IRS modifies “use-it-or-lose-it” rule for health care FSAs
An essential trade-off for the tax benefits afforded by a §125 cafeteria plan is that the plan may not provide for the deferral of compensation from one tax year to the next. With respect to amounts contributed to a health care flexible spending accounts (FSA), this led to a “use-it-or-lose-it” rule that required the forfeiture of any unused benefits at the end of the Plan Year. As a consequence, many were unwilling to participate in such a program for fear of “over” contributing and losing hard-earned compensation.
To address this barrier to participation, the Internal Revenue Service (IRS), in 2005, modified the “use-it-or-lose-it” rule to allow employers to amend their cafeteria plans to permit a grace period of up to two-and-a-half months beyond the end of the Plan Year during which claims incurred during the grace period could be reimbursed using funds remaining in the FSA during the prior Plan Year.
Beginning in 2013, the Affordable Care Act (ACA) limited the amount to $2,500 participants could contribute to a health care FSA during a single tax year. While not directly addressing the “use-it-or-lose-it” rule, this contribution cap lessened the amount that might be “lost” at year-end.
The Notice 2013-71 Relief
Realizing the limitations of these relief efforts, the IRS issued Notice 2013-71 to allow employers to modify their §125 cafeteria plans to allow up to $500 in year-end health care FSA balances to be carried over to the immediately following plan year.
- Amending a cafeteria plan to allow carry-over amounts is optional, not mandatory, and employers can amend their plans to cap the carry-over amount at a lower figure. Adopting such an amendment would allow the unused balance remaining in a participant’s health care FSA at the end of the current Plan Year to be carried over to the following Plan Year, up to the cap set forth in the plan documents.
- These carry-over amounts will be available to reimburse the participant for medical expenses incurred during the entirety of that immediately following Plan Year.
- This carry-over amount is in addition to the $2,500 contribution limit for the Plan Year, so that a participant, who carried over $500 and elected to contribute the $2,500 maximum, would have $3,000 available to reimburse medical expenses during that Plan Year.
- Plans cannot, however, provide for both grace periods and carry-over amounts. If a cafeteria plan had a grace period feature and the employer wanted to include a carry-over feature, it would also have to amend the plan to remove the grace period feature. For those plans with grace periods, this poses a design choice. The grace period feature allows the use of the entire unused balance in the FSA at year-end, but limits the period during which it can be used, i.e. , the first two-and-a-half months of the following Plan Year. On the other hand, the carry-over relief allows for an extended reimbursement period, i.e. , the entire following Plan Year, but limits the amount of the unused FSA balance that can be utilized.
- Adding this carry-over option does not change the uniform coverage rule currently applicable to heath care FSAs – i.e., the amounts available from day one of the Plan Year will include the total elected to be contributed for the Plan Year, plus any amounts carried over from the prior Plan Year.
- Adding the carry-over provision also does not change the ability of a health care FSA to provide for a run-off period following the end of a Plan Year during which claims can be filed for reimbursement of medical expenses incurred during the prior Plan Year. Thus, carry-over amounts can be used for (i) claims filed during the run-off period for expenses incurred in the prior Plan Year, and (ii) any remaining carry-over amounts can be used to reimburse medical expenses incurred during the remainder of the current Plan Year.
- For administrative convenience, reimbursement for medical expenses incurred in the current Plan Year can be deemed to be first paid from carry-over amounts, and then from the amounts elected to be contributed for the current Plan Year.
Amending the Plan to Accommodate this Carryover Relief
To incorporate these changes to a §125 cafeteria plan, the plan must be amended on or before the last day of the Plan Year from which amounts may be carried over, and may be made effective retroactive to the first day of that Plan Year; provided, however, that participants have been notified of the change and the plan has been operated in accordance with the change during the Plan Year. If a plan has a grace period, the amendment must also eliminate the grace period, for the carry-over relief to become effective. A special rule allows that changes to be effective for the 2013 Plan Year may be made by the last day of the 2014 Plan Year. There is also transition relief for non-calendar-year cafeteria plans.
Despite this flexibility, employers with grace period plans may want to proceed with caution as to when this change might be implemented if the 2014 enrollment period has already ended. Those participants who counted on the availability of the grace period might feel that the change divested them of an option they had relied on in making their Open Enrollment elections. Delaying the change for a year, i.e., to be effective as of the 2015 Plan Year, could avoid potential employee challenges to the decision. In addition to this timing issue, employers will also have to think about which design option will work best for their workforce.
Employers considering these new design options for their health care FSAs might wish to consult with any of the Honigman attorneys listed on this Alert. We can help you assess the options, and prepare any amendments or document revisions that might be needed. We also stand ready to help with any ACA compliance issues or any other benefit matters that might concern you.