#1 Advice We Gave our Kids

This post had almost 1,000 page views in large part because it is the only post we’ve had featured on Money Mix. It provides a list of 7 themes about money that my kids heard frequently as they were growing up or as they were starting to make their own financial decisions. In addition, I added two other pieces of advice I wished I had given them.

#2 Should Chris Pre-Pay His Mortgage

This post was one of my favorite ones to write! Chris @MoneyStir published a post given a lot of detail about his financial situation. He asked others whether their opinion on whether he should pre-pay his mortgage. In my response, I showed Chris that, given his particular circumstances, he would be substantially better off after he fully re-paid his mortgage a large percentage of the time if he invested his extra cash instead of using it to pre-pay his mortgage. One of the broader takeaways from this post is the importance of isolating a single decision and not confusing your thinking by combining separate decisions into one process.

#3 Introduction to Budgeting

Introduction to Budgeting was our very first post. I’m not sure how high on the list it would have been had we published it later, as many of our friends viewed the post just to see what we were doing. I still think budgeting, whether done in great detail or at a high level, is a critical component of financial literacy, so hope that it is valuable to our regular followers and not just our curious friends.

#4 What to Do Once You have Savings

This post is the first in a series of three posts intended to provide a framework and guidance once you have some savings. The series talks about how much to put in emergency savings, how to save for big-ticket items, savings for retirement and deciding whether to pre-pay your student loans. For each type of savings, it provides suggestions for appropriate asset choices.

#5 Getting Started with Budgeting

This post is the first in a series of nine posts on how to create a detailed budgetA plan showing targets for income and expenses over a fixed time period, such as a month or a year.. The process starts with tracking your expenses to see how you are spending your money. Subsequent posts talk about setting financial goals and figuring out how you want to spend your money. The series finishes with monitoring your expenses to see how you are doing relative to your budgetA plan showing targets for income and expenses over a fixed time period, such as a month or a year.. This post includes a spreadsheet that allows you to track your expenses.

#6 New vs Used Cars

This post totals up all of the costs of owning a car to help you understand how much better off you might be by buying a used car rather than a new car. For some cars, it is much less expensive to buy used, whereas for other cars it doesn’t cost much more to buy new especially if you plan to own it for a long time.

#7 Traditional vs Roth Retirement Plans

This post provides lots of information about Traditional and Roth IRAs and 401(k)s. It also explains in what situations a Roth is better than a Traditional plan and vice versa, including some examples. The biggest determinant of that decision is your expectations about your marginal tax rateA “marginal” rate is the amount by which the result changes if you make an addition or subtraction to one value in the calculation. In this case, we add or subtract an amount from taxable income... More at the time you save relative to your marginal tax rateA “marginal” rate is the amount by which the result changes if you make an addition or subtraction to one value in the calculation. In this case, we add or subtract an amount from taxable income... More at the time you make withdrawals. The post provides lots of information on taxes, too, to help you make that decision.

#8 New Cars: Cash, Lease or Borrow?

This post explains the costs related to buying a new car with cash, leasing a new car and borrowing to pay for a new car. It provides a detailed illustration for three different models. The best choice among those three options depends on your ability to pay cash, how many miles you plan to drive, and the terms of each individual offer. For some cars and situations, leasing is less expensive than borrowing whereas, for others, borrowing is better. It also provides a spreadsheet that allows you to compare your offers.

#9 Car Insurance

I was surprised that this post made the top 10. I spent my entire career in the insurance business so probably have forgotten how complicated car insurance is! This post describes all of the important terms and coverages you’ll find in a car insurance policy. It also provides some insights on how to decide what coverages, deductiblesThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More and limits to select.

#10 Health Insurance

On the other hand, it didn’t surprise me at all that this post made the top 10. In fact, I would have expected it to rate higher than it did. As with #9, this post explains all of the terms included in health insurance policies. Its companion post explains how to select the health insurance plan that best meets your needs and your budgetA plan showing targets for income and expenses over a fixed time period, such as a month or a year.. That post includes a spreadsheet that follows along with the calculations. I recently had to select an individual health insurance plan as my COBRA benefits expired. I used exactly the process described in this post to make my decision!

January 15, 2019September 28, 2019

6 Tips About Homeowners and Renters Insurance

Homeowners, condo-owners and renters insurance policies cover you for loss or damage to your property and liabilityWhen used as a noun, the amount you owe to someone else. When used as an adjective, an insurance coverage that protects you when you cause damage or injury to someone else or their property. that emanates from your residence. All three policies cover your belongings regardless of where they are as well as injuries to others that happen at your residence. In addition, a condo-owners policy protects you against damage to the part of your condo that you own (generally the walls in). A homeowners policy protects you against damage to your home and any other structures. While that seems quite straightforward, there are some nuances that make the coverage more complicated. In this post, I’ll provide you six tips that will help you better understand your coverage. In the rest of the post, I will use the termThe time period over which you re-pay the loan “homeowers” to include both condo-owners and renters.

1 – Read your homeowners policy

If you’ve read some of my previous posts (such as this one), tip #1 isn’t a surprise! An insurance policy is a contract and, like any other contract, I recommend you read and understand it. To be clear, I’m referring to the 30-or-so-page document with the details of your coverage, not your declaration page which is the 2-3-page summary of what you bought. I get a paper copy of each of my insurance policies every year. If you don’t get one in the mail, you may need to ask for one or visit your insurer’s website to get a copy.

With insurance, it is a little less critical to read the policy before you buy it, as there isn’t anything you can do to change the policy wording itself. The wording of personal insurance policies is approved by the state or provincial insurance regulators. Nonetheless, you’ll want to read your policy to make sure you understand what is and isn’t covered. An insurance policy is actually fairly easy to read. My recollection from when I took actuarial exams a gazillion years ago is that the policy must be readable at the sixth grade level. So, while it has a lot of pages, it shouldn’t take you more than a half hour to read the policy (maybe a little longer the first time).

2 – Carefully check your declaration page

Your declaration page lists all of the coverages you purchased, the dollar amount of limit you bought for each coverage, the locations that are insured and any endorsements you purchased. You’ll want to check this document before you buy. Here are several things to check:

Is the location right?

It probably is. However, I reviewed a relative’s policy one time and saw that his rental property was missing from the declaration page. If there had been damage to the rental property, my relative would have had to first prove that the insurer or agent made a mistake by not including the rental property and then could have made a claim. Fortunately, by reviewing the declaration page for him, I found that the rental property had been omitted before he had a claim.

Do the limits make sense?

If you own a home or condo, does the structure limit seem reasonable? Remember it is the cost to re-build your house or condo. For many years, that amount was much higher than I paid for my house, as existing homes were much less expensive than building a new home. In “hot” markets, the re-build cost could be lower. So, be sure to think about the re-build cost, not the market value.
Do you have any other structures, such as detached garages or workshops? If not, you don’t need much limit for other structures. If so, make sure the limit is high enough to re-build those structures.
How much would it cost to replace all your “stuff,” known as personal property? In most jurisdictions, the personal property limit on a homeowners policy is automatically set to 50% of the limit for the house. That amount may be right on average, but isn’t necessarily right for each individual. When I lived in California, housing prices were very high. As a young homeowner, my personal property was not worth anywhere near 50% of the replacement cost of my home. For places with a very low cost of housing, the opposite can be true. You can’t change the personal property limit in some jurisdictions, but it doesn’t hurt to ask if this limit doesn’t look reasonable. If you have a condo-owners or renters policy, you get to select the limit. (In Tip 5, I talk about creating an inventory with photos. It will be helpful for estimating your limit, too.)
Do the limits on specific items, such as jewelry, musical instruments and collector coins, need to be raised? Not all policies have the same items with these types of limits, so be sure to check your declarations page if you own any individual items or collections that are particularly valuable. Most insurers can add an endorsementA change to an insurance policy that adds, modifies or deletes some aspect of coverage. (essentially a few extra paragraphs that change the terms of your policy) to increase these limits.

Are there coverages you don’t need?

There are a large number of other types of endorsements that either restrict or add coverage. The names of the endorsements on your policy are listed on your declaration page and the wording should be attached to your policy form. If not, ask for it! Take a look at these coverages to make sure that there aren’t any that you shouldn’t be buying. I had one relative who reviewed his declaration page and found that he was paying for sump pump failure coverage. That endorsementA change to an insurance policy that adds, modifies or deletes some aspect of coverage. covers repairs due to water seepage when a sump pump fails. His house didn’t have a sump pump, so the coverage was unnecessary. It is harder to figure out if there are endorsements you should have that you don’t. If you are insuring your first home or condo, you might want to talk to your agent or insurer to review the types of endorsements available to figure out which ones you might want to purchase.

3 – Make sure you understand what isn’t covered

A homeowners policy does not provide coverage against everything that can happen. In fact, the policy includes a long list of causes of loss or perils that are not covered. Many of them are not covered because they are under the control of the insured. That is, if the insured does something to cause a loss or neglects to do something that could have prevented a loss, it is considered intentional. Intentional acts can’t be insured.

Other perils, floods in particular, are not covered because the potential losses are considered (at least by the government) to be so widespread as to be too big for the insurance industry. If you live in a flood zone, you can buy flood insurance from the National Flood Insurance Program.

Some perils, such as earthquakes, are not covered because they are so expensive that insurers require you to purchase them separate from the rest of the policy. By separating the very expensive coverage, the rest of the coverage becomes more affordable. When I lived in California, the cost of earthquake coverage was more than the cost of the rest of my homeowners policy. In addition, the earthquake coverage had a 10% deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More. I chose to not buy the earthquake coverage because it didn’t fit in my budgetA plan showing targets for income and expenses over a fixed time period, such as a month or a year.. Fortunately, we didn’t have any earthquake damage.

There are several sections of a homeowners policy that identify exactly what is and isn’t covered, so be sure to look for all of them.

4 – Be aware of little extras that are covered

You may be surprised by some of the costs that are insured under a homeowners policy. You’ll want to make sure you are aware of them so you can recover the full amount you are due from your insurer. One example is additional living expenseA coverage under a homeowners, condo-owners or renters policy that pays for the increase in your living expenses so you can maintain your normal standard of living if your residence is uninhabitable d... More coverage.

Additional living expenseA coverage under a homeowners, condo-owners or renters policy that pays for the increase in your living expenses so you can maintain your normal standard of living if your residence is uninhabitable d... More coverage pays for the increase in your living expenses so you can maintain your normal standard of living if your residence is uninhabitable due to an insured peril. It also provides coverage if you are required to evacuate due to an emergency. That is, if you need to rent an apartment for several months or stay in a motel for a while, it will be reimbursed by your insurer. Any reimbursement will be reduced by the portion of your deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More that wasn’t used by the damage itself.

As an example, there was a fire in a transformer in my mother’s condo building. The building was declared uninhabitable for a little over a week. In addition, the smoke was bad enough that her walls, ceilings and all of her belongings had to be cleaned. It turned out the ceiling had asbestos that had to be removed. The building insurance covered the asbestos abatement and cleaning, but she was responsible for the rest of her costs so submitted them to her insurer. Her insurer not only paid to replace her belongings that were damaged by the smoke (such as her TV and computer), but also the cost of her plane ticket to my house for her initial evacuation period and the cost of a residential hotel for a month while her condo was cleaned and abated.

There are several other such extras, including financial loss if someone forges your signature and worldwide coverage for loss or damage to your personal property (not just when it is in your home). You can find out more about these coverages when you read your policy. (Hint, hint.)

5 – Be ready if you have a claim

A homeowners insurance policy has a list of duties for the insured in the event of a claim. These duties include promptly notifying your insurer or agent, notifying the police if there is a crime and protecting the property from further damage. When you have a loss, the insurer may send someone fairly quickly to help you prevent further damage, such as drying carpet and furniture to try to avoid having to replace it or tarping or boarding up windows or roof damage.

Keeping an inventory of your belongings is one of the most important things you can do (and one that I have been remiss in doing). If part or all of your residence is destroyed, such as in a fire, you’ll need to provide the insurer with a list of what was lost, including the quantity, replacement cost and age. Obviously, it is impossible to keep a list of every item you own! The most important things to put on the list are those that are valuable – electronics, cameras, furniture, jewelry and watches, collectibles and the like. It is particularly helpful, especially for unique items, if you take pictures of the items and the receipts and store them outside your residence (e.g., on the Cloud). If you have a loss, you will be able to access that information as documentation for the insurer.

6 – As always, buy the highest deductible and highest liability limits you can afford

A deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More is the amount that you pay on each claim before the insurer starts reimbursing you for your loss. On a homeowners policy, the deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More applies only to the property coverages, not liabilityWhen used as a noun, the amount you owe to someone else. When used as an adjective, an insurance coverage that protects you when you cause damage or injury to someone else or their property.. When an insurer sets the premium for a policy, it has certain expenses and often a profit margin that are essentially percentages of the losses it pays to or on behalf of insureds. So, if you buy a lower deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More, the losses paid by the insurer will go up. Your premium, though, will go up by the insurer’s estimate of the average amount of insured losses it will cover under the deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More plus the insurer’s additional expenses and profit margin. The additional premium could be 125% to 150% or more of the additional losses. If you can afford to pay more on each claim through a higher deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More, you won’t have to pay the additional expenses and profit.

If someone gets injured or dies due to a condition that exists at your residence, you may be legally responsible for their medical expenses, lost wages and other costs. If those costs are more than your liability limit (including the limit on any umbrella insurance you buy), you will become legally responsible for those costs. A higher liabilityWhen used as a noun, the amount you owe to someone else. When used as an adjective, an insurance coverage that protects you when you cause damage or injury to someone else or their property. limit can reduce your chance of becoming liable for these types of costs. Of course, a higher limit also increases your premium, so you’ll need to evaluate both your deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More and the premium for a higher limit in the context of your budgetA plan showing targets for income and expenses over a fixed time period, such as a month or a year..

October 30, 2018March 15, 2019

Employer-Sponsored Retirement Plans: Types & Benefits

Once you have the basics covered – food, housing, transportation and a few other things, saving for retirement is likely to become a priority. Many governments have retiree income programs, such as Social Security in the US. However, as is discussed in this post, many of those programs do not replace a large portion of pre-retirement income. In addition, a few people – more in Canada than in the US – are fortunate enough to have defined benefit plansA form of retirement plan under which the counterparty, often your employer, promises to pay you a stated amount of money, sometimes adjusted for inflation, on a periodic basis usually from when you a... More. When it provides a defined benefit planA form of retirement plan under which the counterparty, often your employer, promises to pay you a stated amount of money, sometimes adjusted for inflation, on a periodic basis usually from when you a... More, your employer promises to pay a fixed benefit after your retirement age until you die. Unless you have a very generous defined benefit payment to support you or you plan to cut back significantly on your expenses when you retire, you will need to save money for retirement. An employer-sponsored retirement plan is one way to save tax-efficiently.

Figuring out how much money you need to retire is a very complicated process. Even though I’ve retired, I’ll never be 100% certain I have enough money. I’ll talk about some of the considerations in evaluating how much you need in a future post. For young people, I suggest saving as much as you can towards retirement. If you find yourself with too much retirement savings, you can always stop making contributions at some point in the future.

Starting Early

Compounding of investment returns, a topic I covered in this post, is a significant benefit of starting early. Here are a few illustrations to show how making contributions when you are younger can help you when you retire.

In the first illustration, assume that you save $2,000 for 10 years and that it earns a 5% return every year.[1] The graph below shows the amount of money you will have saved at each age through age 65 under three scenarios. The scenarios differ only by the ages at which you make the contributions. The blue line represents how much you will have if you make contributions only from ages 25 through 34. In this scenario, you will have about $114,000 when you reach age 65.

By comparison, the red line corresponds to savings if you make contributions from ages 35 to 44; the green line, ages 45 to 54. Using the same 5% return assumption every year, you would have about $70,000 if you make the contributions for 10 years starting at age 35. You’ll have only $43,000 if you start your 10 years of contributions at age 45.

Consistent Contributions

The differences become even larger if you make the $2,000 per year contributions every year until you attain age 65. Using the 5% annual return assumption, you can see how much you will have saved if you start your savings at each of ages 25 (blue), 35 (red) and 45 (green) in the graph below.

In these illustrations, the savings at age 65 are $255,000 when contributions are started at age 25, $141,500 when started at age 35 and $71,000 when started at age 45.

Of course, many people are able to make larger contributions as they get older and (hopefully) make more money. Nonetheless, these illustrations show the potential benefits of starting early with your retirement contributions, even if the amounts are relatively and consistently small.

Types of Employer-Sponsored Plans

Employer-sponsored retirement savings plans, also known as defined contribution plansA form of retirement plan under which you and possibly your employer contribute to an account. You are able to withdraw money from the account after you attain a certain age. The name “defined contr... More, can be considered in two broad categories relative to their impact on your income taxes, as follows:

Tax-Deferred Plans

For some plans, the money you contribute to the plan reduces your taxable income. For example, if you make $40,000 and put $2,000 into this type of plan, your taxable wages will be $38,000.[2] You pay income tax on the money in these types of plans only when you withdraw it in your retirement. In the US, the most common form of this type of plan is a Pre-tax 401(k)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More. In Canada, Group Registered Retirement Savings Plans (Group RRSPs), Registered Pension Plans (RPPs) and Defined Contribution PlansA form of retirement plan under which you and possibly your employer contribute to an account. You are able to withdraw money from the account after you attain a certain age. The name “defined contr... More (DCPPs) fall into this category.

Plans with Tax-Free Withdrawals

For other plans, you contribute after-tax money. In the example above, you would pay income taxes on your full $40,000 of salary. In exchange, you do not pay income taxes when you withdraw the money in your retirement. The most common forms of this type of plan are Roth 401(k)s in the US and Group Tax-Free Savings Accounts (Group TFSAs) in Canada.

Individual Retirement Plans

Don’t worry if you do not have employer-sponsored retirement savings plans. There are IRAs and Roth IRAs in the US and individual RRSPs and TFSAs in Canada that have similar characteristics. See this post for more information about IRAs, as well as the choice between Roth and Traditional retirement plans.

Benefits of Retirement Savings Plans

One of the key benefits of a retirement savings plan is that you almost always pay less taxes if you use one of these plans than if you don’t. Another is employer matching. Also, I found that having the money taken from my paycheck before it got to my checking account was very helpful in making sure I saved money for retirement.

Tax Deferral

I’ll use a very simple example to illustrate the tax benefits. Let’s say you are going to save $10,000 of your salary for retirement this year and are trying to decide what type of account to use. Let’s also assume you can earn a 5% taxable return every year on your savings and the applicable tax rate is 20%.

Invest Outside a Retirement Plan

If you invest the $10,000 outside of a retirement savings plan, you will pay 20% of the $10,000 in taxes, leaving you with $8,000 to invest. You will also pay 20% of the 5% earnings in taxes every year. In the first year, you will earn $400 and pay $80 in taxes, so you’ll have $8,320 at the end of the year. After 20 years, you’ll have $17,529 in your account after you make the tax payment for the 20^th year.

Invest in a Tax-Deferred Retirement Plan

If you put that money in a Pre-tax 401(k)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More or an RRSPA type of Defined Contribution Plan available in Canada. No taxes are paid on the contributions or any changes in the market value of the investments in the account until the money is withdrawn. That ... More, you do not pay taxes on the $10,000 when you make the contribution. You also don’t pay taxes on any growth in values until you make withdrawals. At the end of the first year, you have $10,500 in your account. After 20 years, you will have $26,533 in the account. When you withdraw it, you will pay 20% in taxes, leaving you with $21,226 or 21% more than if you had saved the money outside a retirement savings plan.

Invest in a Retirement Plan with Tax-Free Withdrawals

Under these assumptions, you’ll end up with the same amount of money if you deposit your money in a Roth 401(k)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More or TFSAA type of Defined Contribution Plan available in Canada. Contributions are made with after-tax dollars, but no taxes are paid on any changes in the market value of the investments in the account or wh... More as if you deposited it in a Pre-tax 401(k)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More or RRSPA type of Defined Contribution Plan available in Canada. No taxes are paid on the contributions or any changes in the market value of the investments in the account until the money is withdrawn. That ... More. The choice of fund depends on whether you think your tax rate will be higher or lower in retirement. If you think it will be lower, a Pre-tax 401(k)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More or RRSPA type of Defined Contribution Plan available in Canada. No taxes are paid on the contributions or any changes in the market value of the investments in the account until the money is withdrawn. That ... More will provide more money in retirement. Otherwise, a Roth 401(k)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More or TFSAA type of Defined Contribution Plan available in Canada. Contributions are made with after-tax dollars, but no taxes are paid on any changes in the market value of the investments in the account or wh... More will provide more money in retirement.

Employer Matching

Some employers match the contributions you make to their defined contribution plansA form of retirement plan under which you and possibly your employer contribute to an account. You are able to withdraw money from the account after you attain a certain age. The name “defined contr... More. As an example, for every dollar you put in your defined contribution planA form of retirement plan under which you and possibly your employer contribute to an account. You are able to withdraw money from the account after you attain a certain age. The name “defined contr... More, your employer might contribute another 50 cents up to a maximum of 3% of your salary. In the US, employer contributions are not taxable to the employee at the time of contribution. Matching contributions are put into a Pre-tax 401(k)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More regardless of whether the employee’s contributions are put in a Pre-tax 401(k)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More or Roth 401(k)A type of Defined Contribution Plan available in the US. There are three types of contributions that can be made to 401(k)s.
• Pre-tax - No taxes are paid on the contributions or any changes in... More. In Canada, employer contributions to a TFSAA type of Defined Contribution Plan available in Canada. Contributions are made with after-tax dollars, but no taxes are paid on any changes in the market value of the investments in the account or wh... More are taxable at the time of contribution, but employer contributions to a group RRSPA type of Defined Contribution Plan available in Canada. No taxes are paid on the contributions or any changes in the market value of the investments in the account until the money is withdrawn. That ... More are not taxable to you until you withdraw the money.

Vesting

As an incentive for employees to stay with the company, many employers increase your ownership in these contributions over time. For example, you might own only 20% of the employer contributions if you have been employed by that employer for one year; 40%, if for two years; 60%, if for three years, 80%, if for four years and 100%, if for more than five years. This process is called vestingA process by which an employer increases your ownership of an asset based on how long you have worked for the employer. Vesting is often applied to employer’s matching contributions to a defined con... More. Three-year cliff vestingA process by which an employer increases your ownership of an asset based on how long you have worked for the employer. Vesting is often applied to employer’s matching contributions to a defined con... More is another common vestingA process by which an employer increases your ownership of an asset based on how long you have worked for the employer. Vesting is often applied to employer’s matching contributions to a defined con... More schedule. Under this schedule, you are 0% vested until you’ve worked for the employer for three years and then are immediately 100% vested. If you leave the employer before you are 100% vested, the employer will withdraw the portion of its contributions and any earnings on the employer contributions that have not vested. To be clear, you always own 100% of your contributions.

Employer matching can be a terrific benefit. I always contributed enough to my defined contribution planA form of retirement plan under which you and possibly your employer contribute to an account. You are able to withdraw money from the account after you attain a certain age. The name “defined contr... More to get the maximum match. As long as you stay with the employer until you are even partially vested, the employer contributions are essentially free money. If the employer matches 50 cents on the dollar and you are fully vested, you are earning an immediate 50% return on your contributions. Even if you have the five-year vestingA process by which an employer increases your ownership of an asset based on how long you have worked for the employer. Vesting is often applied to employer’s matching contributions to a defined con... More plan above (20%, 40%, 60%, 80%, 100%), you’ll have an instant 10% return on your contributions after you’ve been with the company for one year. That 10% will grow if you continue to work for that employer.

Canada

In Canada, there is a single maximum contribution amount that applies to both your employer-sponsored and individual retirement savings plans combined. If your employer has only a limited number of very conservative investment options, you could save more money for retirement by putting the money in an individual account rather than the employer-sponsored account. For the individual account to have more money upon retirement, you need to be able to invest the money at a sufficiently higher return (i.e., in riskier investments) than can be earned in the employer funds to make up for the loss of the matching funds.[3]

Withdrawals

I won’t spend much time on withdrawals from employer-sponsored retirement savings plans, as I suspect most of my readers are a long way from retirement. Here are very brief explanations.

In the US, you are allowed to start withdrawing from your retirement savings plan without paying a penalty in the year in which you turn 59.5. Also, you are required to take out at least certain minimum amounts starting in the year in which you turn 70.5.
In Canada, you can withdraw money from your retirement savings plan without paying a penalty at any age. Starting at age 71, there are all sorts of complicated rules about converting your RRSPA type of Defined Contribution Plan available in Canada. No taxes are paid on the contributions or any changes in the market value of the investments in the account until the money is withdrawn. That ... More or TFSAA type of Defined Contribution Plan available in Canada. Contributions are made with after-tax dollars, but no taxes are paid on any changes in the market value of the investments in the account or wh... More to a different type of fund with minimum and maximum withdrawals.

At any age, you can borrow money from some employer-sponsored retirement savings plans for certain purposes, such as a down paymentThe amount you have to pay in cash up front for your purchase on a house. The details of the amounts you can borrow, for what purposes you can use the money and the borrowing costs vary, so you should talk to your human resources contact if you are considering a loan.

Acknowledgements

Many thanks to Laura Kenney and John McEwen for all of their assistance in providing details about US and Canadian retirement plans, respectively, and for reviewing early drafts of this post.

[1] It is very difficult to earn the same return every single year. I’ll discuss the risks and returns of different investment options in future posts.

[2] I am familiar with only Federal income taxes at a high level. Some states or provinces may require that you pay taxes on these contributions. If you have any questions about your specific situation, you will want to consult a tax specialist.

[3] See http://investorsavvy.ca/articles-2/articles/ for more information.

October 23, 2018March 28, 2019

How Health Insurance Works

Health insurance is one of the most expensive purchases you will make every year, whether you buy it on your own or through your employer. There are many terms specific to insurance and many more specific to just health insurance that are important to understanding how health insurance works. In this post, I will explain many of the terms related to health insurance coverage. This post covers different ways to finance your portion of medical costs and provide you with a spreadsheet to help compare different options.

Networks

Many health insurance plans are constructed around a “network” or list of medical providers who have contracts with the insurer. The list of medical providers in the network will be made available to you so you can review it. As discussed below, some health insurance plans reimburse you only if you go to providers in the network, while others reimburse a smaller portion of the costs if you go to an out-of-network provider. Plans that do not have a network are called indemnity plans. Under those plans, the reimbursement calculations are the same for all covered services.

Types of Networks

There are two types of networks generally available – health maintenance organizations (HMOs) and preferred provider organizations (PPOs).

Originally, HMOs were very strict in that they didn’t reimburse insureds for any expenses for out-of-network providers. They also required that you go to your selected primary care physician (usually, a general practitioner, family medicine doctor or internal medical doctor) before you could be treated by any other providers in the network, except in the case of emergencies. Some HMOs today are a lot more flexible, but it will be important to read the description of each HMO(HMO) A form of healthcare network, usually with fairly tight restrictions on which medical providers you can see and usually requiring you to see your primary care physician before you see a special... More option carefully to understand exactly it works.

PPOs are much more flexible in that they allow you to go to any medical provider in or out of the network. Your share of costs will usually be higher if you go outside the network.

Covered Expenses

Broadly, health insurance plans often cover “medically necessary” costs from medical providers (doctors, hospitals, various clinics) and prescription drugs. Dental and vision costs and over-the-counter drugs are generally not covered, but there are many exceptions. The specifics of what is covered varies widely from plan to plan and insurer to insurer. You’ll need to review the information you are provided carefully to understand what each option covers.

Deductibles

All health insurance plans I’ve ever seen have had some sort of a deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More.

What are Deductibles?

The deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More is the amount of expenses that you need to pay before any payments are made by the insurance company. Understanding your deductiblesThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More is one of the most important aspects of understanding how health insurance works.

Many PPO(PPO) A form of healthcare network that allows you to see any provider at any time, but usually with higher reimbursement rates by the insurer if you go to a provider in their network than one out of ... More plans have different deductiblesThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More for expenses in the network and those out of the network. I found these concepts quite confusing. It turns out that, in some plans, the out-of-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More applies to just out-of-network expenses and, in other plans, you add your in-network expenses below the in-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More to your out-of-network expenses when you apply the out-of-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More. I had to ask my human resources representative to explain which way the deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More applied in my plan, so don’t be embarrassed if you need to do the same. This distinction will be important in the cost comparisons below, so be sure you know how the deductiblesThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More under your plan work.

Examples of How Deductibles Work

For example, let’s assume you have a $1,000 in-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More and a $2,000 out-of-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More. You then spend $1,200 at in-network providers and $1,300 at out-of-network providers.

In the situation in which the deductiblesThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More apply separately, the first $1,000 of in-network expenses fully satisfy the in-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More, so the remaining $200 will be covered by the health insurer, though likely only in part because of the coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More provision discussed below. You have to pay the full $1,300 of out-of-network expense because it is less than the $2,000 out-of-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More. In addition, you have to pay another $700 of out-of-network costs before any out-of-network expenses would be covered by the insurer.
In the situation in which the in-network costs apply to your out-of-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More, the in-network costs are treated the same – the first $1,000 of in-network expenses fully satisfy the in-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More, so the remaining $200 will be covered by the health insurer subject to the coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More provision. The $1,000 that you paid as your in-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More will also apply toward your $2,000 out-of-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More, leaving $1,000 of out-of-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More. Because you have $1,300 of out-of-network expenses in this example, you would pay all of the first $1,000 of those costs and the remaining $300 will be covered by the health insurer, subject to the coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More provision.

Co-Pays

Some plans, most often HMOs, require you to pay a fixed dollar amount for each visit. Other plans require co-paysThe fixed amount that you pay for each provider visit or prescription. The fixed amount can vary depending on the type of provider or prescription, but does not vary based on the services provided at ... More on prescriptions. You’ll want to review your plan options to see if they use co-paysThe fixed amount that you pay for each provider visit or prescription. The fixed amount can vary depending on the type of provider or prescription, but does not vary based on the services provided at ... More and for what services they are charged.

Coinsurance

Once your expenses have exceeded your deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More, the health insurer pays you for a fixed percentage of the costs. The remaining portion, the percentage you need to pay, is called coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More (which is sometimes incorrectly called a co-payThe fixed amount that you pay for each provider visit or prescription. The fixed amount can vary depending on the type of provider or prescription, but does not vary based on the services provided at ... More). As with deductiblesThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More, the coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More percentage is usually higher for out-of-network expenses than for in-network expenses.

In-Network Co-insurance Example

For example, let’s assume you have the same deductiblesThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More as in the example above and that in-network costs apply to the out-of-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More. In addition, the plan has 20% coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More in network and 30% coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More out of network. For this illustration, you have spent $1,200 at in-network providers and $1,300 at out-of-network providers. You have the same $200 of in-network expenses that will be partially reimbursed by the health insurer. With a 20% coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More, you will have to pay $40 (20% of $200) of those expenses and the health insurer will pay $160.

Out-of-Network Co-insurance Example

The out-of-network piece gets more complicated and is one of the hardest parts of understanding how health insurance works.

First, we take the $1,000 of in-network expenses that you paid up to the deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More. We then add the $1,300 of out-of-network expenses, for a total of $2,300. The out-of-network deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More is $2,000, so a portion of $300 will be reimbursed by the health insurer. (You will pay the entirety of the first $1,000 of out-of-network expenses.) You will pay 30% of the $300 above the deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More as coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More, so you will pay $90 and the health insurer will reimburse you for $210. The table below shows the sharing of all of these costs.

	In Network	Out-of-Network	Total
Your Expenses	$1,200	$1,300	$2,500
DeductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More Amount	$1,000	$2,000	NA
DeductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More You Pay	$1,000	$1,000	$2,000
CoinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More %	20%	30%	NA
Total minus DeductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More	$200	$300	$500
Your CoinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More	$40	$90	$130
Your Total Cost	$1,040	$1,090	$2,130
Insurer Paid	$160	$210	$370

In the spreadsheet in this post, I’ve incorporated all of these formulas, so you don’t need to be able to reproduce the calculations exactly. It is still important to understand generally how they work

Out-of-Pocket Maximum

All health insurance plans I have seen also have a maximum amount on what you have to pay. That is, the health insurer will start paying for 100% of your covered expenses for the remainder of the year if your costs have exceeded the out-of-pocket maximum.

For example, let’s assume you have the same deductiblesThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More and coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More as in the above illustration. In addition, there is a $5,000 out-of-pocket maximum. Assume all costs are from in-network providers. You will pay your $1,000 deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More plus 20% (your coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More) of the next $20,000 of costs. (20% of $20,000 is $4,000 plus the $1,000 deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More totals the $5,000 out-of-pocket maximum.) If your total covered medical expenses exceed $21,000, you will not have to pay any further coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More.

Individual vs. Family Coverage

All of the examples I have provided above have assumed that you are the only person covered by your plan. Many plans also offer coverage options for just you, you and your spouse or partner, or you and your family. Under the “you and partner” or “you and family” options, there are two sets of deductiblesThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More and out-of-pocket maxima ─ one for each individual and one for the family.

Let’s assume you purchase coverage for you and two children. To keep things “simple,” we will assume that all of your expenses are in network. The coverage has a $1,000 per person and $2,500 per family deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More, a 20% coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More and out-of-pocket maxima of $5,000 per person and $7,500 per family. When evaluating how much the insurer will pay if your family has $25,000 of medical expenses, it depends on how much of those expenses emanate from each person in the family.

Out-of-Pocket Maximum Example – One Family Member

If the entire $25,000 of expenses were from one family member, your costs would be $5,000. That would be calculated as the $1,000 per person deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More plus 20% of $40,000 (=$4,800), totaling $5,800. The $5,800 would be capped at the $5,000 per person out-of-pocket maximum, so you would not have to pay the last $800 of coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More because it would put you above the maximum.

Out-of-Pocket Maximum Example – Two Family Members

If two family members each had $10,000 of medical expenses and the third had $5,000 and the second person’s expenses were paid latest in the year, the calculations would be as follows:

	Family Member #1	Family Member #2	Family Member #3	Total
Expenses	$10,000	$10,000	$5,000	$25,000
DeductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More	$1,000	$500	$1,000	$2,500
Excess of DeductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More	$9,000	$9,500	$4,000
Your CoinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More	$1,800	$1,900	$800	$4,500
Your Total Cost	$2,800	$2,400	$1,800	$7,000

Even though each individual’s deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More is $1,000, there is only $500 of family deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More left when Family Member #2’s expenses were paid, so you pay only $500 in deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More payments for that person. Because none of the values for the family members in the “Your Total Cost” row exceeds $5,000, there is no reduction in your total cost for the individual maximum. The total cost for the family is $7,000 which is less than the $7,500 family maximum, so it does not reduce your total cost either.

You can see that the $7,000 that you would pay if three family members contribute to the $25,000 of total medical costs is more than the $5,000 you would pay if all of the expenses were for medical care for only one person.

Negotiated Rates

One of the benefits of having health insurance is that the charges that are covered by insurance are based on amounts that the health insurer has agreed to pay the provider. On almost every medical bill I’ve ever received, the health insurer has negotiated a charge that is somewhat to significantly less than the amount that the medical provider bills. Your total costs will be lower if your health plan has negotiated bigger discounts with providers than if you purchased another plan with smaller discounts. Unfortunately, I’m not aware of any publicly available information that quantifies the amounts of discounts under different plans or different insurers.

Prescription drug coverage

I have seen a few different ways that prescription drugs have been covered by health insurance. Under some plans, you pay one co-payThe fixed amount that you pay for each provider visit or prescription. The fixed amount can vary depending on the type of provider or prescription, but does not vary based on the services provided at ... More amount for name-brand drugs and a lower amount for generic drugs. In other cases, prescription drugs are covered the same way as other medical expenses. If you have a plan similar with this feature, you pay 100% of the negotiated cost until all of your medical expenses have exceeded the deductibleThe amount that you pay before the insurer starts reimbursing you either in part (see coinsurance) or in full. Deductibles can apply per claim (as is usually the case for auto collision and homeowners... More and then you pay your coinsuranceThe portion of each insurance claim, expressed as a percentage, you pay after you have reached the deductible and before you have reached your maximum out-of-pocket payment amount. Coinsurance is ve... More until you reach the out-of-pocket maximum.

Acknowledgements

Many thanks to Laura Kenney and Jingyi Huang for their help with this post.