06 Nov IRS Modifies “Use-or-Lose” Rule for Flexible Spending Accounts (FSAs)

On October 31, 2013, the Internal Revenue Service (IRS) modified the longstanding cafeteria plan “use-or-lose” rule for health Flexible Spending Accounts/Arrangements (FSAs). Under this rule, unused FSA account balances are forfeited at the end of the plan year. Now, up to $500 of unused money may be carried over to the next plan year.

A cafeteria plan FSA, which is offered with other employer-established benefits, reimburses employees for qualified medical expenses. FSAs are usually funded by employees through voluntary salary reductions of up to $2,500 per year, though employers may also contribute. FSA contributions are not included in an employee’s income and reimbursements for qualified medical expenses are not taxed.

For nearly 30 years, FSAs have been subject to the “use-or-lose” rule. However, last year the IRS asked whether the rule should be modified to provide greater flexibility. The overwhelming response was yes. The reasons for increased flexibility include:

• Difficulties in predicting future medical expenditures
• Minimizing incentives for unnecessary spending to avoid forfeiture
• The possibility that lower paid employees are reluctant to participate in FSAs because even modest forfeitures can be significant
• Easing and simplifying the administration of FSAs

Under the new rule for cafeteria plan FSAs, employers may allow employees to carryover up to $500 of unused FSA money to the next plan year. Any amounts carried over may be used to pay or reimburse medical expenses incurred during that entire plan year. Employers have the option, not the obligation, to let employees carryover unused FSA money. And, since $500 is the maximum amount that can be carried over, employers may choose a lower amount.

Currently, cafeteria plans are allowed to have a “grace period” of up to two months and 15 days after the plan year during which participants may use remaining FSA money from the previous plan year to pay expenses incurred during the grace period. Since this is a popular feature among many plans, it is important to note that plans may provide employees with a carryover option OR a grace period. A health FSA cannot have both.

Employers wishing to utilize the new carryover option must amend their cafeteria plan. The amendment must be adopted on or before the last day of the plan year and may, in some cases, be effective retroactively to the first day of that plan year. Plans must also be amended to eliminate any grace period by no later than the end of that plan year, though the IRS notes that this may be subject to “non-code legal constraints.”

Given the complexity of providing and managing cafeteria plans, as well as the liability for getting it wrong, employers should consult with appropriate professionals to make sure their plans meet their minimum needs and provide maximum benefits.

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