The COVID-19 pandemic has reminded investors of the value of rebalancing portfolios. Because of my age, I’ve paid more attention recently to portfolio reallocation. People approaching retirement – certainly, retirees – should be more inclined to rebalancing from equities to bonds. For most of my life I’ve fretted more about inflation than rebalancing, but age has a way of redirecting one’s thinking.
History shows that redeploying equities into bonds does, in fact, contribute to tempering a portfolio’s volatility. But there are other reasons for rebalancing, too… reasons aside from volatility (risk) reduction. Folks already in retirement might need to convert stock into cash to meet increased living expenses. This accomplishes two purposes: volatility reduction AND cash flow enhancement. Younger investors might derive certain benefits by increasing risk via adjustments in equity shifting within their own asset groups (growth to value, domestic to international, dividend chasing, etc.).
Those wild inflation years in the late 70’s and early 80’s instilled in me a cautious nature regarding the erosion of purchasing power. I knew that rebalancing could deliver multiple benefits, but I put it off… still do to a certain extent. Face it, the stock market has been a good place to be since the mid-1980s, and there is a natural aversion to monkeying with a positive trend. I also debated about what a proper portfolio balance might be at given points in time – and whether the rebalancing effort might trigger unnecessary tax events, reducing net yield over time. Most of my early rebalancing efforts were within my own portfolio’s asset groups… small-value to mid- or large-, value to growth and back, individual stocks to funds (mostly index), but truth be told, most of my shifting was from individual stocks to low-cost mutual funds to gain diversification. These are all legitimate rebalancing choices and can reduce risk and enhance portfolio yield.
If, like me, you’ve been flirting with rebalancing but just aren’t certain when or where to start, here are some things to consider. Start with what’s motivating you to even consider rebalancing in the first place. Is it because retirement is at hand and risk reduction is of major concern? Are you worried about today’s generous market valuations? Has the market’s recent volatility given you more heartburn than usual? Perhaps, then, a movement from stocks to bonds is the right strategy for you – a reallocation that will likely reduce risk but NOT necessarily enhance returns. Over time, a stock-heavy portfolio traditionally outperforms one emphasizing bonds.
After considering your primary motivation for rebalancing, take a hard look at your existing portfolio (including real estate) and your stage in life. If you’re a new retiree with a portfolio heavy in equities, you are particularly vulnerable to a market decline. That comforting paycheck is gone but spending for day-to-day necessities remains a part of life. There is no worse time to experience a bear market… and no better time to comfortably shift more equities to bonds and cash (that Rainy Day fund) and to appreciate that inflation-adjusted Social Security check. If you’re still a bit light on day-to-day cash, this also might be a good time to convert a portion of those equities into an annuity – but use prudence about those non-inflation adjusting annuities. If you’ve been a reliable saver, Required Minimum Distributions (RMDs) are very much a part of your future, but if possible, don’t tap them until “required” (age 72). Avoid early draw downs of any source of capital… a key to your portfolio’s sustainability. Remember, it’s not uncommon to spend two or three decades in retirement.
By the way, if you’re like me and tend to procrastinate about rebalancing your portfolio, don’t forget the previously mentioned Target-Date Funds for all ages – funds that automatically rebalance across the years (until they match the Target Retirement Income Fund allocation). I’m not suggesting that you go whole-hog into target-date funds, but their presence in a portfolio will provide some comfort despite a malingering nature. For younger investors, low-cost, highly diversified target-date funds invest heavily in domestic and international stock funds and give lighter weight to domestic and international bond funds. As the years go by, those positions gradually reverse. I joined the target-date crowd later in life as my inflation-neurosis calmed a bit in the face of my ever shorter time horizon. With some target-date funds in hand, I now feel more at ease with chaotic markets.
It’s important that an investor have a meaningful blueprint by which to measure his or her investment successes, particularly when engaging in routine rebalancing. Comparisons to a benchmark will provide you with a better feel for what kind of rebalancing has worked for you over time. Since my primary objective to keep things simple – and because my portfolio is built around index funds – my benchmark is the S&P 500. Simple, yes, but a gauge that works for me.
Rebalancing necessarily involves buying and selling securities of one sort or another – activities that can lead to tax consequences. Accordingly, it makes sense to rebalance to the extent practicable within your tax-sheltered retirement accounts. For example, in an IRA brimming with low-cost Vanguard products, two things are avoidable: taxable events and high transaction costs. The same might be said for an employer’s 401(k) or 403(b) retirement vehicle, except fees tend to be a bit higher.
As to those taxable accounts, if yours is equity-heavy – and retirement is on the horizon – in lieu of triggering a tax bill explore the possibility of investing monthly contributions in underweighted (i.e., bonds) areas. If retirement is at hand, follow the “specific identification method” of selling winners… simply earmark your high-cost-basis units for sale versus the lower-cost-basis units… an effective way of minimizing capital gains.
Rebalancing an individual’s portfolio from stock to bonds – particularly in or near retirement – is clearly a risk reducer but is less rewarding from a yield perspective. Stocks tend to be more volatile and routinely outperform bonds. But stage in life is important when considering rebalancing. Typically, younger investors worry less about controlling risk. Because time is on their side, generating higher returns take precedence… and rebalancing takes a back seat.
I recall those years of making routine contributions to retirement accounts heavily weighted with equities. Volatile markets bothered me less than low yielding investments. And I must admit that this practice of not rebalancing can become a habit in the pursuit of higher yields… even in retirement. So, let me emphasize the importance of rebalancing as retirement nears. With less time for recovery from major market declines, risk reduction becomes increasingly important – more so than in those early years of asset accumulation. And as mentioned earlier, rebalancing can help with cash flow sourcing, diversification, tax avoidance, and if you’re so inclined, charitable giving. Give it some thought.
"Your portfolio is like your face: Don't touch it! Market declines ultimately become market recoveries. Also, keep in mind that bear markets do not destroy wealth. The behavior of panic-prone investors during bear markets is what destroys wealth."
― Hugh F. WynnSights
Subscribers tend to come and go, but during Wynnsights' first year the blog retained 96% of its subscribers. Although some subscribers are routine readers, and some are not – we all lead busy lives – I appreciate the fact that most of you have stayed in touch. What concerns me are those nonsubscribers who tend to come and go and may have missed details of some of the principles I admire. I suspect these “quiet” followers join us with less regularity than subscribers who likely are more familiar with my PDQ Principles of Investing… Patience, Diversification and Quality. Without question, I’m a John Bogle proponent (he’s gone now but his commonsense books on investing remain), and I fear that many of the blog’s occasional readers might have missed some of my year-old comments that preached Bogleisms.
I’m going to take another shot at ‘em in today’s remarks, hoping “the silent ones” are checking in. If so, they’ll hear another Bogleism sermon. It’ll be short and sweet but to the point because Bogle’s principles are the foundation for and embedded in my own PDQ principles. And a good place to rehash old news is to start at the beginning: The development of a simple investment plan.
Without an investment plan… a savings strategy if you will… you’re sort of flapping in the breeze. The plan needs to be simple… and followed. Otherwise, why bother? In order to effectively use this plan, an individual should save on a routine basis. And then, as Bogle would advise, “Buy Right And Hold Tight”. The time to start would be soon after nailing down that first real job. The place to start would involve buying an index fund around which to build a long-term portfolio. That’s right, make quality investments and keep them. If you don’t make informed investments, you’re just another ill-prepared investor chasing the latest rumor – essentially practicing the strategy of buying high and selling low.
My own search for quality led me to John Bogle.
The “Bogleism” that really impressed me involved his own pursuit of quality and his sound advice: “Forget The Needle, Buy The Haystack”. Advice that involves both attraction and avoidance – the attraction of investors to mutual funds in general (and index funds specifically) while at the same time avoiding the purchase of individual stocks… the killing of two birds with one stone shall we say. And, yes, I’ll continue to mention ad nauseum that index funds consistently outperform most actively managed funds as well as other investment strategies. Why, you ask? In large part because index funds save investors billions of dollars in fees, which reminds me of another Bogleism: “Minimize Costs”. During a 35-40 year working career, cost minimization will result in additional tens of thousands of dollars in your retirement fund. Reminds me of another Bogleism: “Investors not only don't get what they pay for, they get precisely what they don't pay for." In short, every dollar you save by investing in a low-cost, unmanaged index fund is a dollar of return that benefits you, not some Wazoo.
In other words, avoid the Wazoos. Investment fees matter – a lot – as do those taxes generated by Wazoos who manage high turnover funds. Be as ruthless as you can in minimizing fees. Be an investor, not a gambler. Make quality purchases and fall in love with them… such that if you have to hold them through several lengthy bear markets, you won’t mind. I call this index fund methodology “Daring To Be Average”. It involves being realistic about your long-term expectations of investment earnings. Be satisfied with earning “just the market average”. Over the long haul, you’ll end up more successful than most by doing so. Let “time” (compounding) instead of “timing” (inappropriate risk-taking) be your friend.
Speaking of being patient with quality investments, another Bogleism rears its head: “Time Is Your Friend; Impulse Is Your Enemy”. It brings to mind the true value of patient investing and the benefits of The Amazing Power of Compounding. Patience opens two major avenues of benefits: that of compounding and of not flushing in highly volatile markets. No herd instinct for you. Stay the course as insinuated above in “Buying Right And Holding Tight”. One of my favorite Bogleisms is “Hedgehog Beats The Fox”, an effective thought process I employ in times of excess market volatility. I simply imagine rolling myself into a spiny ball and ignoring the foxes… those Wazoos… while patiently holding my low-cost, high-quality, well-diversified index funds. It’s not a pretty sight, but it works.
In the final analysis, there’s no avoiding risk in the marketplace. All of us must constantly weigh the risk of loss against the risk of not reaching our investment goals: creating a comfortable life; sending kids to college; developing a low-stress financial retirement nest egg, etc. Managing risk is the key. Exercising patience… controlling emotions… time spent in, not timing of the market… all the while, keeping things simple. Most of us don’t need the Wazoos and their costly, complex strategies. And it’s been my experience to ignore what they do during those volatile markets we all experience from time to time.
A predicate of this simple approach to investing is that all-important “Rainy Day Fund”; a stash of cash set aside to cover the inevitable financial emergencies – events such as employment interruption, medical emergencies, auto or home repairs, etc. – and to provide a financial firewall to protect one’s long-term investment portfolio. Rainy Day funds help avoid borrowing money against 401(k)s or IRAs, loans, which too often are not paid back with long-lasting impact on life after retirement.
In summary, develop a simple plan, stick with it, and start saving and investing early (which will allow you to enjoy the amazing power of compounding); buy and hold low-cost, high-quality, well-diversified investments; avoid making impulsive decisions; and ignore the machinations of the so-called experts. They tend to flush on a whim, often advising others to do the same. Be Patient… Be Diversified… Buy Quality… and you’ll likely enjoy a low-stress financial life before and during retirement.
Can your Social Security stream of income (let’s call it SSSI) be viewed as a bond in your asset allocation? One camp argues no because it cannot be sold. The other camp argues yes because it provides a predictable “bond-like” income stream. The way I see it, your SSSI is a valued asset regardless of its salability... with caveats, of course. Its fixed-income feature does in fact give it a very bond-like shine despite its inflation-adjusted attributes. Point is, why argue the point? What the hell difference does it make? Social Security is what it is – and admittedly, a rather valuable and unique asset. Many investors do, in fact, stick it on their balance sheet at some calculated present value as if it was a bond. But such a calculation has validity only so long as the individual is alive and is only as valid as the “rate of interest” applied to its income stream. You might conclude that it’s an individual sort of thing.
It is an individual thing because its meaningfulness to you depends a great deal upon what other assets you have in your retirement portfolio. A huge plus-factor is that your Social Security income stream is inflation-adjusted, meaning it will hold its value… its purchasing power… as long as you live. Another relevant – but in this case, negative – factor is that when you and your spouse depart this life, it, too, disappears, making it an inconsequential asset to heirs. And another negative is its susceptibility to political uncertainties, meaning that the Social Security Trust Fund is nearing depletion. But intense political pressure by the AARP crowd will likely resolve that issue. In my mind, to most SSSI recipients, these negatives are offset by some significant positives – that this stream of income is not subject to market risk, nor is it influenced by what is happening in the interest rate world – or by the quality of the issuer of bonds an investor might otherwise choose to own.
If you’re terribly concerned about viewing SSSI as a bond – or not – then set it aside when determining your “proper” asset allocation and net portfolio annual spending requirement. This will enable you to make portfolio-related decisions without cluttering up the “net required spending” (3%?… 4%?... 5%? per annum) from your portfolio. No doubt, there is a lot of difference between a stream of income with a calculated present value of say… $350,000… as opposed to having bonds with a collective redeemable value of $350,000 in your retirement account. If you should need to raise a large sum of money quickly, bonds would no doubt better fit that dilemma than your Social Security stream of income. Alternatively, if you need the comfort of knowing that a portion of your retirement portfolio is not being eroded by Izzy The Inflation Monster, your SSSI should provide a certain measure of such solace.
In the real world, SSSI is an inflation-adjusted, guaranteed stream of income that will continue throughout your life – but not beyond the life of you and your spouse (child benefits notwithstanding). Except for the most recent government check in hand, SSSI’s guaranteed revenue stream is essentially illiquid. It cannot be sold, and it is subject to political risk. Facts, all. But by viewing SSSI as simply a “bond” in your portfolio, you’re overlooking some of its unique and very comforting characteristics. In a nasty bear market like the current COVID-19 mess, families in retirement with one… often two… social security checks in their portfolio are much less exposed to the stock portion of their portfolio than those without inflation-adjusted income streams. Being reminded of this fact might bring you some peace of mind that, heretofore, you haven’t bothered to enjoy.
Folks nearing retirement are often advised to delay taking Social Security in an effort to enhance future benefits. Some calculate that this delay can increase benefits by an estimated 8% for each year a retiree waits past full retirement age (the age at which a person may first become entitled to full or unreduced retirement benefits) to take them. Such credits accumulated by waiting no longer accrue beyond age 70. In normal times, this well-intended advice will, in fact, result in a guaranteed balance-of-life benefit – one that can even carry over to a surviving spouse if that spouse isn't claiming benefits on his or her own work record.
Compared to today's anemic returns on cash and investment-grade bonds, that 8% is a tough yield to beat. But is the advice to delay taking Social Security is still sound amid the chaos of the current COVID-19 crisis and the accompanying market drop that has so devastated investor portfolios. Face it, most portfolios aren't as robust as they were three months ago (despite recent recoveries). Not surprisingly, investors on the verge of retirement likely find themselves with slimmer retirement assets. Those caught holding inadequate “rainy day” funds to meet current cash needs might wish not to delay taking Social Security, thus buying time for their portfolios to “heal”. Just a thought.
My apologies for this rather wordy blog, but for those who might qualify for a Health Savings Account (HSA) and who are searching for beneficial tax-deferred retirement vehicles, it just might be worth your while to read. To watch the video, click here.
Our discussion last week about healthcare Flexible Spending Accounts (FSAs) spurred some queries about a related subject, Health Savings Accounts (HSAs). Are they one and the same? Because HSAs are frequently confused with FSAs, let’s briefly discuss the major differences.
Although both are tax-advantaged accounts for healthcare savings, they are quite different. Unlike an FSA, money contributed to an HSA can be invested much like contributions to a 401(k) or an IRA. And unlike an FSA, HSA contributions don’t fall in the category of “use-it-or-lose-it” if not spent in a given plan year. Unused HSA contributions can be carried over from year to year, year after year. That’s right, a plan participant doesn’t need to spend HSA money during any specific timeframe. This makes HSAs excellent vehicles for saving and investing to cover healthcare expenses after retirement – when such expenses are likely to increase. You must have a qualifying high-deductible health plan to enroll in an HSA. Not all employers offer HSAs, but some of those who do make contributions on their employees’ behalf. If your employer does not offer such a plan, HSAs are available with any number of reputable financial institutions.
There is no deductible or out-of-pocket maximum to save in a healthcare FSA. The “use it or lose it” clause is the limiting factor here since most of the money in an FSA has to be used during the same plan year. An FSA participant simply can’t accumulate a large balance in this type of account because of the “use it or lose it” feature. With an HSA, there is no requirement to use the money contributed every year. In fact, the characteristics of an HSA actually encourages the participant to contribute more each year.
Problem is, unless folks are enrolled in a health insurance plan with an annual deductible of at least $1,400 for single coverage ($2,800 for a family), they aren’t eligible to contribute to an HSA. However, tons of people meet this standard, but few take advantage of the numerous benefits an HSA offers. Many simply aren’t aware of its several advantageous features: no “use-it or-lose-it” clause to deal with each year; its tax-deductible contributions, which can be invested; and qualified healthcare expenditures you make from this account are tax-free. In short, an HSA is a tax-advantaged savings and investment account designed to help folks save for their out-of-pocket medical expenses. The central requirement for participation is having a qualifying high-deductible health plan. For 2020, it’s an insurance plan with a deductible of at least $1,400 for single coverage ($2,800 for family coverage). And in 2020, the plan must also conform to an out-of-pocket maximum threshold for an HSA-qualified health plan of not more than $6,900 for self-only coverage or $13,800 for family coverage. An out-of-pocket maximum is a cap, or limit, on the amount of money you have to pay for covered healthcare services in a plan year. If you meet that limit, your health plan will pay 100% of all covered healthcare costs for the rest of the plan year.
Contribution limits, which must be made by April 15, are set annually by the IRS. In 2020, they're $3,550 for self-only coverage and $7,100 for a family (HSA participants 55 or older can contribute an additional $1,000 as a catch-up contribution). Be aware (but it’s a good thing) that if your employer makes HSA contributions on your behalf, these are included toward the annual limits.
Contributions made to an HSA don’t have to remain idle – as they would in an FSA. That’s one of the beauties of this type of account. The money can be invested, usually in a selection of options not unlike 401(k) choices. Of course, a participant can leave it in cash or a near-cash equivalent, but why do that? If the money is wisely invested, why not pay certain healthcare costs out-of-pocket and leave your invested dollars intact? If affordable, this practice would allow the participant to use an HSA’s investment feature to build a long-term health savings account… only one of several tax advantages offered by HSAs, some of which aren’t available with other “tax-advantaged” vehicles. Curiously, this investment capability is not widely understood and practiced. Only a small percentage of HSA participants invest their fund accounts – in my mind, the most compelling reason to enroll in an HSA, and let’s discuss why.
If you qualify to enroll in an HSA, and then if you invest all of your annual contributions, you’ll be blessed with certain tax advantages that “collectively” aren’t available with other tax-deferred investment vehicles. Consider one of my endless examples using a Bankrate investment calculator: Suppose that at age 25 your qualifying family joins an HSA and contributes the tax-deductible annual maximum of $7,100 (about $592 per month). Suppose further that this money is invested at 7%, compounded annually and grows tax-deferred (just like it would in an IRA, 401(k), or other retirement vehicle) for 25 years. Then suppose, after 25 years, tax-free withdrawals from the HSA (now totaling $469,400) are available to pay for qualified healthcare expenses. What a huge stress-reliever that would be.
Viewed another way, your HSA combines the tax-free withdrawals of a Roth IRA with the tax-deductible contributions of a traditional IRA or 401(k). Or you could simply let it continue to grow another 15 years to provide you with an even larger nest egg ($1,472,000) for healthcare expenses going into retirement at age 65. Even after assuming a 2% annual inflation rate, you would still have spending power equivalent to $667,000 in today’s dollars. And don’t forget the $284,000 of contributions from age 25 to 65 that your family has been able to exclude from income. The only kicker is that the money must be spent on qualified healthcare expenses UNTIL YOU TURN AGE 65!
So what qualifies as tax-free healthcare expenses? Because the IRS provides an exhaustive list in Publication 502, I’ll only mention a few: Prescription medications, nursing services, dental and eyecare, hearing aids, surgical expenses, and yep, long-term care is on the list. By and large, HSA withdrawals must be spent on “qualified” medical expenses as defined by the IRS. However, as subtly mentioned above, once you reach age 65, money can be withdrawn for any reason, but there’s a tax kicker. If not used for qualified medical expenses, withdrawals after age 65 will be treated as taxable income, but no penalty will apply. In short, “over age 65 HSA withdrawals” will be treated the same as withdrawals from a traditional IRA or 401(k), although it's worth mentioning that the penalty-free withdrawal age for most other retirement accounts is 59½ years old. This treatment is another reason why HSAs make good retirement savings vehicles.
But be advised, there is no such thing as a flawless investment account. HSAs, too, suffer the imposition of penalties for “non-qualified withdrawals”. Most prominently, if a participant under age 65 withdraws money to pay for a non-qualifying expense, the result is a stiff 20% early withdrawal penalty – double that of 401(k)s, IRAs, and most other retirement plans. Why? Such non-qualifying expenditures defeat the purpose of HSAs and are discouraged.
To summarize, the characteristics that make an HSA such a good retirement savings vehicle includes the enhanced family contribution limit of $7,100 ($1,100 greater per annum than for a 2020 IRA); no maximum income threshold as with an IRA; upon retiring, no fretting about Required Minimum Distributions (RMDs) after reaching age 72 as is the case with other tax-deferred retirement accounts; and don’t forget the absence of that onerous “use it or lose it” provision.
Contributions can be carried over year to year, year after year and can be invested just like IRA and 401(k) contributions. It’s a dollars-and-cents game, folks. Studies show that retired couples should prepare to spend upwards of $300,000 (in today’s dollars) on out-of-pocket healthcare expenses in retirement… all the more reason, if qualified, to consider this tax-deferred investment combined with the ability to take tax-free distributions to cover qualified medical expenses. I’ll close with another boring example: If your tax bracket after retirement is 25% (very possible), without an HSA you would have to withdraw $400,000 from IRA or 401(k) tax-deferred accounts to scrounge up the aforementioned $300,000. With an HSA, you could cover those medical expenses with a $300,000 tax-free withdrawal.
Last week we discussed a recently revised IRS guidance that allows for mid-year changes to dependent care Flexible Spending Accounts (FSAs). The taxing agency also provided similar relief for the even more popular healthcare FSAs that allow pretax employee contributions to employer-sponsored FSAs to cover unreimbursed medical expenses. Fun Fact: Over 22 million workers participate in healthcare FSAs, four times as many as use dependent care plans.
Healthcare Flexible Spending Accounts (FSAs) are popular among workers. However, like dependent care FSAs, they have become potential liabilities for participants who set aside hundreds… even thousands... of dollars to pay for medical care that might no longer be accessible due to the Covid-19 virus. Healthcare plans allow for $2,750 in pretax contributions to cover out-of-pocket qualified healthcare expenses for the worker, his/her spouse, and dependents. A married worker’s spouse can contribute $2,750 to another healthcare FSA with his or her employer. This represents a significant savings to employees who avoid paying federal income and FICA taxes on the pretax paycheck withdrawals. Employers benefits, too, because they avoid paying the 7.65% employer FICA tax match.
Like the dependent care FSA, the tax-advantaged healthcare version includes an onerous “use it or lose it” feature. Quite simply, if a healthcare FSA participant doesn’t use the money set aside for unreimbursed medical bills within the plan year, the unspent funds are forfeited to the employer. And here’s the Covid-19 rub. Because folks have delayed so many elective surgeries, dental procedures, and other non-emergency medical treatments during the height of the pandemic – and because so many have been reluctant to reschedule such treatments – money set aside in the plan could go unused… and forfeited.
The new IRS guideline allows – but does not require – employers to amend their plans. The revision allows employees to change their healthcare contributions, including dropping them altogether, going forward. But the employer can choose to amend its FSA, or not. And as to that innocent sounding “going forward” caveat, the employee must spend the money already deducted from his paycheck in the current plan year. Of note, most employers support this change and will likely participate.
The benefit of these rule changes allow the Covid-19 impacted worker to opt out of making contributions during a plan year, an option not previously permitted before, except under restrictive circumstances. At their option, employers may allow either a 75-day grace period after the end of the plan during which any remaining healthcare FSA funds can be spent or grant the ability to roll over up to $550 of unused funds into the next plan year, but not both.
With regard to the money already set aside but yet unused, workers can spend it on certain out-of-pocket medical care to include deductibles and co-payments (but not premiums), dental work, eyeglasses, prescription medications, medical equipment, transportation costs, parking and mileage expenses when making doctor visits, and the like. Also, the IRS healthcare rules had already been tempered a bit by the earlier Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which will allow workers to use “captive” contributions on such expenditures as over-the-counter medicine and feminine hygiene products.
A worker’s designated annual pretax contribution to a healthcare FSA is “preloaded”… available for use on day one of the plan year. Workers reimburse the employer FSA’s disbursed funds incrementally through paycheck deductions during the plan year. In short, an employee can be reimbursed for a full year’s plan contribution before paying back a penny. And the employer cannot recover unreimbursed funds if the worker is terminated before the balance is repaid. Seems unfair to the employer until we’re reminded that any unused worker contributions at the end of the plan year revert to the employer. Further, if a worker is terminated for whatever reason before all of a given year’s funds are spent, the remaining contributions revert to the employer.
Here is the IRS notice in black-and-white:
IRS (2020-95, May 12, 2020) Notice 2020-29
Provides greater flexibility for [workers] by extending claims periods to apply unused amounts remaining in a health FSA for expenses incurred for those same qualified benefits through December 31, 2020; and by expanding the ability of taxpayers to make mid-year elections for health FSAs programs, allowing them to respond to changes in needs as a result of the COVID-19 pandemic.
Responds to Executive Order 13877, which directs the Secretary of the Treasury to "issue guidance to increase the amount of funds that can carry over without penalty at the end of the year for FSA arrangements" from $500, to a maximum of $550, as adjusted annually for inflation.
Dependent care Flexible Savings Accounts (FSAs) are set up with an individual’s employer who has agreed to participate in such a program. Roughly 85% of employers with 500 or more employees offer them. In those cases, workers authorize their employers to withhold funds from their paychecks each pay period for deposit to an FSA. The worker pays for “qualified” expenses out-of-pocket, and then applies for reimbursement from the account administrator by completing a claim form with receipts or proof of payment attached.
Dependent care FSA funds can only be used for reimbursements that meet the IRS’s definition of an eligible dependent care service. (i.e., care necessary for the participant and/or spouse to earn an income). Qualified expenses include physical care, in-home care, daycare service, summer day camps, before- and after-school care, caregiver transportation, and fees associated with obtaining care. Expenses that do not qualify include overnight camps, housekeeping, music and sports lessons, and education (e.g., kindergarten, summer school, private school tuition, etc.).
With millions of people currently out of work, dependent care has become an even more critical issue – perhaps even a looming liability – and a continuing burdensome expense for many American families. Families rely on childcare to facilitate their ability to work. Millions of others are responsible for the care of aging parents or disabled dependents. In short, workers who need care for children under age 13, or an adult incapable of self-care, who lives in their home and who can be legitimately claimed as a dependent on their federal tax form, may qualify for a dependent care FSA. Question is, in today’s Covid-19-plagued environment, how do workers spend FSA funds for dependent care if both their children’s school and/or their after-school facility is closed? The most obvious solution is to request that their employer stop deducting – or adjust – dependent care contributions. The new IRS guidelines make these requests possible… but do not require employer compliance.
In any event, FSAs in 2020 are more flexible for participants whose budgets have been upended by the Covid-19 pandemic. Under these revised (and probably temporary) IRS guidelines, employees can make mid-year changes – adjustments up or down – regarding their contribution amounts. But as before, no carryovers into the next dependent plan year are permitted.
The primary benefit of a dependent care FSA is its tax treatment. All money contributed to the account by a worker is considered pretax, which means employees don’t pay federal, Social Security or Medicare taxes on contributions. (And employers benefit, too. They don’t have to pay Social Security and Medicare taxes on the portion of employee salaries set aside in FSAs.) This effectively reduces the amount of a participant’s income subject to taxation – a significant savings depending upon one’s tax bracket and the amount of the contribution.
However, the IRS does limit the amount of money per annum that a worker can contribute to a dependent care FSA. More specifically, dependent care FSA participants can automatically put away a specified amount of money from their paychecks to spend on child and other qualified dependent care. But there is a catch – a “use it or lose it” feature. Yep, all money in a dependent care FSA must be spent before the plan year ends. Unspent funds are forfeited to the employer. Each worker can contribute up to $2,500 of earned income per plan year to cover qualified dependent care, or $5,000 for workers who are married, filing jointly. If a worker and his/her spouse are divorced, only the parent who has custody of the child(ren) is eligible to use FSA funds for childcare. If a couple is still married, both must work and earn income to qualify for reimbursement (unless one spouse is disabled and unable to work). If not, money contributed to the account will be forfeited to the employer and applicable taxes will become due.
Before the IRS rule changes, account participants were not permitted to adjust their contributions mid-year except in specific circumstances, including if a school closes, if the employee shifts to working from home, a marriage or divorce, the birth of a child, or some qualifying event that added or subtracted a dependent or spouse. The new IRS guidance allows companies to amend their plans that allow workers to opt into, drop out of, or adjust their contributions mid-year. And to repeat, these new IRS guidelines apply only if the employer chooses to amend its FSA plan (it’s anticipated that most employers will adopt the IRS guidance quickly).
Regarding money already contributed in the plan year, it must still be spent on qualified programs for kids under age 13 and/or for older dependents unable to care for themselves. The agency’s rule changes regarding both dependent care and healthcare FSAs are part of a larger federal government effort to provide affected households “some maneuvering room” under tax rules due to a job loss and/or reduced cash flow. A companion adjustment was that federal filing deadlines and tax payments were also postponed – to July 15. More on the healthcare FSAs in a later blog.