose without the 20% penalty, though withdrawals for non-medical expenses will be subject to regular income tax. This means that you can kind of use the HSA as a separate retirement account. This is actually a smart way to think of the HSA — if used strategically it can serve as another retirement account where you allow your money to grow over the course of your career and eventually withdraw it at a low tax rate. 
  • Workers’ Compensation — These are laws in all 50 states that allow employees to recover damages from an employer who may or may not have been at fault for an injury of some sort. If you are injured or suffer some kind of other harm while at the workplace, you could file a workers’ compensation claim. By doing so, you give up your ability to actually sue the employer. Medical expenses are the No. 1 benefit paid my workers’ compensation. Various forms of disability are second.
  • Chapter Takeaway — In addition to its benefits for paying various medical expenses, an HSA can be used as another retirement account. There are a lot of great tax benefits that come with an HSA.