The IRS has modified the “use it or lose it” rule for health flexible spending accounts (“health FSAs”) in cafeteria plans. See IRS Notice 2013-71. A health FSA in a cafeteria plan will now be permitted to allow participants to carry over up to $500 of unused salary reduction amounts to the next plan year. Previously under the “use it or lose it” rule, any unused amount in a health FSA at the end of a plan year was required to be forfeited. The details are a bit more complex.
Carryover Option vs. Grace Period
Since 2005, health FSAs have been permitted to use a “grace period.” Under this option, the health FSA may permit employees to use amounts remaining from the previous year to pay expenses incurred for qualified benefits during a period of up to two months and 15 days following the close of the plan year. This grace period is not required to be included in a health FSA, but many plans adopted it to ease the potential forfeiture of deferrals inherent under the “use it or lose it” rule.
The new carryover rule is fairly simple. An employer is permitted to amend its cafeteria plan to allow a carryover of up to $500 of unused amounts in a health FSA at the end of a plan year to be used to pay or reimburse qualified medical expenses under the FSA incurred any time during the following plan year. A written amendment is required, but the new rule allows the carryover to be put into place for the 2013 calendar year, provided that the formal plan amendment is adopted by December 31, 2014. The real key to making a change for the 2013 calendar year (or at any later time) will be communication with the employees about the change.
A health FSA is not obligated to use either of these rules designed to minimize the forfeiture of unused amounts. If a plan wishes to use one of these rules, however, the health FSA may choose to adopt either the new carryover rule or use the optional grace period. Both of these options may not be included in one plan. If a calendar year plan already has the grace period rule, and a decision is made to move to the carryover rule for the 2013 plan year, an amendment will be required by December 31, 2013 to remove the grace period provisions from the plan.
Effect on “Run Out” Claims and Annual Limits
Use of either the new carryover rule or the two month/15 day grace period has no effect on standard health FSA “run out” rules. Under a “run out” provision, a covered employee is given a reasonable period of time after the end of a plan year to present a claim for an expense incurred during the plan year but presented for payment after the end of the year.
The new rule also has no effect on the $2,500 salary reduction limit for health FSAs that was introduced by legislation for the 2013 year. The $2,500 limit remains unchanged for 2014. If a plan adopts the new carryover rule, an employee may carry over up to $500 of unused reimbursements and also elect an additional $2,500 in salary reduction for a health FSA.
To maximize use of the run out period and to reduce the need for a carryover, the IRS guidance permits a health FSA to treat claims for expenses that are incurred in a current plan year to be reimbursed first from amounts credited for the current year. This rule is recommended if the health FSA is going to adopt the new carryover rule.
There is no change in the general FSA rule that prohibits unused deferral amounts to be cashed out or converted to any other taxable or non-taxable benefits.
Should You Act Now?
If action is taken promptly, a calendar year health FSA can be amended for the 2013 plan year to allow participants to carry over up to the $500 maximum of any unused amount remaining in the FSA at yearend. To take this step in 2013 will require immediate communication with employees about the change. If this is done, and the plan has previously adopted the grace period rule, it will be especially important to advise employees that the grace period rule will no longer apply to any unused amounts at the end of the year and to adopt a plan amendment by December 31, 2013.
Because the 2013 plan year may be nearly over for many plans, changing the rule for 2013 deferrals could be disruptive, unless the plan never adopted the grace period. A more measured response to this planning opportunity for plans that use the grace period rule will be to adopt the carryover rule for 2014 and leave in place the grace period for the 2013 amounts.
Communicating a change to the new carryover rule for the 2014 plan year is nonetheless an important immediate step because it will allow more flexibility to participants in their decisions on the 2014 salary reductions for the health FSA.
If the health FSA runs on a year other than the calendar year, and in circumstances where a cafeteria plan participant may be purchasing health care coverage through an exchange under the Affordable Care Act, there are some transition rules that will apply. There is a description and reference to these transition rules in IRS Notice 2013-71.
If you have any questions about this memorandum, including the transition rules, please contact Dan Sharpe in our Buffalo office (716-566-2846; firstname.lastname@example.org). You may also contact one of the other members of our Employee Benefits and Executive Compensation Practice Group listed below.